Could Secondaries Wipe Out the Primary Fundraising Market?

Could the active secondary market ruin the primary fundraising market for next year? It’s a long shot, but so was missing capital calls, we thought.

The question was posed by Mac Hofeditz of Probitas Partners at the recent Buyouts West conference, based on a thesis that secondaries are too cheap to pass up.  Why would you pay full price for a piece of Carlyle Partners V when you can get exposure to the same managers in Carlyle Partners IV at a deep discount?

Think about it. Just two years ago, secondary buyers were paying premiums for access to top-tier firms like they were memberships to exclusive clubs, said John Poerink of LJH Linley Capital. Now, it’s open enrollment season, and at bargain prices. For example, The Financial Times and Bloomberg this morning reported discounts as high as 50% and 65% on funds from Madison Dearborn, TPG, KKR and Terra Firma.

The problem with this argument, however, is that it doesn’t consider the motivations of sellers on the secondary market. Most LPs are selling because of (1) Liquidity issues, or (2) They want to cut bait on a particularly disastrous fund. The deepest discounts are on the latter — TPG Partners V, with Harrah’s, part of WaMu and the recently downgraded Saber, comes to mind. The attractive pricing doesn’t justify the risk associated with go-go-era covenant lite, overleveraged mega-buyouts that may be headed for default.

Even portfolios formed before the boom in ’04 and ’05 are packed with companies leveraged to the hilt, since their owners were happy to recap while liquidity was cheap and easy.

Lastly, if an investor really wants exposure to an exclusive brand-name fund, why bother with a tainted, boom-era effort? Why not just start fresh with some of the big funds currently struggling to meet their targets, a secondary buyer argued.

So, it seems unlikely that the primary market be completely wiped out by secondary action. More likely is the secondary market topping the primary market dollars spent next year. The Bloomberg report estimated roughly $100 billion, or 10% of the world’s $1.2 trillion private equity interests, could change hands in the next year. (That’s up from a mere 1% in 2007.)

Meanwhile, 2008 fundraising as of September is $339 billion, and last year total was $322 billion. We can only assume next year will be down significantly, considering the denominator effect of shrinking investor portfolios and the resulting over-allocation to private equity, not to mention worries over LP liquidity and lowering of targets by marquee firms in 2008. Besides, firms are spending much at a much, much slower pace than in past years. The need to return to market is a distant concern.

So if Bloomberg’s prediction is correct, then secondary activity could top fundraising in the primary market in 2009. But it won’t replace it altogether.