Is the liquidity crunch over for institutional investors in private equity?

Not by a long shot, but the secondary private equity market appears to be making strange, even contrarian moves. Up until the first quarter of this year, the secondary market was rife with predictions of an explosion in sales of private equity assets, such as limited partnership interests in private equity funds or portfolios of direct investments. Industry trackers such as Cogent Partners of Dallas initially anticipated that more than $30 billion would change hands in 2008, with a further $45 billion in 2009.

Though it's difficult to capture hard data on actual sales, current estimates are much more modest -- with the volume of deals this year probably dwindling to about half of last year's, according to industry practitioners. By all accounts, transactions in the first half of 2009 are only about 50% of what they were in the first half of 2008. "There are some who believe that if you think last year's volume was between $15 billion to $20 billion, it's not inconceivable that the volume this year will be around $10 billion," says Nigel Dawn, co-head of UBS' private funds group.

This seems counterintuitive. Expectations have run high for the secondary market. After Lehman Brothers Holdings Inc. collapsed in September, many institutional investors, primarily pension funds and endowments that usually make up private equity's LP base, were bedeviled by liquidity issues. The public market's precipitous decline left investors overcommitted to illiquid alternative assets, presaging wholesale rejiggering of portfolios. Add to that the delayed impact of full year mark-to-market accounting for 2008, and you would expect an avalanche of dealflow, or so experts predicted.

Things haven't worked out that way, though. The pressure to sell has eased, at least for now, because capital calls have slowed dramatically amid too few deals. "Markets are trading at roughly 50 cents to 60 cents on the dollar, whereas they were much closer to par last year," says Dawn. "You actually might have a similar notional trading, but the actual price -- cash plus unfunded obligation assumed -- will be lower, given the discounts associated with transactions."

The really distressed or liquidity-constrained investors have already passed through the market, observers argue, and bid-ask spreads have narrowed. "It's not too dissimilar from when the technology bubble burst, as secondary market investors had to recalibrate their pricing expectations, and buyers had to get used to the risks they were being asked to accept," says Tristram Perkins, managing director at Neuberger Berman LLC's secondary private equity unit.

More than anything, pricing an asset has been tougher than ever. "The challenge for getting it right has never been bigger," says Michael Granoff, CEO of New York specialist investor Pomona Capital, which completed a $1.3 billion secondary market fund in July. Pomona plumbed $40 billion worth of dealflow last year, more than twice the previous year's, and bought less than 1% of "doable" deals, versus the 3% to 5% of dealflow that it usually completes.

SecondMarket Inc., a New York-based online marketplace for illiquid assets that launched its private equity listings in February, has listed $1 billion in LP interests but has closed only on a handful of sales. Sellers are just not willing to take the haircuts, says SecondMarket director Jeffrey Bollerman.

Still, almost every LP in private equity who had expected PE assets to be self-funded -- with distributions being funneled back into capital calls -- will want some liquidity from these assets once capital calls resume.

Specialist funds, with about $27 billion in commitments raised last year alone, have to park that money somewhere.

"Buyers will increase their prices," Dawn says.

Equally compelling is the amount of private equity overhang -- nearly $200 billion -- in the hands of the largest buyout funds, raised in the past two years and waiting to be called.

If secondary markets lag primary markets, the golden years for secondaries may yet materialize.