Morgan Stanley Exec. Predicts Major Growth In Secondaries

Dec 15 2006 | 12:11pm ET

By Hung Tran 

Back in 1997, the secondary market was less viable than it is today, with few firms engaged in it in an “unorganized manner,” recalls John Wolak executive director at Morgan Stanley Alternative Investment Partners. Today, the market is experiencing strong growth with more buyers, sellers and intermediaries.

“Virtually any deal today greater than $25 million in size is being sold through an auction process, which is quite competitive and priced at premiums at asset value,” said Wolak, speaking at a recent conference in New York sponsored by IncreMental Advantage.

Secondary Only In Name
Historically, the secondary market was where distressed sellers went to get out of an asset class, and while that still holds true today, Wolak said that investors increasingly view the secondary market as a portfolio management tool. “They’re looking for liquidity options in advance of liquidations provided by the general partners, and it’s becoming a broader market in the sense that it’s not only related to distressed sellers,” he said.

Sellers, including pension funds, are employing auctions to maximize their portfolios’ value with larger trades having taken place within the last few years on the order of $500 million to $800 million, according to Wolak. 

General partners have taken notice of investors’ interests in the secondary market and are looking to take advantage of their positions by utilizing stapled primary-secondary to get value out of the transfers as well as shape their investor base. “Quite often they’re looking for a substitute LP to invest in their next fund, and they don’t necessarily want a pure secondary player to buy their paper,” explained Wolak. “Really, what they’ve been trying to do is either approve or disapprove transfers to different buyers.”

Secondary Trends
One trend that is taking place among buyers is that they see secondary investments as less risky than investing in blind pools of GPs’ primary funds because they can look at each underlying company in each portfolio, price them out and understand what they’re buying, said Wolak. As a result, deals are bid down to lower-to-mid teens with fewer discount-driven deals.

A second trend among buyers is the continuing usage of widely available leverage to buy secondary portfolios.

Also, there is a third trend is occurring within the fund of funds universe, involving the convergence of primary funds of funds, which invests in blind pools of GP funds, and secondary funds of funds, which invest solely in secondary LP interests. “We believe primaries and secondaries are a bit countercyclical and complimentary with the market right now quite strong for primary fundraising,” said Wolak.

This year, by Wolak’s estimates, there is some $400 billion of capital committed to p.e. funds worldwide and an estimated $10 billion to $14 billion available annually for the purchase of secondary LPs. Going forward, Wolak says some $25 billion can “easily” be raised for the secondary market within the next few years.

Morgan Stanley AIP typically allocates between 10% and 15% of its assets to secondary transactions, but doesn’t manage separate secondary funds, according to Wolak. The firm performs due diligence on GPs and also spends a lot of time going through their forecasts, exit timing and valuation methodology. “GPs are so busy with raising and investing capital, but if they have a sense that you’re going to be a follow-on investor in their next fund, then they’ll be quite willing to spend the time with you,” said Wolak.

A More Direct Approach
The so-called direct secondary market, where investors take direct interest in the underlying companies and responsibility for managing those assets, is also a nascent marketplace on the rise, according to Wolak, who estimates that there have been 80 transactions since 2002 totaling some $4 billion.

Since 2000, the average time to liquidity for a private equity deal has more than doubled from 2.4 years to 5.4 years, so holding periods, particularly for venture capital deals, are extending out very significantly, said Wolak.

“People are holding assets longer and investors are getting itchy and want to get their money out.” 

Direct secondary investments really began taking off between 2001 and 2002 when VC subsidiaries experienced massive drawdowns when the tech bubble burst, he explains. “There were a number of very high profile transactions, with companies like Lucent, Motorola and Shell, where buyers of those assets made significantly returns.”

Today, direct secondary investors are targeting venture and buyout groups and buying the tail end of their dated portfolios so they could concentrate on raising their latest funds.

“Recently, Warburg Pincus did a deal with company that they had in their portfolio for five years and I think this is something that would likely be a trend going forward,” Wolak said.

Morgan Stanley AIP was recently involved in a so-called synthetic direct secondary investment deal, acquiring a portfolio of direct investments and hiring a portfolio manager to manage those assets, according to Wolak, who also believes that this type of transaction will become more common going forward.


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