Secondary Private Equity Funds: The Perfect Storm

Last month, the authors began discussing how the recent growth and maturity of the private equity market has generated significant secondary market opportunities. The discussion continues with one more motivation for selling and concludes by addressing regulatory changes and asset allocation shifts.

Awareness of Options. The increase in supply of direct assets for sale has helped attract new capital for secondary funds, while concurrently expanding the number of secondary buyers. There are now at least twice as many well capitalized buyers in the market as there were only two years ago, and many secondary specialists have far exceeded fundraising goals; some by more than 50%. Some market participants believe that there has been too much money raised in the secondaries, which they speculate will drive up prices; a thought welcomed by sellers. The development of a formidable yet diverse buy-side has helped initiate very broad market activity that can now meet most sellers' needs. For example, many sellers would rather offload an entire portfolio at once, rather than having to sell bit pieces over time. Other sellers would prefer to only sell rights and minority interests, and again the range of market activity has proven this is also possible. The momentum and acceptance of creating solutions for sellers is creating visibility and comfort, quickly spiraling up the number of sellers, buyers, and deals completed. These options have led to some very notable large spin-offs that have received a good deal of press coverage, such as: Deutsche Bank, Lucent, BTexact Technologies (British Telecommunications plc), Quantum Corporation, Accenture Ltd., Wachovia Corporation, National Westminster Bank PLC, and Pioneer Corporation.

Changes in Regulation

Direct portfolios are being sold by banks, partly in response to new requirements and regulations. Banking authorities are now stipulating an increase in reserves to offset potential private equity losses. Currently, as much as 25% of the value of private equity assets is required. Thus, banks have found themselves over allocated to private equity as an asset class. JP Morgan Chase and Wells Fargo are among recent banks announcing they will trim private equity holdings in response to these policies. Another example includes, FleetBoston which said in 2002 that it would reduce its private equity portfolio from $3.6 to $2.5 billion over the next two years (See Kelly Holman, “Carlyle to Launch Secondary Fund,” The Deal, May 14, 2002.)

Asset Allocation Shifts

Microeconomic drivers for sales are primarily related to an asset allocation shift. The main internal force for sales by financial investors is overexposure, compounded by the coinciding widespread relative decline of public market investments. The unprecedented capital raised for private equity in the late 1990s is naturally seeing a correction. Similarly, strategic sales by corporation are often rationalized because strategic focus has shifted away from an industry or sector once considered relevant, or the relationship benefit of the portfolio has diminished. Many corporations are fully retrenching and focusing on core businesses, leading them to reevaluate their ability to extract any strategic benefits from their direct investment programs. These corporate venture funds made investments for a weighted combination of strategic and financial reasons between 1998 and 2001. As the financial benefits continue to erode, strategic investments are no longer positive NPV projects.

Preemptive Sales. Venture capital returns in the current primary markets are down nearly 30% over the last twelve months. However, many involved in private equity believe that valuations have not yet bottomed out, making investments subject to even greater loss. As a result, sellers are looking for exits before their investments have reached maturity, and even more hurriedly, before valuations hit rock bottom. Thus, the secondary market is one of inherent inefficiency ' where the sellers are motivated for various reasons and the buyers can exploit these inefficiencies in order to have a positive return on investment.

Rapid Deployment and Earlier Return of Capital for Buyers. Compared to traditional private equity investors, secondary investors are exposed to timing and reinvestment risk over much shorter holding periods due to: i) the rapid deployment of capital and ii) when combined with a quicker return of that capital.

Capital commitments in traditional private equity funds may be tied up for considerable periods of time before being drawn down for investment. Until the capital is drawn down, investors earn money market rates of return on that portion of their portfolio they have allocated to private equity. In general, an investment in a secondary fund ensures the rapid deployment of capital. On average most secondary funds are fully invested by the end of the third year.

Last month, the authors began discussing how the recent growth and maturity of the private equity market has generated significant secondary market opportunities. The discussion continues with one more motivation for selling and concludes by addressing regulatory changes and asset allocation shifts.

Awareness of Options. The increase in supply of direct assets for sale has helped attract new capital for secondary funds, while concurrently expanding the number of secondary buyers. There are now at least twice as many well capitalized buyers in the market as there were only two years ago, and many secondary specialists have far exceeded fundraising goals; some by more than 50%. Some market participants believe that there has been too much money raised in the secondaries, which they speculate will drive up prices; a thought welcomed by sellers. The development of a formidable yet diverse buy-side has helped initiate very broad market activity that can now meet most sellers' needs. For example, many sellers would rather offload an entire portfolio at once, rather than having to sell bit pieces over time. Other sellers would prefer to only sell rights and minority interests, and again the range of market activity has proven this is also possible. The momentum and acceptance of creating solutions for sellers is creating visibility and comfort, quickly spiraling up the number of sellers, buyers, and deals completed. These options have led to some very notable large spin-offs that have received a good deal of press coverage, such as: Deutsche Bank, Lucent, BTexact Technologies (British Telecommunications plc), Quantum Corporation, Accenture Ltd., Wachovia Corporation, National Westminster Bank PLC, and Pioneer Corporation.

Changes in Regulation

Direct portfolios are being sold by banks, partly in response to new requirements and regulations. Banking authorities are now stipulating an increase in reserves to offset potential private equity losses. Currently, as much as 25% of the value of private equity assets is required. Thus, banks have found themselves over allocated to private equity as an asset class. JP Morgan Chase and Wells Fargo are among recent banks announcing they will trim private equity holdings in response to these policies. Another example includes, FleetBoston which said in 2002 that it would reduce its private equity portfolio from $3.6 to $2.5 billion over the next two years (See Kelly Holman, “Carlyle to Launch Secondary Fund,” The Deal, May 14, 2002.)

Asset Allocation Shifts

Microeconomic drivers for sales are primarily related to an asset allocation shift. The main internal force for sales by financial investors is overexposure, compounded by the coinciding widespread relative decline of public market investments. The unprecedented capital raised for private equity in the late 1990s is naturally seeing a correction. Similarly, strategic sales by corporation are often rationalized because strategic focus has shifted away from an industry or sector once considered relevant, or the relationship benefit of the portfolio has diminished. Many corporations are fully retrenching and focusing on core businesses, leading them to reevaluate their ability to extract any strategic benefits from their direct investment programs. These corporate venture funds made investments for a weighted combination of strategic and financial reasons between 1998 and 2001. As the financial benefits continue to erode, strategic investments are no longer positive NPV projects.

Preemptive Sales. Venture capital returns in the current primary markets are down nearly 30% over the last twelve months. However, many involved in private equity believe that valuations have not yet bottomed out, making investments subject to even greater loss. As a result, sellers are looking for exits before their investments have reached maturity, and even more hurriedly, before valuations hit rock bottom. Thus, the secondary market is one of inherent inefficiency ' where the sellers are motivated for various reasons and the buyers can exploit these inefficiencies in order to have a positive return on investment.

Rapid Deployment and Earlier Return of Capital for Buyers. Compared to traditional private equity investors, secondary investors are exposed to timing and reinvestment risk over much shorter holding periods due to: i) the rapid deployment of capital and ii) when combined with a quicker return of that capital.

Capital commitments in traditional private equity funds may be tied up for considerable periods of time before being drawn down for investment. Until the capital is drawn down, investors earn money market rates of return on that portion of their portfolio they have allocated to private equity. In general, an investment in a secondary fund ensures the rapid deployment of capital. On average most secondary funds are fully invested by the end of the third year.