The overall secondary market for private equity has been booming for some time, driven by corporate abandonment and cut-rate prices for bubble-era venture capital funds. Most industry players expect 2004 will finish as the biggest year ever for secondary activity. And like previous years, buyout assets are expected to dominate this market.
To meet the soaring supply, secondary managers have begun raising larger and larger funds. In 1998, secondary funds larger than $500 million had an aggregate of just $1.1 billion of capital under management, while such funds smaller than $500 million sat on approximately $9.4 billion, according to Thomson Venture Economics (publisher of Buyouts). By 2002 the overall numbers had grown dramatically, while the split between big and small players had reversed, with large funds maintaining $9.4 billion in capital commitments compared with $5.2 billion for smaller funds.
Fund raising really took off last year, when Lexington Partners raised the second-largest secondary fund in history with $2 billion. Credit Suisse First Boston closed on $1.9 billion for two secondary funds-CSFB Strategic Partners II with $1.6 billion and a $300 million co-investment fund focused on secondary real estate investments.
There remains a substantial number of secondary firms in the market, as well. Paul Capital and Pantheon Ventures are each seeking $800 million and $600 million, respectively. Merchant bank Thomas Weisel Partners announced that it raised $115 million in a first close of its first exclusively secondary fund. It hopes to raise $200 million.
Perhaps more interesting is that this enthusiasm has prompted a jump in secondary fund-raising among fund-of-funds managers, who traditionally have taken a cautious and skeptical view of the secondaries market. London-based AXA Private Equity, for example, raised $300 million for a secondary market fund-of-funds back in March. More recently, Boston-based HarbourVest Partners raised a pair of $2 billion funds that will invest both in direct private equity partnerships (one fund focused on VC, the other on buyouts) and secondary fund portfolio opportunities.
Not surprisingly, some are concerned that the market has grown too large-both in the volume and the number of participants-fearing that what’s currently a hot trend could produce cold returns in the future. “In our view that market has become distorted in the last few years by a number of newcomers who have identified secondaries as an interesting way into the private equity market for a variety of reasons,” says David Currie, a managing director with Edinburgh, Scotland-based Standard Life Investments. “They have been pricing deals at a level that has not been attractive. People are buying these positions and paying some very full prices for them, sometimes just to get access to a manger. They just latched on to secondaries as a way to build their portfolio.” (According to Currie, Standard Life has not made a secondary investment in about three years.)
In response, Currie says traditional secondary investors have been taking their time to deploy capital and have been making investments through more complicated structures in order to eliminate “those people who are just coming along with a checkbook and looking to buy things.”
While traditional secondary firms like Lexington Partners and Coller Capital often buy in bulk, a fund-of-funds can be more selective by focusing on smaller groups of assets. They also can be more flexible. Philip Shaw, a partner Invesco Private Capital, says that his firm, which has made four secondary purchases this year, has an advantage in not being solely dedicated to secondaries. “Funds that have raised partnerships dedicated exclusively to secondaries have no flexibility but to pursue them if the market is good or bad,” says Shaw. “They don’t have the discipline to bid carefully. Obviously we’re not in that boat so we don’t feel that pressure.”
Invesco, says Shaw, wants to identify opportunities in existing relationships where selling shareholders allow them to invest in firms they already know well. Its avoidance of bulk purchases allows them to be more selective on deals. Invesco is currently at work raising a fund-of-funds that will likely close this October. The firm closed Invesco Partnership Fund III with $300 million in 2001. “I feel we’re appropriately sized by raising pools of $300 million to $500 million,” he says. “That gives us the ability to be highly successful. Someone raising significantly larger amounts has less flexability and has to gravitate towards larger sized funds or do numerous investments that may tend to produce index like returns.”
Bent Toward Buyouts
Not surprisingly, most of the fund-of-funds entering this market are looking to buyouts as their bread and butter secondaries investments.
Invesco, for example, favors buyout assets. Its exposure is approximately two-thirds in favor of buyouts with one-third dedicated to venture assets, with its largest shift in the past has put its balance 60% to 40% in favor of buyouts. It’s never been evenly split or in favor of venture capital. It shifted to its current balance in 2002 as it began considering it latest fundraising effort. “We realized that at the time the number and venture size had exploded into dangerous territory,” says Shaw.
Investors gravitate toward buyouts for several reasons. First, the buyouts sector offers greater prospective volume due to particularly large fund sizes and a wide range of market players. Also, buyouts have produced more stable returns than has venture capital, particularly in Europe, which has a well-developed buyout market and a still-fledgling venture capital market.
“Everyone tends to drink their own Kool Aid,” says Ashton Newhall, a general partner with fund-of-funds investor Montagu Newhall, which focuses on VC but also evaluates buyout assets. He says that the buyouts industry still needs to go through the corrections that have already hit the venture capital industry.
“The buyout space has a lot of capital overhang it’s more profound in the LBO arena. The venture industry has taken the initiative in management fee reduction and fund reduction to right size itself. We haven’t seen that be the case in the buyout arena,” he says. “That said, there’s a deep cyclical nature to both venture and buyout returns. Given the run-up in venture, I can see the argument that it’s the buyout firms’ turn. [But] I still think there are some structural issues that need to be resolved.”
What is up for sale has changed as well for buyout secondary fund-of-fund buyers. More sellers are putting assets up for sale that are less mature. Traditionally, secondary buyers purchased shares in funds that were at minimum 50% drawn, but now it’s not uncommon to see funds on the auction block that are as little as 20% drawn, particularly on the venture side.
Cup Runneth Out?
While there is plenty of deal volume now for the LBO secondary market, fund-of-fund managers may soon have to scrounge for deals.
Jason Gull, a partner with Chicago-based Adams Street Partners, believes that secondary-buyout asset volume for fund-of funds may decrease precipitously within the next three years. “Where will we be in 2006 when the bubble year commitments have largely been sold?” he asks. He says that while deal volume is pretty brisk, it appears that the market is unbalanced. He says that once the bubble-era assets are cycled through the secondary market, the recent drop in primary side funding will confront the secondary market. “There is a tremendous falloff on the primary market and there will be a commensurate falloff on the buyout side.”
What will finally drive these secondary tourists out of the market is when the returns don’t add up for them. Eventually these unsophisticated buyers will vacate the market, or so the veterans believe confidently, because the returns will be far below what more more seasoned private equity players expect. “We’re looking for something that somewhat north of a bond return,” Currie jokes.