Transacting in the Open-End Fund Secondary Market
Overview
While secondary markets are common in the closed-end fund space, there are also mature real estate secondary markets in the open-end fund space. The open-end secondary market first emerged in Europe and has witnessed considerable growth in the U.S. over the past five years.
The open-end funds offer enhanced liquidity to investors compared to the closed-end fund vehicles, but liquidity is not guaranteed. Open-end funds price quarterly and investors face timing considerations when submitting subscription and redemption requests. Investment managers have discretion over the timing of honoring redemption requests, which, like subscriptions, are assigned at net asset value (NAV)– often creating entry and exit queues when the supply and demand are imbalanced. The result may be that the investor is open to potential valuation pricing movements that may occur in between these entry/exit times, particularly in uncertain environments. Liquidity may be less available during these times, as managers may elect not to accept contributions or pay redemptions by “gating” entry/exit to the fund, which occurs in the open-end fund universe to protect investors until prices stabilize or transaction activity resumes.
The secondary market offers buyers and sellers improved liquidity in the open-end fund market. However, liquidity often comes at a cost. Depending on the fund structure, incoming investors may circumvent the entry queue and outgoing investors may achieve liquidity via the secondary mechanism. Open-end fund secondaries can take between 2-6 weeks to complete, depending on the fund requirements and legal agreements needed to accommodate trades, such as KYC and transfer/assumption documentation. While most open-end funds in the U.S. allow for secondary trades to take place, there are a few exceptions. New managers launching open-end funds should take this element into consideration during the structuring process.
An important factor to consider when utilizing the secondary market for liquidity is the transaction price: buyers and sellers generally transact at a discount or premium to the latest quarterly NAV. Discounts and premiums are primarily dependent on the buyer/seller appetite, motivation to circumvent any entry or exit queue, fund exposures and ease of the transaction process with the fund. For example, a buyer of interests in an open-end industrial fund may pay a premium to NAV to skip an entrance queue and gain exposure to a preferred property type at a time when they believe the sector is poised to outperform. On the other hand, a seller facing liquidity issues at the portfolio level may be willing to exit another open-end fund position at a discount for the sake of liquidity. Outside of more urgent scenarios, the regular rebalancing of core and core-plus positions is historically the main driving factor behind secondary activity. Today, buyers of secondary interests can acquire or dispose of positions in funds ranging from an 8% discount to a 3% premium to NAV, depending on the fund and the NAV reference date used in the transaction.
Core Secondary Transaction Volume
Recent uncertainty surrounding portfolio valuations remains the most significant investor concern, leading to reduced or limited transaction volume. Pressure on managers to satisfy redemption requests continues, with exit queues aggregating to over $15 billion for NFI-ODCE funds as of Second Quarter 2020. That is offset by entrance queues totaling over $2 billion.
In the First Half of 2020, as a result of COVID-19, transaction volume in the real estate secondary markets was severely affected, reflecting the lack of transactional and subsequent valuation data across most alternative asset classes. According to Phil Barker, who leads the secondary advisory business for CBRE Capital Advisors, the investment banking arm of CBRE Inc., First Quarter 2020 real estate secondary trades were interrupted before quarter-end. “If a transaction wasn’t signed and watertight, it didn’t close.” CBRE Capital Advisors’ brokerage team had executed over $2 billion of real estate secondary Limited Partner fund transfers through their global advisory platform in 2019, evenly spaced across the year.
Buyers of open-end fund units in the secondary or primary fund market sought either a substantial discount to prevailing NAV’s corresponding with the decline in the equity markets or were on hold, waiting for valuation drops to materialize in the private markets. After evaluating their private real estate portfolio exposures, sellers were not ready to transact at the steeply discounted secondary pricing due to the market’s significant uncertainty. Additionally, both buyers and sellers faced unprecedented challenges of having to conduct all due diligence virtually. The result was a pause in secondary market trading activity at the onset of the COVID-19 pandemic and a rush of redemption requests in the diversified open-end funds.
Core Open-End Fund Redemption Activity
Redemption activity increased in the first three quarters of 2020 for the following reasons:
Rebalancing needs due to total plan asset declines
Balance sheet stress
Rebalancing desires/hope to take advantage of the precipitous decline in equities
House view that real estate values will be disproportionately impacted in the future
Reducing exposure to underperforming managers and/or property types
Managers with overweight positions in adversely impacted sectors
Investors recognize there is an opportunity cost to holding an underperforming position long-term and continue to ask themselves, “where can we derive the most value, and is it worth making capital available for that strategy?”
Current secondary market conditions
In First Quarter 2020, there was an increase in redemption requests for open-end fund vehicles and a sharp decrease in commitment activity (due to concerns about NAV declines). Motivated sellers emerged in late Second Quarter and throughout Third Quarter seeking to expedite an exit from certain positions. CBRE Capital Advisors notes that their team has executed ~$1.7 billion of notional volume in the last five months, with the break-down consisting of approximately 30% in North America, 20% in the U.K. and the balance in European funds. The number of trades has decreased year-over-year, but the average deal size has increased.
CBRE Capital Advisors notes: “Sellers were more willing to accept modest discounts to their valuations in exchange for an exit at a known price at a known date, rather than wait in redemption queues with uncertainty of timing and NAV. Conversely, there are now many buyers willing to buy into real estate funds at these discounts rather than wait for continued NAV declines”, Barker says. Adding that the majority of the U.S. buying they are seeing is from overseas institutional players looking to invest in the U.S. for the continued accretive relative returns compared to their domestic markets – particularly from Asia and Europe. “The discounts traded appear to be a reasonable reflection of the anticipated NAV movements coupled with some liquidity premium (to the buyer). This is a rare example of a win/win situation as the buyers achieve discounted entry levels while the sellers obtain liquidity for illiquid positions, often allowing them to participate in other investments that have a higher anticipated return profile, such as the public traded equities or distressed assets in the physical market”.
Buyers of Secondary Units
Asian and European buyers dominated recent secondary market activity, but interest globally was comprised of the following groups:
Pensions & Endowments seeking core/core-plus returns
Consultants, for their advisory and discretionary clients
Global Multi-Manager platforms
Interval and Market Tracker Fund of Funds
Dedicated Secondary Fund of Funds (limited due to return profile)
Key Takeaways
According to investors and brokers seeking to trade on the secondary market, a considerable increase in transaction and activity results from sellers and buyers understanding their overall portfolio needs and forming more consensus around current and future pricing.
Over the past five years, industry participants have increased their understanding and acceptance of the secondary market mechanism by Limited Partners.
Compared to 1Q2020, late 2Q2020 and 3Q2020 actions indicate that significant price discovery is taking place, bringing sellers and buyers closer to agreements and transactions. As price valuation adjustments have worked their way through 2020, secondary pricing is starting to settle in the low single-digit discount range and, in some cases, small premiums.
Fund managers are increasingly aware of the benefits of facilitating secondaries in their fund vehicles to satisfy entry and particularly exit queue imbalances.
Transacting on the secondary market offers investors (and investment managers) the following benefits:
Ability to transact when traditional avenues may be limited
Reduced pressure on selling assets to satisfy the redemption queue
Access to a new and diverse pool of fund investors
Ability to acquire or redeem interests at discounts or premiums to NAV
More control of the timing of investment entry and exit points
About Alliance Global Advisors
Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with approximately $80 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.
Disclaimer: This blog was originally published on October 29, 2020 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.