Secondary Private Equity Funds: The Perfect Storm

Who is Selling and How Much?

Limited Partners (LPs) of private equity funds seeking liquidity are selling LP fund stakes, particularly in early stage funds. General Partners (GPs) of private equity firms are selling direct company investments (directs) in part or in whole, particularly those who do not have adequate follow-on capital and 'tail-end' funds, which are in the last few years of a fund's life cycle and have yet to fully exit due to the macro-economic slowdown. Finally, corporate and strategic investors are selling both LP and direct investments as a function of divesting non-core assets.

Often, new CEO's are charged with cleaning up the balance sheet – and where better to start then with assets that have not been marked to market price? Foreign banks, which once generously invested in U.S. based private equity funds are currently seeking to reduce their exposure to this asset class in order to focus on domestic issues. US banks and insurance companies have begun reducing their private equity positions to enhance capital positions and reduce earnings volatility. Finally, corporate pension funds, in light of the merger and downsizing activity that has occurred from 2000 to present, have changed their focus. In a merger situation, cash on the books is much more beneficial than illiquid assets, as in many mergers, the parent has divested of the acquired private equity portfolio.

The Perfect Storm: Motivations for Selling and Market Drivers?

This is an advantageous time to acquire private equity secondary interests based on supply, discounted valuations, higher rates of return, the rapid deployment of capital and more important, the quicker distribution of returns. When simply looking at supply and demand, the timing is fortuitous. However, other factors have aligned that make this an interesting time in the secondary market.

Distress. The single most important driver of secondary direct sales is a poor macroeconomic environment, including liquidity pressures and poor operating performance. With the overall decline in the performance of equities and a 3-year recession, many LPs are experiencing a liquidity crisis and cannot meet capital calls. Likewise, many GPs do not have sufficient follow-on capital available to protect their current investments from the dilution created now with the preferences put on recent fundraising rounds.

On the corporate front, many corporate venture funds are a drag on earnings due to the write-downs that must be taken in conjunction with the long holding periods required before returns are realized. Responding to such pressures and the corresponding inability to make follow-on investments in their portfolio, corporations are choosing wholesale asset dispositions at heavy discounts to market value. They would rather realize some capital back than merely wait and hold to see their ownership stakes inevitably diluted down by other investors to such small levels as to be essentially worthless.

Higher Returns and Diversification. Another market driver is that over a lone period of time, private equity returns are higher than other asset classes. Generally speaking, private equity has out performed the other indexes over the past twenty years. Since 1982, there has been a 16.9% return net of all fees and carried interest for private equity (compared to 12.4% (Dow), 11.5% (S&P 500), 11.2% (Nasdaq)). Superior return is the primary reason why private equity is an asset allocation. Diversification is another reason.

Reduced Risks for Buyers. Private Equity funds typically have ten-year terms, often with limited 1-year extensions. In most cases, a fund's investments are made through years 1-5, with harvesting occurring in the latter years. The highest level of investment risk is during the early years, or through the trough of the “J” curve, after initial investments have been made. Secondary acquisitions, which often take place after this period, obtain the benefit of reduced risk without reduction of potential return.

Secondary buyers have the opportunity to further reduce risk through pricing based on the analysis of the value and return potential of a seasoned basket of assets. A secondary investor acquires a secondary portfolio where the assets in the portfolio are at a point of maturity since the non-maturing assets have largely been written off. The performing assets are growing and closer to a liquidity event, but still held at conservative valuations – frequently at cost.

Thus, as secondary acquisitions generally occur at a discount from reported values and have a shorter period to investment realization, secondary buyers can receive higher returns with lower risks relative to the sellers of the partnership interests.

Corporate Restructuring. Another driver of sales is merger and acquisition activity that creates excess corporate baggage and 'orphan funds.' As companies merge, corporate funds are divested, such as in the merger of Wachovia Capital with First Union ' a transaction which led to the spin-off of the bank's direct investments in 2002. Likewise, National Westminster Bank sold three portfolios to Coller Capital during a hostile takeover by the Royal Bank of Scotland in 2000 (See Charles Fleming, “UK: Deals and Deal Makers ' Secondary Funds Go Hunting For Private-Equity Holdings,” The Wall Street Journal, January 6, 2000.) Similarly, bankruptcies, such as that of Global Crossings, yield divestitures or spin offs of direct portfolios. Corporate venture funds often fall victim to cost cutting measures, as venture assets are often costly to maintain and operate. As a result, many corporations seek to dilute or remove the cost of the venture program directly from the parent's balance sheet by sale. Today, they have the ability to retain strategic relations with the portfolio through a spin-off of assets as part of an MBO or other private equity sponsored play, where they retain a small percentage of ownership in the new entity.

Shareholder Pressure. Justifying a private equity program without a euphoric market is a tough argument to make to shareholders and corporate boards. Investors are increasingly pressuring companies to reduce areas of volatility in their business, even at the loss of potential long-term growth, to generate consistent returns. Private equity has created a great deal of volatility in corporate earnings, particularly in banks. Additionally, another difficulty is the ongoing cost of managing a portfolio, which include, at a minimum: dedicated corporate fund managers (who are typically higher paid than their divisional counterparts), reporting, legal, and relationship management personnel, in addition to general administrative costs.

The recent growth and maturity of the private equity market has generated significant secondary market opportunities. In a maturing private equity industry, the secondary market has become increasingly viewed as a tool for private equity portfolio management and a source of liquidity, in a relatively illiquid market.

Historically, approximately 2-3% of all private equity commitments turn over in the secondary market. Over $860 billion of private equity was raised from 1997-2002 (VentureEconomics). Based on this data, Landmark Partners, a dedicated secondary investor, estimates the volume of secondary activity generated from these commitments to approach $22 billion or approximately $2 billion annually over the next decade.

Secondary funds have currently raised nearly $14 billion to buy existing primary investments in private equity funds and direct company investments. Transaction projections, compiled by Colu- mbia Strategy, LLC, estimate that between $6 to $16 billion of secondary deals will be completed by 2006. This “dry powder” represents both opportunities and challenges for buyer and seller alike. This article outlines the unique forces driving the current secondary market and the associated transactional risks and opportunities it presents to the private equity industry.

Who is Selling and How Much?

Limited Partners (LPs) of private equity funds seeking liquidity are selling LP fund stakes, particularly in early stage funds. General Partners (GPs) of private equity firms are selling direct company investments (directs) in part or in whole, particularly those who do not have adequate follow-on capital and 'tail-end' funds, which are in the last few years of a fund's life cycle and have yet to fully exit due to the macro-economic slowdown. Finally, corporate and strategic investors are selling both LP and direct investments as a function of divesting non-core assets.

Often, new CEO's are charged with cleaning up the balance sheet – and where better to start then with assets that have not been marked to market price? Foreign banks, which once generously invested in U.S. based private equity funds are currently seeking to reduce their exposure to this asset class in order to focus on domestic issues. US banks and insurance companies have begun reducing their private equity positions to enhance capital positions and reduce earnings volatility. Finally, corporate pension funds, in light of the merger and downsizing activity that has occurred from 2000 to present, have changed their focus. In a merger situation, cash on the books is much more beneficial than illiquid assets, as in many mergers, the parent has divested of the acquired private equity portfolio.

The Perfect Storm: Motivations for Selling and Market Drivers?

This is an advantageous time to acquire private equity secondary interests based on supply, discounted valuations, higher rates of return, the rapid deployment of capital and more important, the quicker distribution of returns. When simply looking at supply and demand, the timing is fortuitous. However, other factors have aligned that make this an interesting time in the secondary market.

Distress. The single most important driver of secondary direct sales is a poor macroeconomic environment, including liquidity pressures and poor operating performance. With the overall decline in the performance of equities and a 3-year recession, many LPs are experiencing a liquidity crisis and cannot meet capital calls. Likewise, many GPs do not have sufficient follow-on capital available to protect their current investments from the dilution created now with the preferences put on recent fundraising rounds.

On the corporate front, many corporate venture funds are a drag on earnings due to the write-downs that must be taken in conjunction with the long holding periods required before returns are realized. Responding to such pressures and the corresponding inability to make follow-on investments in their portfolio, corporations are choosing wholesale asset dispositions at heavy discounts to market value. They would rather realize some capital back than merely wait and hold to see their ownership stakes inevitably diluted down by other investors to such small levels as to be essentially worthless.

Higher Returns and Diversification. Another market driver is that over a lone period of time, private equity returns are higher than other asset classes. Generally speaking, private equity has out performed the other indexes over the past twenty years. Since 1982, there has been a 16.9% return net of all fees and carried interest for private equity (compared to 12.4% (Dow), 11.5% (S&P 500), 11.2% (Nasdaq)). Superior return is the primary reason why private equity is an asset allocation. Diversification is another reason.

Reduced Risks for Buyers. Private Equity funds typically have ten-year terms, often with limited 1-year extensions. In most cases, a fund's investments are made through years 1-5, with harvesting occurring in the latter years. The highest level of investment risk is during the early years, or through the trough of the “J” curve, after initial investments have been made. Secondary acquisitions, which often take place after this period, obtain the benefit of reduced risk without reduction of potential return.

Secondary buyers have the opportunity to further reduce risk through pricing based on the analysis of the value and return potential of a seasoned basket of assets. A secondary investor acquires a secondary portfolio where the assets in the portfolio are at a point of maturity since the non-maturing assets have largely been written off. The performing assets are growing and closer to a liquidity event, but still held at conservative valuations – frequently at cost.

Thus, as secondary acquisitions generally occur at a discount from reported values and have a shorter period to investment realization, secondary buyers can receive higher returns with lower risks relative to the sellers of the partnership interests.

Corporate Restructuring. Another driver of sales is merger and acquisition activity that creates excess corporate baggage and 'orphan funds.' As companies merge, corporate funds are divested, such as in the merger of Wachovia Capital with First Union ' a transaction which led to the spin-off of the bank's direct investments in 2002. Likewise, National Westminster Bank sold three portfolios to Coller Capital during a hostile takeover by the Royal Bank of Scotland in 2000 (See Charles Fleming, “UK: Deals and Deal Makers ' Secondary Funds Go Hunting For Private-Equity Holdings,” The Wall Street Journal, January 6, 2000.) Similarly, bankruptcies, such as that of Global Crossings, yield divestitures or spin offs of direct portfolios. Corporate venture funds often fall victim to cost cutting measures, as venture assets are often costly to maintain and operate. As a result, many corporations seek to dilute or remove the cost of the venture program directly from the parent's balance sheet by sale. Today, they have the ability to retain strategic relations with the portfolio through a spin-off of assets as part of an MBO or other private equity sponsored play, where they retain a small percentage of ownership in the new entity.

Shareholder Pressure. Justifying a private equity program without a euphoric market is a tough argument to make to shareholders and corporate boards. Investors are increasingly pressuring companies to reduce areas of volatility in their business, even at the loss of potential long-term growth, to generate consistent returns. Private equity has created a great deal of volatility in corporate earnings, particularly in banks. Additionally, another difficulty is the ongoing cost of managing a portfolio, which include, at a minimum: dedicated corporate fund managers (who are typically higher paid than their divisional counterparts), reporting, legal, and relationship management personnel, in addition to general administrative costs.