Secondaries: plenty to chew on

With a staggering increase in the amount of money raised for and invested in primary private equity investments over the last three years activity in the secondaries market could be expected to be hotting up. The pace has been sharply accelerated, however, by the collapse in public markets globally and the fall in value of many private equity portfolios.

Last year the secondary market and its possibilities as a liquidity mechanism for private equity investors came to wide attention with the sale of NatWest’s $1 billion private equity portfolio to Coller Capital, Hamilton Lane Advisors and Lexington Partners consortium last summer. This was followed by Chase’s sale of circa $2 billion in private equity commitments into the secondary market at the end of last year. Both events saw wide coverage in the international business press and significantly raised the profile of the participating secondary investors and secondary private equity investors at large.

Apart from Bank of America’s publicly announced foray into the secondary market in March this year, when it sold $260 million of its private equity commitments to Landmark Partners, the secondary market largely retains the shroud of secrecy. This is often impressed upon it by the primary private equity investors to which it grants liquidity. While deal flow in 2000 was steady conversely it has been 2001, while the majority of private equity headlines have focused on the technology, venture capital, and public markets collapses and general economic malaise, that things have really taken off in the secondary private equity investment space. That said, compared to the primary private equity investment market the amount of secondary investment that goes on is small. “On the basis of what we have seen I would say that less than five per cent of the European primary market will be sold as secondaries,” said Elly Livingstone at Pantheon Ventures.

This view is backed up by Marshall Parke at Lexington Partners: “Historically our figures show primary funds that change hands into the secondary market are between three and five per cent globally.” Small is a relative term though when you consider that in the period 1996 to 2000 some euro121 billion was raised in primary private equity funds. In 1996 the figure was euro7.9 billion, in 1997 it was euro20 billion, in 1998 it was e20 billion, in 1999 it was euro25.5 billion, and in 2000 it was euro47 billion. (All figures sourced from the European Venture Capital Association.) Tim Jones at Coller Capital says: “We believe there are about $20 billion of [secondary] assets, at fair market value, for sale at this moment. Some of those assets no one will want to buy.” He estimates that in the first three-quarters of 2001 some $2.5 billion to $3 billion worth of secondary assets had actually changed hands in the European market.

The Bank of America sale was aimed at creating liquidity. This is the type of transaction that the majority of secondary players say they prefer because it involves a committed seller. They typically look for sellers of non-distressed, sufficiently mature assets (five to seven years invested.) Michael Granoff at Pomona Capital says: “We look for non-competitive negotiated transactions. Over 70 per cent of the deals we have done historically have been non-competitive and that percentage has probably increased recently.” Some secondary players anticipate that the overhaul in capital standards for European banks, as outlined by the Basel Committee in January this year, may trigger a further round of sales of this nature. (The eight per cent risk-adjusted assets continues to be the minimum capital requirement but extra capital is required and is dependent on the sophistication of a banks internal risk mechanisms.)

Regulatory change aside, other drivers include the knock-on effect of M&A activity. For example, when NatWest was acquired by the Royal Bank of Scotland last year this resulted in NatWest’s private equity interests being sold into the secondary market. Those primary investments continue to be managed by Bridgepoint Capital, the former NatWest Equity Partners team that spun out of NatWest following its change of ownership. While it’s normal to see deals resulting from M&A activity, Tim Jones notes: “We are getting far more portfolios coming out of institutions and individuals who are going through some sort of financial distress.” Institutional sellers of this nature can be corporates that have invested in private equity off their own balance sheet and as the economy has started to move into recession are finding they need cash, which is bound up in private equity investments, to put into other areas of the business. And corporates that, for example, downsize their workforces may need to make adjustments to their company pension fund’s private equity asset allocation.

There are also currently a lot of potential sellers in the private equity secondary market that are motivated primarily by value rather than a pressing liquidity issue. These sellers, while of interest, can ultimately be frustrating since the work done on a transaction may not come to fruition if the price isn’t right. Many of these types of sellers (which are reported to be predominantly banks) are looking for a way to lock in the value of their portfolio, hence their price sensitivity. Locking in the value of a private equity portfolio is also driving the development of deal structures in the secondary market. “Deal structures in secondary transactions are becoming more sophisticated involving things like equity swaps and staged payments. Sellers are increasingly looking for a sale into the secondary market that gives them liquidity and retains an upside in the equity investment,” says Elly Livingstone.

Most of the secondary players in today’s market are long established and clear in their objectives, which do not include bailing investors out of poorly performing funds. Unfortunately there are currently quite a few of these types of sellers in the market. “The sellers that are trying to get out in a rush are mainly the ones that got into private equity for the first time in the late 1990s. Most of the distressed vendors that we have seen are based in the States,” says Elly Livingstone. And the many of these types of sellers have distressed assets that were invested in the technology space.

An increasing and welcome element of the European secondaries market is the sophisticated institutional investor. “Most European institutional investors coming to the secondaries market are looking to manage their portfolio in a more active way rather than being distressed sellers,” says Elly Livingstone. Over allocation is an issue predominantly facing the US market where the methodology that for every dollar invested in private equity only 60 cents is ever drawn down’ has been thrown out of the window with public markets closing down and exits slowing to a crawl. “Distributions drying up is the simplest driver to access the secondaries market in our experience,” says Marshall Parke. “All the liquidity has been taken out of the market so limited partners are not getting much cash back at present.”

However, as Tim Jones notes, a lot of the public pension funds in the US can look to their board to change the allocation threshold for alternative assets, which includes private equity. Boards may well be willing to change this threshold given that there has been at least a 12-month gap between public market valuations falling flat and the fall in the valuation of private equity investments. Once private equity valuations reach the correct level pension fund managers can realistically change allocations if they find themselves overexposed to private equity as an asset class.

Regardless of over-exposure the sophisticated private equity investor will want to ensure capacity for investment in forthcoming fund vintages, with next year and the one after uppermost in many investors minds. “Because there is more realism on pricing and more discipline about investing, there is a sense that primary funds investing in 2002/03 could turn out to be better vintages,” explains Elly Livingstone. Additionally, secondary investors note they are also seeing deal flow as a result of institutional investors consolidating their positions in different private equity funds. This involves the identification and eventual sale of funds deemed by LPs to be non-core to their investment strategies.

Aside from all of these diversely motivated sellers of primary private equity positions the market is further being clogged up by individuals and institutions that are trying to sell their unfunded private equity commitments. Individuals in this position often turn out to be last year’s technology paper millionaires no longer with the pocket to see these commitments through. It’s most likely that if there is any interest in taking over these commitments that it will come either from the fund-of-funds market or a limited partner already participating in the fund.

Unfunded commitments are of no interest to secondary investors and are described by one such investor as being as risky as catching falling knives. This is not a judgement on the quality of the funds that have limited partners unable or unwilling to commit so much as an expression of where a secondary players’ skill lies: it is in the assessment of the value now, and at exit, of existing assets. For this reason the majority of players would not express interest in a fund until somewhere between year four and year seven. Most funds (operating on a ten year limited partnership structure) are fully invested by year three on average, and must be invested by year five. This means a secondary investor can assess all the funds investments, the fund has a discernible track record to measure and will for the most part (depending on the fund stage) have started to see or be close to some exits.

Perhaps because of the peculiar type of expertise required, secondary investing remains a niche market, despite the volumes transacted each year. Marshall Parke notes: “This is a very expensive business to get into. You need to build a database, and build a team and you’ve got to raise the money to invest.” For these reasons there are few new entrants to the private equity secondary investor market. Greenpark Capital, started by former Coller Capital employees, entered the market last year and Goldman Sachs has raised a fund for secondary investment, as has Credit Suisse First Boston (CSFB.) CSFB is leveraging is private equity fund placement business and is targeting auctions and one off transactions, although primarily the latter. Since getting started earlier this year Steve Can, MD & CEO for secondary funds at Credit Suisse First Boston, has closed or contracted to invest in around $400 million of the firm’s first $832 million secondary fund. Independent secondary investors level criticism at the investment banks now entering their market pointing to the conflict of interest generated by the investment banking deal-related annual bonus system. This puts the emphasis on investments being made rather than their subsequent performance the latter being the benchmark against which independent secondary investors are remunerated. In Can’s case this is not a concern since the team is incentivised on the basis of the performance of the fund and Credit Suisse First Boston, while investing in the fund itself, has also set up an employee investment plan.

Aside from wholesale new entrants to the secondaries market there has also been some toe dipping by fund-of-funds. This ranges from taking over other limited partners investments in a fund in which the fund-of-funds is already a limited partner to opportunistic buying of secondary positions. “There are four or five groups that do the large transactions and a number of groups that can do smaller deals. I would say there is a reasonable balance between [secondary] capital available and deals in the market,” says Marshall Parke.

On the whole capacity in the secondaries market has come from existing players raising larger funds. Lexington Partners expects to close its fourth fund, which is already 50 per cent committed, at $2.5 billion in the first quarter of next year. Pomona Capital is significantly upping its funds under management now that it is in the process of raising its latest fund, which has held its first closing at $180 million, has another $100 million circled, and has an eventual target of $400 million. Coller Capital is another in need of new funds to invest. “We started fund raising in May 2001 for Lexington Capital Partners IV and it’s a difficult market for everyone,” says Marshall Parke. However, he goes on to say: “Secondary investors are viewed as a bit of safe haven in this market in that we are widely diversified and are able to buy assets that we can analyse.”

As for what next year holds, expectations of the secondary market are positive. “We’ve been very disciplined about price for the last couple of years and done very little because we were very concerned about the price and quality of assets available. In 2001 and beyond we expect to do more transactions than in the previous two years,” says Michael Granoff of Pomona Capital. US-based Pomona set up its London office some three years ago under the leadership of Brian Wright in recognition of the European market and from the need immerse itself in this market, which is hard to do from a US base. “The European market is still less efficient and less transparent than the US secondaries market,” says Michael Granoff.

The pricing issue is two-fold. Firstly it’s the price paid for assets by GPs (although this issue is likely to kick in some years hence for secondary investors when 1999 and 2000 funds hit the secondary market). Secondly, when valuations rocketed during 1999 and 2000 portfolios were revised upwards but have been slow to return to realistic levels. Elly Livingstone echoes the views of many secondary investors: “We expect much of the bad news [in primary funds] will have come out by the time GPs issue their year-end reports for 2001.”

That said, year-end is not likely to conclude matters. As Michael Granoff points out: “Valuations have not hit bottom yet. The end of year reporting will help, although it’s quite hard to predict the behavior of GPs of private equity funds – so far there hasn’t been a uniformity of response to the downturn.”

The secondaries market undoubtedly faces a number of challenges at the presence time. As Tim Jones points out: “It has been easy to be a successful secondary investor in last decade because of the bull market.” And now the aim of the game is to continue that run now the bear is back.