Secondaries: Older vintages grow in popularity

Not only is the secondaries market attractive for its ability to offer institutional investors a far wider diversification of their private equity interests through multiple vintages and multiple fund types, but it’s popularity and understanding of how it works has grown as many have begun to use it both as an exit route and a route to actively manage private equity interests.

“Today if you turn to any GP almost all of them has experienced secondary transfers. Now sellers don’t have to be ashamed. Sellers used to be distressed or more structural sellers, for example, where the mother company was saying lets get rid of this. This still exists but in many cases a lot of the people we work with are sellers but continue to invest in private equity. They may sell some positions and even buy some at the same time; they actively manage their portfolios,” says Antione Drean, managing partner at Triago, a placement agent that has been actively involved in brokering sales of LP interests for the last decade.

Active management of portfolios is an area where Triago has witnessed significant growth. Drean continues: “Some are potential sellers and when they start seeing offers on some funds they realise at certain prices they could be buyers. Apart from the financial aspects of the deal it is about building relationships. It’s a way to start a new relationship. Today some GPs are not fund raising so investors can try to start a relationship with them through a secondary [transaction].”

David Jeffrey, managing director of Europe and Asia at BancBoston Capital, which has been an active secondary investor off its parent company’s balance sheet since 1991, alludes to the fact that some of the changing profile of the secondary industry is the result of the industry being a victim of its own success. “This was a cottage industry, whereby the transactions were very discrete because the vendor and GP did not want to shout from roof top. Only when people had to raise subsequent funds in the market did it advertise that the secondary class was established in its own right,” he says. (See European fund raising tables from 1993 to 2003 starting page 36, which includes details of secondary funds raised during that period. Although this only gives an indication of the size of the market since many institutions involved in secondary investing, such as BancBoston Capital, do so off their balance sheet.)

Signs of the secondary market’s maturity can be seen from the way it has become segmented, both in terms of the types of deals some of the existing players have become recognised for and in terms of the niches new entrants have determined to exploit. “[The secondaries market] is becoming a lot like the buyout market where you have people doing smaller deals and big deals. That segmentation became broader last year. Companies spinning out of direct portfolios; that is a whole set of transactions that did not exist a couple of years ago. Breaking up of portfolios, you were not able to do that in quite the same way a few years ago. Some of that is just a shift in power from sellers to buyers,” says Michael Granoff CEO at Pomona Capital.

The move to direct investing has been one of the more prominently evolving features of the secondaries market in the last 18 months, although some established players have been doing these types of transactions for some time. For example, Coller Capital, which set up in 1990, did its first secondary transaction in 1996, although this aspect of its investment strategy was perhaps less well known until it bought the Lucent portfolio in a well-publicised transaction early in 2002.

Direct investing (as opposed to the fund-of-funds approach to secondary investing), faithful to the secondaries market opportunistic code of conduct, has evolved in direct response to the difficulties facing many owners of direct portfolios, such as corporate venturers (from whence many of these transactions have sprung), and parent companies with strategic direction changes or an inability or unwillingness to continue to meet the ongoing investment requirements of their portfolios.

While directs have obvious attractions, there are some equally obvious problems they present too. “If you are going to buy a portfolio of directs, particularly in control positions, you are moving much closer to being a primary manager. The problem with buying portfolios of directs is finding the teams that can manage them. If teams are really good they can probably raise money on their own. It’s a question of how strong we think the manager is,” says Marshall Parke, general partner at Lexington Partners.

David Williamson is joint managing director at Nova Capital Management, which was set up in late 2002 with the specific aim of taking over the management of private equity investments where either there was dissatisfaction with the incumbent management team (as in the case of LICA Development Capital, which Williamson’s team took over the management contract for during 2003), or where there was going to be a change of ownership and awarding of a new management contract as a result.

Williamson says: “Every secondary fund will acknowledge that, if doing direct portfolio deals, they don’t have the resource in-house to manage those deals and they also don’t have the desire to bring resource in-house so they need someone else to manage them. In some cases, like the Deutsche/MidOcean deal there will be an existing team to manage it.”

While new groups like Nova Capital Management, IRRfc (the ex Phildrew Ventures team which span out of UBS Capital in spring 2002 taking that portfolio with them to manage to exit, as well as looking for new secondary management opportunities), Inflexion Portfolio Advisers (set up to manage the ProVen VCT, which transferred management in the form of Gordon Power from Beringea to AIM-listed Inflexion in 2003), and Vision Capital, an investment banking boutique with backing from Goldman Sachs that took over the management of the Morgan Grenfell Private Equity’s remaining investments that Deutsche Bank no longer wanted on its books, have all emerged to meet the management requirement of investing in direct secondaries.

It may work that some may negotiate the purchase of direct secondaries with backing from the traditional sources of secondary finance or, as they establish a reputation and track record for themselves, they are asked to put together a management proposal on deals that traditional secondary players have themselves identified.

Nova Capital Management, IRRfc, Inflexion Portfolio Advisers and Vision Capital although relatively new are clear about their proposition and, barring any disasters, should remain in the market. However, true to the opportunistic nature of the secondary market, primary investors have also emerged as interested transactors.

Sven Lingjaerde, general partner at Vision Capital Europe, which is an early stage technology investor focused on transatlantic investments in the communication, software and Internet/ e-commerce space and completely unconnected to London-based Vision Capital mentioned earlier, says: “Our investment strategy is direct investment but we thought that last year was the right time to take advantage of a down market and since we had a lot of cash from our third fund we went back to some of our in LPs to have the right to consider the purchase of a secondary portfolio where we would know some of the existing portfolio companies. This window will open and close in very short amount of time, say 12 to 18 months.”

Despite looking at eight opportunities in some detail, two of which the firm was prepared to move on, the final two fell apart, one on price and the other resulting from a change of decision to sell on the part of the parent company. This is a common problem for everyone looking to invest in direct secondary transactions.

“In direct portfolios there has been much more talk than action. The number of completed deals is still only a handful. We are incredibly busy. There are an awful lot of opportunities but how many are really going to turn into completed transactions? We are trying to make sure we focus on those opportunities that have a real likelihood of being completed,” says Williamson of Nova Capital Management. This is a problem for all secondary players, wherever they are in the size, relative maturity spectrum as Parke of Lexington Partners notes: “There is a lot of shopping around, I don’t think it’s growing though. We take each seller seriously that approaches us because if they don’t sell now, perhaps they will come back to us in the future if we handle it professionally.”

Even those experienced in direct secondary transactions are both well aware of the risks involved and the difference in nature to the more traditional fund-of-funds approach around which the secondaries market was originally established, whereby individual limited partners sold their interests in particular funds to other interested parties. “Some secondary investors may take a fund-of-funds approach, where the quality of the GP name is an important part of their analysis. When doing directs it’s all about the assets. Buying directly you don’t have the same level of GP comfort zone,” says Jones of Coller Capital.

Where traditional fund-of-funds interests have appeared in the market they are tending to be run on a much more limited auction basis than previously, with just three or four bidders invited to join. This may in part be down to the fact that only the serious need apply. Serious in secondary terms means not just the funds and willingness to bid but the ability to structure and close transactions. With some auction situations having reached preferred bidder only to fall apart reputations are beginning to build in the market.

“Which are the institutions that can close and which cannot?” asks Jones at Coller Capital. “A number of auctions were aborted in the last year and a half because after the bid some try and negotiate the price down; it’s either price or not having the ability to close [that leads to an aborted bid.] It has happened to us that someone else has won the portfolio but has not been able to close it. Then we moved back to have another look, but no longer on auction basis. If we put a price in we try and stick to it; what changes price is material changes,” he says.

One of the most notable auctions in 2003 involved the €1.5bn MBO of DB Capital Partners late stage private equity portfolio. Ted Virtue and Graham Clempson led the buyout of this unit from parent company Deutsche Bank and are now trading as MidOcean Partners

What this demonstrates is a seemingly increasing willingness among secondary players to join up and present either a joint or consortium bid. Sheer size of bid and complementary skills sets among consortium bidders is the most oft cited reason for such activity. But for the most part secondary players seem to prefer to work alone. A mix of dedicated secondaries players and a range of international institutional investors, including HarbourVest, NIB Capital, Ontario Teachers’ Pension Plan, CPP Investment Board, Bregal, and The Yucaipa Companies funded this deal.

In this particular deal Deutsche Bank retained a 20% interest in the DB Capital Partners/ MidOcean portfolio. This is not unusual. A similar situation arose when Coller Capital bought the Lucent portfolio. The attraction is obvious from both seller and buyer’s point of view since it shares both the risk and the rewards. The sale of DB Capital Partners’ portfolio was part of a sustained effort by Deutsche Bank to cut its private equity exposure, which also involved a securitisation of its fund-of-funds interests and sale of the left over assets from Morgan Grenfell Private Equity to the Goldman Sachs-funded Vision Capital bid mentioned earlier.

What players are not reporting is losing bids to outrageous pricing from their competitors. Jeffrey of BancBoston Capital explains why this might be the case: “For secondary investors there is nothing worse the catching a falling knife. It has occasionally happened and people have quickly learned from those mistakes.” Michael Granoff, CEO at Pomona Capital, endorses this view: “There is a reasonable amount of fear that remains in the market. People look at transactions done a couple years ago and they are still living with the results. People are looking at results in a hard way and they will continue to be disciplined”

But on the side of sellers, the generally conservative pricing on offer just isn’t attractive enough leaving many to withdraw from the market only to return at a later date. “We have seen portfolios come back to the market two or three times. Quite often when they come back they are damaged goods, if there has been another year of no funding,” says Jones of Coller Capital.

Williamson of Nova Capital Management believes that sometimes the pricing is not reflecting the economic reality that either buyers or sellers find themselves facing. “In many cases buyers are trying to do deals by buying at discount to value now to make money. So they are virtually assuming there is going to be no growth in the value of the portfolio. If you applied that sort of thought process into the primary market you would never do a deal, or do very few deals.”

In with the issue of pricing is lumped structuring. For the most part buyers and sellers in the secondary market transact, effectively, for cash but as the market matures and the sellers diversify there has been an increasing focus on the way transactions are structured. “There is a lot of talk about structuring but I’m not sure that much is happening in reality. Talk is centred on securitisaton and all sorts of structured means of paying for private equity portfolios. There have been some, but it’s not significant as a proportion,” says Parke of Lexington Partners.

Jeffrey of BancBoston Capital notes where some of this structuring may be emerging. “A very significant number of people entered this industry with a corporate finance investment banking background. They bring some form of creativity to bear from a structuring point of view,” he says.

Outlook remains good

“2003 has been a very fruitful for year for secondary players and 2004 will continue to be a very good year in terms of the market and pipeline. Many [investors] are still going through really major upheavals; M&A, regulatory issues like Basle II, and tiredness of asset class,” says Jeffrey of BancBoston Capital.

Williamson wonders whether another feature will be added to the list of seller motivations, namely performance. “Will LPs become more active in forcing change?” he asks. “They have signed up to terms that make it difficult to change. If only from corporate governance point of view, they can’t sit around and watch under performance and not do anything about it. Some are giving the benefit of the doubt, but also many take a portfolio view.”

The portfolio effect means that if an investor has interests in 20 limited partnerships, for example, and two of those are seriously underperforming, the performance of the other 18 may well drag up the combined performance of all 20 limited partnerships to an acceptable level. Since investors seek diversification to cancel out these very effects, plus the fact that there is minimal investor activism among private equity investors, plus the difficulty of removing a manager aside from in exceptional circumstances all amounts to apathy, which in turn results in preservation of the status quo.

Although the underlying fundamentals that ensure the deal flow for secondary investors remains strong, this has not necessarily improved the quality. “A negating factor has remained the quality of the assets. We did not see the same kind of turn up in assets held by private equity firms, like the public markets did. We still see a lot of companies in private equity funds we don’t want to own. The digestion process is not over yet, although more of it is behind us than ahead,” says Granoff of Pomona Capital.

As might be expected from increasing deal flow without a corresponding increase in quality, the size of the secondaries market is expected to remain relatively static, vis-à-vis the fund raising market. “Primary commitments just went straight up between 1996 and 2000 and then they fell off dramatically between 2000 and 2003. It looks like primary fund raising will recover in 2004 and then clearly there will be ups and downs in the secondary market but there will always be a core market of 3% to 5% of investors who will need liquidity for one reason or another,” says Parke of Lexington Partners.

But whether, given the difficult economic backdrop against which many secondaries have been buying and the fact that many of the secondary investors that have recently moved from the traditional fund-of-funds into direct transactions as well, returns can be maintained is something that will not be clear for another two or three years at best. The dip into new areas and market segmentation is not as pronounced as some players would have you believe. Drean of Triago explains: “Practically, most buyers buy everything. The reality is that they do have sweet spots, but they transact on many things.”

But Jeffrey of BancBoston Capital is optimistic about future performance of the secondary asset class: “The real beauty of it is the ability to benefit from diversification. Most of the secondary portfolios are clearly benefiting from an element of diversity that primary investors don’t have the benefit of. While expected returns are lower than traditional primary, the likelihood of achieving those returns is far greater.”