In recent years, the secondary market for private equity interests has grown substantially, and this is providing limited partners with greater opportunities to exit from their investments, albeit at a net loss.
Both institutional and private investors are prompted to sell for a number of reasons, including the desire to improve liquidity and reduce contingent liabilities. Still other investors have sought to reduce their private equity exposure because of strategic changes in portfolio strategy, philosophy or asset allocation.
Limited partners who seek to sell their private equity interests often encounter significant obstacles. Despite a growing list of buyers in the secondary market, illiquidity is still the norm. Furthermore, the process of valuing venture or LBO interests can prove to be deceptively complex. As a result, finding the right buyers, attracting competitive bids, and evaluating bids in a meaningful manner can be a frustrating and stressful experience.
A small number of private equity investors, primarily the largest pension plans and foundations, have resources at their disposal to adequately value their private equity interests and implement an effective disposition strategy. However, the greater number of limited partners, by far-including mid-sized pension plans, charitable institutions, family offices, trust groups, private banks and wealthy investors-lack the expertise and resources to liquidate holdings efficiently and under favorable terms. For these investors, it often is prudent to retain the services of an advisor with the experience and contacts to expedite a secondary market sale.
The Valuation Challenge
For virtually all limited partners who commit to selling private equity interests, the greatest challenge is to arrive at a reasonable valuation. Sellers tend to have insufficient information about the structure and economics of a fund’s 20 to 30 underlying portfolio companies, where lack of access to pertinent data is the norm. This makes it difficult for sellers to estimate the priority of distributions and preferred returns, capital call schedules and use of proceeds, carried interest and management fee calculations, claw-back exposure, and the cost basis and maturity of underlying portfolio companies. Furthermore, the legal, financial and accounting complexities of valuation can overwhelm investors who consider themselves to be otherwise well informed.
In addition to helping limited partners determine the fair market value of their private equity interests, an experienced advisor will have a “feel” for the market’s current liquidity discount. Without this knowledge, the seller is at a disadvantage when negotiating with established buyers. Consistent with an inefficient and fragmented market, the liquidity discount is amorphous, almost constantly in flux, and can vary across a wide range. Based on the current liquidity discount, an astute advisor can counsel the seller on when it is an opportune time to “pull the trigger” on a sale or when it is time to hold back.
However, it would be a mistake to assume that all secondary market sales are completed at significant discounts. Although inefficient by most measures, the secondary market for private equity interests is considerably broader today than it was only a few years ago. As a result, discounts have narrowed to some degree. An experienced advisor will help a seller develop a transaction strategy based on the current discount, the direction in which it is expected to move, and the potential impact of capital calls and other significant events.
Finding the Right Buyer
Currently, there are approximately 200 funds interested in pursuing secondary interests, but this market is dominated by seven specialist funds that manage over $17 billion and control more than 60% of all market activity. In general, these seven Lexington Partners, Landmark Partners, Coller Capital, CSFB Private Equity, HarbourVest Partners, Paul Capital Partners, and Goldman Sachs-focus primarily on relatively large transactions. A limited partner who seeks to sell a private equity interest in the $20 million or less range will, in all likelihood, find greater interest among buyers outside the top seven.
Most secondary market buyers, from the largest to the smallest, narrowly define the interests they are willing to purchase. The parameters may include transaction size (anywhere from six figure deals to well over nine figures); asset type (venture, buyout); investment focus (early or late stage, middle market, etc.); and industry sector (software, manufacturing, telecommunication, etc.). An experienced and well-connected advisor is able to direct sellers to the most appropriate buyers, based upon these and other criteria.
At this time, many of the more successful secondary market buyers cannot accommodate potential deal flow, as the supply of private equity interests in the secondary market dramatically exceeds the availability of capital. In effect, the top secondary funds are currently operating in a buyer’s market. Most are enjoying above-average private equity returns, due to high purchase discounts and shorter holding periods. This is another reason why it often is prudent for the sellers to search beyond the “most obvious” funds that buy secondary interests. Other potential buyers might be general partners and other limited partners, as well as traditional private equity investors with secondary allocations, including public and corporate pension funds, primary fund-of-funds, financial institutions, foundations and endowments and family offices.
Sellers generally find that buyers do not spend a lot of time on competitive situations. The majority of transactions take place privately, wherein buyers and sellers negotiate a price that is acceptable to both sides. There are times when sellers may fare better by employing a regular auction, although these are relatively rare. A number of electronic exchanges have been introduced to match buyers and sellers, but this has not proven to be a viable solution. Private equity usually does not lend itself to secondary market exchanges, because each interest is unique and has numerous components.
Potential sellers into the secondary market should note that buyers are averse to giving credit for the fees that the limited partner has paid to the GP to manage the fund and obtain deals. Consequently, a seller of a private equity interest has to take consider this “built-in discount” when searching for a buyer.
Managing the General Partner
It is never easy to anticipate for certain how a general partner will respond upon being informed of an LP’s intent to exit a fund. There are GPs who react in a fearful manner and instinctively become uncooperative. At the other end of the spectrum, there are GPs who view a limited partner’s exit as an opportunity to attract a new investor or investors who can bring fresh capital to the fund.
Advisors who can successfully address the concerns of GPs and help to make a GP an ally in the transaction process can provide considerable value to a seller. Limited partners often assume, incorrectly, that it is best to avoid involving a GP early in the sales process. In virtually all cases, most advisors will move to immediately notify a GP of the limited partner’s intent to sell. This helps to ensure that key information will be available to provide to prospective buyers. Sellers also should keep in mind that a GP is motivated to ensure that interests be transferred to investors that are willing and capable of making primary commitments to future funds.
By notifying and working closely with the GP, the seller also may acquire crucial information, like foreknowledge of a pending portfolio exit event or the amount of cash on a portfolio company’s balance sheet. Without the information, important value can be “left on the table” during negotiations with buyers.
The Sale Process
Although each sale in the secondary market is distinct and unique, in general there are four (4) steps required to achieve a successful, private negotiation:
1. Portfolio Analysis
This step includes requesting information from the GP regarding each portfolio company, preliminary analysis of that information, and further discussions with the GP to address issues that have a bearing on valuation.
Sellers should expect the marketing phase to take about two months. Once marketing materials for each interest are developed, and a preferred list of buyers is identified, the seller can begin to introduce the portfolio to buyers, execute non-disclosure agreements, solicit indications of interest, and seek to determine preliminary pricing. The major goal of the Marketing phase is to effectively narrow the buyers list.
3. Detailed Due Diligence
At this point, the seller organizes due diligence meetings with the prospective buyers, completes their information/data requests, and collects fair pricing estimates.
4. Negotiations and Closing
Upon selecting preferred buyers for each interest, the seller distributes and then negotiates the Transfer & Purchase/Sale Agreement, and executes final legal documents. This is followed by the closing.
The Role of an Advisor
For the vast majority of limited partners who contemplate a secondary market sale, value can best be maximized by employing an advisor with the experience and contacts to (a) arrive at a credible valuation of the seller’s interest; (b) identify the most appropriate buyers, based upon the size and type of the assets to be sold, as well as other factors; (c) determine the current liquidity discount in the market; (d) create a productive relationship with the general partner; (e) manage a competitive bidding environment that preserves the confidentiality of all parties; and, (f) provide an informed and independent voice throughout the sales process on all negotiations.
There are very few limited partners who can successfully perform all of these tasks are their own. Retaining an effective advisor can result in a secondary market sale that is significantly more favorable for the seller than it might otherwise be.
SSG Capital Advisors, L.P. (www.ssgca.com), advises under-capitalized, middle-market businesses nationwide and in Europe. With more than 100 investment banking assignments completed since 1994, the firm is recognized for its expertise in mergers and acquisitions and private placements of debt and equity for companies facing challenges and in turnaround situations; complex financial restructurings; valuations and fairness opinions; and private equity services for general and limited partners.