Wealth managers make up a tiny portion of the secondary private equity markets, but they’re making their voices heard.
Financial advisors are increasingly helping wealthy families give investments as gifts, according to NYPPEX Private Markets, a New York-based private equity transfer administrator, and the movement is having an impact on private equity secondary markets.
In its 2017 midyear report, NYPPEX says that it observed more donors making non-cash gifts, and more non-profit organizations accepting such gifts and selling them via its platform.
“In the past five years, there’s been a trend where more gifts are being made in non-cash form, but now this is going a step further into the private equity markets,” says Laurence Allen, managing member of NYPPEX. “We’re seeing a lot of this behind the scenes.”
NYPPEX says the trend is being driven by the growth of holistic wealth management and by clients seeking tax benefits and flexibility in their philanthropic initiatives.
During the second half of 2017, NYPPEX is recommending that wealth managers who handle alternative investments take steps to facilitate gifts and transfers of private equity assets on behalf of their clients.
Whereas the private equity industry has traditionally looked toward wealth managers as a potential sales force for limited partnership or direct offerings, today’s individual private equity buyers have an advantage when investing with an advisor, says Allen.
“Private wealth advisors, especially a multi-family office or RIA, are more proactive with the way they’re handling these investments,” says Allen. “Let’s say an investor is two years into one of these investments and a key partner dies. The client might not feel comfortable being a part of the partnership anymore, but they can turn to the advisor for guidance.”
Allen says that the secondary private equity market should be attractive to the wealth management industry because of the cyclical nature of private investments.
Funds tend to go through a growth period of one to five years, during which they accumulate assets and the general partners make investments and call capital back, but the end investor receives little or no return. After the growth period, there’s typically a one-to-five-year harvesting period where the investor receives cash distributions. On the secondary market, private clients can access limited partnerships close to or at the harvesting period and avoid waiting while the fund is grown and invested.
Investors on the secondary market should be able to generate an even higher internal rate of return from acquisitions made in 2017, as cash distributions will likely be received quickly after purchase, says NYPPEX.
Advisors’ presence is also being felt within the secondary private equity market as they rebalance client accounts, says Allen.
“The secondary market is all about risk management, because if someone is unhappy with a private equity investment, they have a means to get out of it,” he says. “Since right now there’s more capital than supply, they’re not having to sell at a big discount.”
Many wealth managers and some wealth management software programs now actively rebalance client private equity and direct investment portfolios, which has created selling and buying activity on the secondary market.
Yet private client transactions only accounted for 7 percent of the overall volume on the secondary private equity market, says Allen.
“These private clients are increasingly important, though, because certain big institutions like pensions are probably decreasing in size over the long term,” says Allen. “We’re only reaching the tip of the iceberg with private wealth clients and advisors for this asset class.”
According to the report, the volume of secondary transactions for limited partner interests in private equity funds increased significantly during the second quarter.
NYPPEX estimates that the limited partnership secondary transaction volume increased by 14 percent in the first half of 2017 to $20.6 billion for limited partner interests in private equity funds.
Volume increased from $8.5 billion in transactions in the first quarter to $12.1 billion in the second quarter.
The volume of secondary private equity fund transactions should break the $40.6 billion record set in 2015, says NYPPEX, which estimates that total secondary transaction volume should exceed $41 billion for 2017.
The secondary limited partnership market should continue to grow, says NYPPEX. The researchers estimate that buyers in the secondary market are sitting on $145 billion in cash and leverage.
“Right now, there’s more capital looking for secondary offerings than there are secondary offerings,” says Allen.
After three years of declines in private equity fund cash flows, the market should also have more sellers, he says. Institutional investors like endowments, foundations, insurance companies and sovereign wealth funds are pressured to sell on the secondary market as they struggle to meet their annual funding obligations.
Among private clients, divorce, death, price volatility and regulation are also driving the sale of private investments on the secondary market.
“Anything that causes an adverse change in financial profile also drives selling activity,” he says. “There are wealthy families in emerging market countries with commodity-based economies dealing with the volatility in oil prices who are faced with sell decisions, for example.”
In the first quarter of 2017, the annualized rate of net cash flow going to limited partners declined from 2.57 percent to 1.96 percent, a 24 percent decline. For reference, limited partners enjoyed a 3.17 percent net cash flow rate in 2015 and a 3.18 percent net cash flow rate in 2014. As private equity income declines, more limited partners will sell their investments to raise cash, according to NYPPEX.
Bid prices on the secondary market peaked in early June, then declined, likely because of buyers’ concerns that tax reform could be delayed by political gridlock in the U.S. Congress. However, since supply and demand could move together for the remainder of the year, prices on the LP secondary market will remain near historical highs.
