A junior partner at a mid-market buyout firm recently confided to me that he felt like his firm was trapped in private equity purgatory. A group of angry limited partners had visited his offices, pitchforks in hand, demanding liquidity in short order. If the firm failed to comply, these malcontents would have no reservations against sending the firm to its fiery demise. On the other hand, several of the remaining portfolio companies had excellent prospects and a bright future was not difficult to imagine. One step from destruction, one step from paradise, private equity purgatory was a tense place to be.
What the firm didn’t realize was that there is a way out of private equity purgatory—the stapled secondary. While a stapled secondary is not quite a ticket to private equity heaven, it can surely avert the flaming inferno below. As the first firm formed to purchase private equity interests on a secondary basis, my firm,
Stapled Secondaries
A stapled secondary involves the simultaneous purchase of an interest in an older fund (the “secondary”) with a commitment to a new or annex fund (the “staple”). In most cases, the general partner of a fund locates an investor in an older fund who desires liquidity. Typically, this investor would no longer participate in future funds because of changes in leadership and/or corporate structure or for other reasons. A secondary private equity firm will then simultaneously buy the orphaned fund interest and commit to a new or annex fund. The new fund will generally have a shorter investment period than a traditional fund and may contain performance hurdles.
The mid-market buyout fund in private equity purgatory was a strong candidate for a stapled secondary. The fund had raised several hundred million dollars almost ten years ago and was now past its investment period. With few realizations to show for their efforts, the partners could not raise a new fund until their existing investments proved successful. But any near-term sales would be at depressed prices, given the current softness in the M&A and financing environment. While their best option was to hold their existing investments for an additional two to three years, this would mean that they would be unable to make any new investments. The lack of capital also caused tensions within the firm as younger employees questioned its future viability. By pursuing a stapled secondary, the firm could ensure near-term stability in its operations and provide a bridge to long-term success.
Advantages
General partners considering a stapled secondary should make certain that they understand the advantages and disadvantages of pursuing such a transaction. While there are benefits to executing a stapled secondary, there is a substantial investment required to execute the transaction properly. Too many GPs see a stapled secondary as a panacea for more pervasive fundamental problems in their firm, including lack of leadership or a portfolio of highly troubled companies. Indeed, a transaction that has unrealistic expectations for value for the secondary part of the transaction will never be completed. Likewise, a GP that demands an excessive staple will be disappointed by the end result.
The primary advantage to executing a stapled secondary transaction is that it enables a fund team to be “in the market” for new investment opportunities. These new investment opportunities can be a combination of new companies and follow-ons to existing portfolio investments. A source of torment for those in private equity purgatory is that the worst times to realize investments are often the best times to make new investments. Even with the use of a placement agent, raising a new fund is a time-consuming endeavor. Executing a stapled secondary transaction will typically be faster than completing a traditional fund-raising effort and will thus enable a firm to be actively investing in short order. We have been able to complete stapled secondary transactions in just a few weeks.
Another advantage to a stapled secondary transaction is that it can often begin the process of a fund restructuring, allowing the GP to reset the economics to match current circumstances more effectively. This may be of particular value in cases where poorly performing early investments have made it nearly impossible for the fund to achieve carry— where even if the value of the current assets were to double, those significant early write-offs could put the resultant value below initial capital contributions. In a fund restructuring, the hurdle rate can be changed in exchange for a change to management fees. Restoring carry to the fund re-aligns the incentives of the GPs and LPs.
Finally, a stapled secondary may provide an opportunity for LPs to exit in an orderly manner. Very often, investors in older private equity funds may no longer be active in the asset class. For example, a bank might have been an investor in a fund and then subsequently been acquired, or a pension plan might have decided to shift its investment focus in favor of marketable securities. A stapled secondary allows these investors to gain liquidity earlier than they would otherwise have been able to. Although individual investors could seek secondary buyers on their own, when a staple is involved, a firm is often motivated to assemble a large amount of information about the portfolio to “sell” its value. The staple thus could ultimately result in a higher valuation for the portfolio companies than a non-staple transaction.
When a secondary process is successful, the fund will add an investor who is extremely knowledgeable about the portfolio. Having new, engaged investors can serve to revitalize an investment team. Investors can sometimes tire of an investment, and the new blood can breathe life into a fund.
Disadvantages
The primary disadvantage to the use of a stapled secondary is that the amount of new capital will be constrained by the size of the secondary transaction. A secondary firm will generally be able to invest only in situations where the secondary/staple ratio is no more than 2:1. For example, if a secondary firm purchases a $10 million interest in a fund, it will only be able to commit $5 million to a new fund. The limitation on capital can be challenging for managers seeking to expand. A stapled secondary should best be thought of as either a transitional fund or part of a larger fund-raising effort.
A second disadvantage to a stapled secondary is the limited diversification of the investor base. Most firms with the ability to execute a timely stapled secondary are specialized firms with limited ability to commit to future funds. A fund manager may be tempted to approach a perceived long-term investor such as a foundation or endowment with the stapled secondary opportunity. While adding more long-term investors is certainly always desirable, it is important to remember that stapled secondary transactions usually require analysis that stretches the resources of these organizations. Further, a non-specialized firm will have difficulty adapting if and when a stapled secondary evolves into a restructuring. In the past, VCFA has involved some of its institutional LPs as co-investors in larger stapled secondary transactions, and in some ways this is the best of both worlds: The fund can draw on the expertise of a seasoned secondary investor while adding a potential long-term investor for future funds.
Life After The Staple
Perhaps the most important lesson we have found is that a GP should plan for life after the stapled secondary. The transaction is meant to be a ladder out of private equity purgatory, not a source of permanent capital. A GP should have a clear idea of the plans for the organization’s future. We have seen a wide range of plans, including raising a new private equity fund, raising a hedge fund, or retiring. Having at least realistic aspirational goals and making them known throughout the organization will help motivate long-term employees while enabling the firm to escape from private equity purgatory.
Sidebar: Best Practices In Secondary Staples1) Communicate With Your LPs
If there are no LPs willing to sell, there can be no transaction and all parties have wasted their time; if there are too many sellers, the deal can quickly become unwieldy. As a best practice, we believe that a GP should be open with its LPs, keeping them informed as the process progresses.
2) Prepare Thorough Materials
The materials you prepare should be similar to a very detailed annual meeting report—enough so that an intelligent investor can reasonably estimate a valuation. Providing a potential new investor with detailed information on each portfolio company will facilitate more informed offers for the portfolio. It also allows the secondary buyer to understand more fully the fund’s philosophy and style.
3) Don’t Assume A Broad Auction Will Maximize Value
A broad auction often has the effect of reducing the level of engagement and diligence of many firms, which will often lead to a lower valuation. A fund will be better served by having a focused group of active buyers, rather than a large group of somewhat interested buyers.
4) Set Realistic Expectations
A GP should abe wary of over-enthusiastic intermediaries who may overstate the potential interest in order to win business. It may be helpful to have a preliminary discussion with a secondary firm to gauge the feasibility of a transaction. In the current economic environment, some of the strongest portfolios may still be sold at a discount relative to the last valuation.
David Tom, CFA, identifies and advises on investment opportunities for VCFA Group, which pioneered the secondary private equity market. VCFA is currently investing a $250 million buyout secondaries fund and a $250 million venture secondaries fund. David can be reached at dtom@vcfa.com.
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