Counting the cost of secondaries

Interest in sales of secondary private equity interests is at an all time high as specialists raise record funds for investment in this niche of the private equity market, but do secondary deals offer fair value to limited partners with assets to sell? Louise Cowley reports

The boom and bust of the Internet bubble, teamed with the slump in public market valuations, means many investors who poured cash into private equity funds in the late 1990s are now looking for an early exit. The increase in the volume of secondary assets for sale and the lucrative returns possible at what should be a lower risk than primary PE investment means there are plenty of investors in the market at the moment. Columbia Strategy, a private equity portfolio management strategist, has calculated that secondary specialist funds alone currently have at least $10 billion available to purchase such assets. However, do the bullish returns anticipated by these players mean LPs are paying a high price for liquidity?

In a recent report, “Opportunity in Adversity: Private Equity Secondaries and Directs”, Columbia points out that liquidity can come at a cost; as in publicly disclosed transactions, buyers have paid significant discounts to the seller’s already written book value of assets, leaving some sellers feeling taken advantage of. Among the many issues to consider, according to the report: “In select cases, sellers have potentially made grievous errors in pricing their holdings. Given that many of these deals were managed and negotiated by the same teams that were eventually spun-off, new worries about conflict of interest come to light.” Eyebrows were raised when press reports indicated that Coller Capital had more than cleared the purchase price of 80 per cent of the 27 companies in the Lucent Technologies portfolio it had acquired only the month before. This was achieved by selling just one of the 27 portfolio companies – Celiant – for some $470 million in February 2002.

It’s very rare for a secondary transaction to be publicly announced but when this does happen both the vendor and the acquirer present the deal as a success. Spin aside, the reality is still that the opacity of this market makes it very difficult to determine whether or not deals really represent good value for LPs. But then “good value” for the LP can be defined in a number of ways according to their motives for wanting to dispose of the private equity interests in the first place. Price is not the only consideration; if a deal meets the seller’s needs then it can still be seen as good value, even at a hefty discount.

Investors are looking to sell for strategic and financial reasons. Macro-economic factors, as well as the recent volatility of private equity earnings, mean many banks; insurance companies and corporates are under pressure to dispose of some or all of their private equity assets. The individual financial situations of these LPs dictate to a large extent the type of secondary deals they are prepared to accept.

;Some of these investors are willing to bite the bullet and take the steep discount just so they can get it all behind them,” says Anthony Romanello, director of investor services at Venture Economics. However, the increasing sophistication of the secondary market means LPs are beginning to see it as a portfolio management tool. According to Mathieu Dréan, partner at placement agent Triago: “Sellers are not necessarily groups who want to get out of their whole portfolio, more and more are still interested in private equity but want to rebalance their portfolio.” Many of these LPs are looking to rid themselves of some of their more recent vintage fund investments, often weighted towards venture and with large unfunded commitments. Unfortunately these are exactly the types of asset where LPs will loose most value.

According to Mike Rudnicki, managing director of US-based alternative asset manager Trident Point Capital, in these cases sometimes the best option for LPs can be to default on their commitment to a problem fund, especially if only a small percentage of the capital has been called. The massive volumes of capital returned to LPs last year show general partners tend to reduce the size of a struggling fund before it reaches this stage. However, indications are that more sellers with these type of problem funds in their portfolios are going to emerge in the next couple of years and LPs are not likely to be able to reclaim much value via the secondary market.


Although secondary buyers and sellers are understandably coy about the pricing of deals it is safe to assume that in the case of most venture funds it will be at a steep discount to what the LP originally put in. Ultimately the price will always depend on the assets on offer. Dréan says it is possible for a premium to be paid to an LP in a transaction and it still be a good deal for the secondary fund. However, this situation is rare at the moment, as there’s a lot of deal flow about and buyers will always try and get cheap deals. Their aim is to look for hidden value that is not yet visible to the LP.

According to Romanello, at the bottom end of the range of discounts, it could be as little as 20 per cent but this can go up to as much as 98 per cent for the worst assets. New investors are most likely to be offered the lowest prices, as they probably won’t have been able to get into the top tier funds. Paul Misir, founding partner of Columbia Strategy, says LPs selling interests in well-known funds with a good track record and strong portfolio can expect to sell for little, or even no discount, regardless of a fund’s investment stage. However, typical discounts that the firm has encountered at the moment generally range from 40 to 80 per cent of book value, and 20 per cent of perceived market value. “Sellers should expect to fight to realise anything over the current significant discounts,” he says.

It stands to reason that secondary players don’t want to overpay for early stage investments in the current environment. As one secondary investor puts it, you can

see all the losses on venture but not yet where the successful exits are going to come from. The post-bubble collapse of technology prices and closing down of exit routes make secondary investing in the venture space tricky. Tim Jones, investment director at Coller Capital, explains: “Portfolio companies are generally pre-revenue and therefore difficult

to value. They are still in cash-burn phase so are also likely to need to raise more money.” Secondary funds that are willing to look at technology deals are few and far between but some players, such as Coller, have already shown there’s money to be made from these assets. Nevertheless, Jones says a cautious and conservative approach is needed.

There are undoubtedly some good quality, valuable venture assets on the secondary market. But for most investors picking the right deal from the multitude of assets on the market, and then closing it, is going to be harder than finding a needle in a haystack. Perhaps wisely, most secondary investors are giving recent vintage technology-orientated funds a wide berth in favour of more reliable buyout interests.

Misir says: “Buyout funds are often traded more fairly and at lower discounts, as their value is more immediately apparent and based on cash flows and earnings projections that have historical context. The elements of brand, asset quality, and transparency are what the discount hinges upon, all other factors, such as a seller’s situation, held constant.”

According to Rudnicki the majority of secondary players are trying to pursue this buyout-focused strategy and are not considering venture at all, at a time when it could pay to buy these interests. However, positions in buyout funds are more likely to go to be sold via an investment bank-organised auction and due to the high demand, pricing is very tight. While this is good news for the lucky LPs with buyout fund positions to sell (and bad news for the venture-heavy), with everyone in the secondary market pursuing the same strategy the basic value-play principle of secondary funds is jeopardised.

Although it is difficult to track the actual number of secondary deals being closed it is known to be substantially less then the number of assets that have been put on the market. This lack of completions demonstrates that many LPs feel secondary buyers are not offering them good value. “Selling LPs are in full control of the deal, if they don’t like the price they won’t do it,” says Dréan. Few LPs are in such dire straits that they will sell at any price and patience is often rewarded. Although seller expectations are often still too high the expectation is that as the market matures and a better balance develops between supply and demand, sellers will get better deals. For the mean time though, buyers still have the upper hand and prices reflect this.

Maximising value

For an LP to get the best value from the secondary market it helps if they have a good hand to play. Ideally they aren’t under too much pressure to sell, have some older vintage funds in their portfolio and a good proportion of buyout commitments among their more recent investments. However, not all investors are in this fortunate position and as a result will have to add heavily discounted secondary sales to the write-downs they will undoubtedly already have made.

There are options for LPs to explore to try and maximise value, as a general rule closer co-operation between the buyer and the seller results in a better deal for both sides.

By finding the right buyer for the assets the LP is assured of getting as much value as possible from the secondary deal. “It’s not rare to see an 80 per cent spread on prices for the same portfolio,” says Dréan. While this highlights the inefficiencies of the market, the difference can be explained by the strategy and personal motivations of buyers.

LPs that typically invest in private equity at a primary rather than secondary level are sometimes willing to pay more if they like the funds on offer. If they already have interests in some of the funds and like the GPs they may be prepared to pay a premium. It also helps them build relationships with funds they may not have been able to get into when they were raised and can create an instantly vintage-diversified private equity portfolio for newcomers. Similarly, if the assets align with the strategy of a corporate investor value can also be increased.

The way a deal is marketed can also effect the outcome for the seller. Investment banks claim auctions can get better prices for vendors and although the competitive environment generated may appear to increase the price, this practise is flawed. Inexperienced LPs can have their hopes raised by banks, then when the offers come in lower than anticipated the LP goes into a state of shock and defers making any kind of decision on the sale, frustrating all the bidders.

Misir says LPs should avoid involving too many buyers as buyers aren’t comfortable with auctions and are unlikely to offer their best prices under these circumstances. It takes time and effort for secondary funds to prepare a bid and if buyers are competing against each other it puts pressure on the time they have to do due diligence and structure the deal. “LPs should be careful about approaching buyers and should aim to communicate from the perspective that they are a prepared, informed and committed seller,” says Misir.

He believes intermediaries can add value in certain situations, such as the sale of direct investments. “The use of intermediaries is good for large or complex deals. In small deals where the LP is well prepared and has the time it doesn’t make sense.” Another way they can help vendors is with large portfolios that might be segmented and bundled by industry, geography, or otherwise. Size can limit the number of potential buyers but by segmenting a portfolio for different types of buyers, especially strategic ones, a seller can increase value.

Innovative secondary deal structures allow LPs to de-risk their private equity investments and retain some of the upside. Examples of this are Coller Capital’s deals with Lucent and BT. In the first case Coller formed a joint venture partnership with Lucent Technologies to buy a portfolio of 27 businesses from Lucent’s R&D arm, Bell Labs. This meant when Coller successfully sold a portfolio company, Celiant, not long after the deal, Lucent also benefited. In Coller’s recently announced deal to acquire a majority stake in BTexact’s corporate incubator, Brightstar, BT still holds a 23 per cent stake.