Secondary market offers permanent capital for managers and an exit option for investors
Before 2008, the secondary market for hedge fund interests was dominated by investors willing to pay a premium to gain access to closed funds.
The global financial crisis turned that market on its head. Even top-flight hedge fund managers couldn’t sell portfolio assets they had considered liquid and, as a result, they gated or suspended withdrawals from their funds by limited partners who were desperate for cash or terrified at the prospect of losing their investments. Resale premiums quickly gave way to discounts, in some cases as deep as 85% of reported net asset values.
Now, four years later, the hedge fund resale market is bristling once again, only this time it’s appealing to a much wider audience. Currently estimated at $65 billion, the market not only serves sellers cashing out of poor performing hedge funds or funds-of-funds facing substantial redemptions, but also buyers looking to ‘average-down’ their existing positions in top-performing hedge funds or to enter into closed funds. One recent survey projects that the market will more than double in size in the next twelve months.
Discounts today in the hedge fund secondary market range from 15-25% of reported NAVs for top-shelf funds while illiquid ‘side pockets’ and liquidating funds are being marked down by as much as 70%-80%. The average price reduction across the entire secondary hedge fund market is just over 50%.
Private equity resales are even more voluminous than hedge fund transfers. In the first half of 2012, $13 billion of PE fund interests were traded in the secondary market and as much as $70 billion of such interests are currently reported to be on offer. Reportedly also, more than 60% of PE investors have already accessed the secondary market as buyers or sellers or expect to do so in the next 2-3 years. The average high bid across the market is about 80% of reported NAV.
The most active players in the PE secondary market are large financial institutions and pension funds (such as CalPERS, Ontario Municipal Employees Retirement System (OMERS) and the New York City Retirement Systems to name just a few). The buy-side is represented primarily by 10-15 large private funds formed specifically to acquire PE interests in the secondary market (such as AXA Private Equity, HarbourVest Partners, Lexington Capital, Coller International and Partners Group).
Major sellers of PE interests are pruning their PE portfolios of underperforming PE managers on the ground that too many relationships drive performance toward the median. CalPERS, for example, has more than 350 PE fund managers in its stable. The largest and most sophisticated public pension plans expect more concentrated and selective PE portfolios to improve returns, and one, OMERS, has begun to shift from investing in PE funds to direct investing in operating companies. Another, the State of Wisconsin Investment Board, just culled from its PE portfolio three managers that have gone public (Blackstone, KKR and Carlyle), viewing them as more focused on the short-term interests of their shareholders than on the long-term concerns of their limited partners.
To date, neither the hedge fund nor the private equity fund secondary market is centralized or automated. Buyers and sellers in both markets are matched either by the funds themselves or by a growing list of secondary market brokers who are paid commissions by one or both sides of the transaction and who do not take positions or make markets in fund interests. Trades are carried out between the parties (and their counsel) and generally take from 3 to 4 months to complete due diligence, price negotiations, transfer documentation and settlement.
To date, neither the hedge fund nor the private equity fund secondary market is centralized or automated. Buyers and sellers in both markets are matched either by the funds themselves or by a growing list of secondary market brokers who are paid commissions by one or both sides of the transaction and who do not take positions or make markets in fund interests.
Several new secondary market electronic platforms for both hedge funds and PE funds are in various stages of development, and the emergence of a bona fide electronic exchange for secondary interests would provide GPs with the prospect of permanent capital and LPs with a more liquid alternative to scheduled hedge fund redemptions or unlimited PE lock-ups.
Legally, HF interests and PE interests cannot be traded without general partner approval. For hedge funds, the only issue is whether would-be buyers meet their financial qualifications. For PE funds, however, there may also be credit issues if requested transfers occur before investor commitments have been fully drawn down. Even absent these concerns, however, some GPs will simply not approve secondary market transactions because, in their view, discount trades in fund interests erode the value of their brands.
There is one additional legal constraint that affects all hedge funds and PE funds with more than 100 investors. It’s called a publicly traded partnership (“PTP”) and it’s a tax classification with which no private fund wants to be branded. Without going into painful detail, most funds are conservatively advised by counsel not to allow more than 2% of their interests (or profits) to be transferred in any year. More than that amount of secondary traffic could result in their being deemed to be PTPs and taxed, not as partnerships, but as corporations. In the U.S., that would be very bad news for both fund managers and investors.