Secondaries Pros Discuss Market’s Evolution – Cont’d –

MORGAN: I guess the gatekeepers and the investment banker placement agents have helped that education process. Now there’s a piling on. And what we’ve seen I think in the recent generation funds for various clients is not new types of investors coming in, but more of the same in coming in waves, and in much larger numbers.

NEWMAN: This was never a very popular category until the last year or two. We would speak with people. And, just even in deal flow we had handed them business cards. And they’re sort of like, where are they going to file it? Under drop dead. It wasn’t very interesting. It’s about as interesting as getting a card from a lawyer or an accountant. Sorry if there are lawyers around the table.

ETTELSON: I knew it was coming.

NEWMAN: Well, our cards were in that same pile. So the concern I have is there was a lot of money thrown at the venture markets and the buyout markets in the late 90s. And now it’s being thrown at the secondary market. And one of my concerns is this hot money being thrown at this category.


ETTELSON: Moving on from the macro to the micro. Both David and Chad had mentioned building a portfolio across vintage years and across funds, as well as across the good, the bad, and the ugly. Is there any current focus or is slight weighting to buyout versus venture, foreign, mezzanine or any other area when you’re purchasing interests that you may be weighting higher or have more than an interest in.

de WEESE: We like middle market buyouts. On the venture side we have a much tougher time trying to get our arms around what the portfolio is going to be valued at an exit, and when that’s going to occur. And consequently, it’s difficult for us to know how much to bid. I think there’s also been a bigger bid/ask spread on venture funds than those that even you’re interested in, because the NAVs were written up fairly substantially during the 98, 99, 2000 period.

I think on the buyout side, NAVs have tended to be established differently. Many portfolios are held at cost. I think you also have many more opportunities to get external viewpoints on what the portfolios and assets are worth if there’s leverage on companies. And that is publicly traded, so you can go out and find people trading the debt. And obviously if the debt’s trading at 25 cents on the dollar, you’ve got to be careful. But I think there are more good external valuation points. I think on the larger buyout side there are also some decent opportunities. But we think that’s a more competitive space right now for the primary investors. They tend to be more auction situations than happen in the market.

GRANOFF: Everyone likes buyouts because they’re easier to get your arms around. And there’s more of it because it’s where more of the money went to. In our most recent fund, 83 percent of the assets were buyout assets for those reasons. And we bought very little venture product over the last few years. In our earlier funds, however, we bought more venture products, a larger percentage than we have recently. And that worked out pretty well. And I think that in some ways you could argue that maybe the venture rationalization process is further along than the buyout value rationalization process. And perhaps over the next year or two there’ll be an interesting opportunity that emerges in the venture area.

ALFELD: We’ve tended with our portfolios to somewhat mirror the market at the end of the day in terms of the allocation between venture and buyout. We also buy mezzanine. However, that oftentimes is harder to do. And it is a much smaller segment of the overall market as well. In 2001 we were buying principally buyout. In 2002 we’ve started to step back into the venture. So in our current fund we’ll wind up being between 60 and 70 percent in buyout. And the balance of that being in venture. It’s really a function of what’s available for sale, what you’re able to price these things at. And David mentioned that the buyouts are more palatable and clear from the standpoint of being able to get your arms around these things while they do things at cost. You still need to pay attention to what the EBITDA multiples were because they’re in a different place today. But again, you can benchmark that fairly easily. And your risk with the buyouts as opposed to the venture, where it’s really kind of financing on the buyout side, it may be more structuring how these buys have been structured, what are the breaking covenants with debt and whatnot.

de WEESE: I agree with Michael. I think it’s a question of where you are in the cycle. Our first fund was raised in the second half of 1991. Our first fund ended up a $100 million transaction, with 40 LPs, clearly venture. And it performed incredibly well. So we’re not averse to ventures. It’s a question of…when is the time to really become more aggressive? I’m not sure that, at this point, that the damage in venture funds has been reflected from the point it makes us comfortable. You’ve got three quarters of the GPs or more who are never going to see a dollar of carry. And then you have to ask yourself, how much attention are they going to spend on focusing making money on this fund?

MORGAN: The key word about this industry is opportunistic. And the blends vary with the cycles and what’s available. And most funds are structured to take advantage of that. I have one client now who’s bucking the trend, who has historically been more concentrated in venture, but is bringing out a fund that’s devoted just to middle market buyouts, and trying to segment the market to see if there’s interest in one side or the other.

GRANOFF: In some ways it is right. This is a relative issue, though-a relative pain issue. And I think the venture blow-up got lots and lots of ink. You find major losses in the best and biggest buyout funds in the world over the last year. And the theory used to be, you know, we didn’t have the huge highs. We didn’t have the huge lows in the buyout business. And it was a less risky, better business to be in. [However, now] it’s hard to name a large buyout fund that hasn’t had a major write-off. You’ve had significant multi-hundred million dollar write-offs of companies in relatively undiversified portfolios in the buyout space over the last year. And that is the meltdown that hasn’t been written about. And it’s a big risk for us looking at things because it’s different than what people thought it was going to be.

ETTELSON: To what extent does the fact that you already own an interest in a fund affect your pricing or willingness to take on more interests in that fund? What effect is that in your pricing and whether you have any diversity limitations as to how much of a particular fund you’ll take either from a dollar amount or from a percentage of that fund?

NEWMAN: We faced this very issue where we’ve bought into the same fund several times. And the big determiner on that is, particularly if there’s an unfunded component, what level of unfunded component do you want, because we’re all seeing our unfunded components rise.

de WEESE: We do have limitations on the amount of money that we would place with any one manager. I don’t think we’ve hit those limits. Some of the problems that we’ve had is where once you start to get more than 10 percent of a GP, they may not want to transfer to you. So you can get some push-back from them just in terms of their ending the transfer once you start to become potentially too large a piece of their fund. Typically, if someone brings us a portfolio we would like to see something more than $10 million in value for us to spend time looking at it. If, however, someone brings us a fund that we already own and we’re tracking and we follow on a regular basis, then we can do something that’s a lot smaller than that.

GRANOFF: Subject to all diversification limits, if it’s something you own, know and like, you’re interested in owning more of it. So we aggressively try to look. If there’s something we like, we aggressively look for other pieces of it, subject to maintaining prudent diversification.



ETTELSON: What is your current approach with respect to the percentage of funded versus unfunded commitments? Everyone has mentioned the general proposition that they preferred to have more funded and less unfunded.

GRANOFF: Given what you know right now, given what people invested in over the last few years, there’s an interesting argument that you may be better off with unfunded than funded. But I think that’s a temporary situation, hopefully. Because if that persists, it doesn’t bode well for the industry as a whole. Historically, we have bought interests that have been on average 80 percent funded. And if you think about what the fundamentals are of the secondaries business, you want to be able to look at the assets, being able to decide what you think of them and how much you’re willing to pay for them, and hopefully own them for a very short period. Everything that’s unfunded is not bought as a discount. You don’t get to look at it. It’s the inverse of all those advantages. So when it comes to unfunded, it makes the issues of GP quality, GP permanence, GP strategy, business strategy, really more important maybe today than they were a couple of years ago.

MORGAN: To the extent unfunded is used for follow-on investments to protect the GPs’ current positions and their portfolio companies, that might be a good thing to have rather than new investments.

GRANOFF: That may be right. And there’s certainly a distinction between unfunded and looking at the percentage that’s going to support the existing portfolio, good and bad, and the percentage that’s likely to go to new investments.

ALFELD: Landmark has historically had a similar mix where we’re about 80 percent funded. In the current fund we’re closer to 70 percent. We would limit it to such that we wouldn’t go over having more than 30 percent unfunded. But we’d really rather buy interests that have some unfunded component today if it’s successfully funded now that you’ve potentially increased that financing risk. Are you going to be crammed down? Does the GP have the ability to affect the follow-on financing for the companies that need that? So, to some extent, all other things being equal, we’d prefer to see some unfunded in these portfolios. But obviously there’s a point at which I know we were all seeing a lot of interest out there [in funds] that are 50 percent unfunded to 90 percent unfunded. And those things are not secondary plays. There may be a space for those elsewhere. But it’s really not a secondary buy.

NEWMAN: We [all] used to say that we wouldn’t look at anything unless it’s 50 percent funded. And I think that’s pretty much the case around the table. The problem is, we’re now pushing that up to probably 60 or 70 percent. By and large, we’ve done our statistics recently and we’re 80 percent funded on the portfolio. And so, therefore, you can have some unfunded components. One of the advantages to having some unfunded is often your last dollars in are going to determine your return. You know, unless you keep ponying up, you’re typically washed out in a deal. But the bane of our existence in analyzing it is, how is that unfunded going to be used, and what sort of projected return do we do on the unfunded capital that we’re taking on? Is it going to be what is done over the last few years, let’s say 25X, is it going to be a 1X or are you going to get a 2X on that money?

ETTELSON: Based on your statements it would seem large venture capital funds that had a very small percentage of their commitments drawn down, that in the last year or so have reduced their commitments, are actually increasing potential liquidity for their secondary interest because they would have such a small percentage funded. And by reducing their complement number, they get how much closer to the point where you may be willing to purchase an interest.

NEWMAN: We haven’t seen a lot of turnover in the funds at a reduced size. You’re typically talking the big, big name 15 of the last two years. But it is a good question because, yes, at some point it will be. It’s quite interesting to us when all of a sudden your unfunded goes from 40 to 80 percent because it’s that fund size. So that helps a lot. But by and large, if you name the name-brand funds that have cut their fund size, you’ve not seen a heck of a lot of turnover there.

de WEESE: The concept is a relatively modest 10 percent of the fund as opposed to 50 percent of the fund. By and large, it’s been under pressure. Most funds will try to play with the feed before they cut us out of the fund.


ETTELSON: How large a role is being played by intermediaries who broker transactions between potential buyers and sellers, if at all?

de WEESE: Well, investment bankers don’t have a lot to do today, so some of them have been trying to make a business out of brokering private equity portfolios. I don’t think they add much value to the process. But some of them are doing it. I don’t think this is going to be a permanent fixture in the marketplace because I don’t think that some of the big portfolios are going to be on the market as a regular event going forward. And as soon as these more attractive kinds of activities come along for investment bankers and they get back in the M&A business or IPO business, that’s where they’ll go.

GRANOFF: Historically, very few transactions have had intermediaries. Lots of transactions are competitive but they don’t necessarily have intermediaries. And I think Dave’s point is the right one, which is, in the end, the secondary business is quite a small business. There aren’t that many of us that are actually in a position to look at portfolios, understand them, step up and buy. Lots of people would be interested. But the reality of it is that you can read the last month’s edition of Buyouts or the Private Equity Analyst and pick out who the five or 10 likely buyers are. And you don’t have to pay an investment bank for it. So the people that have done auctions, investment bank auctions have found that it’s still us. And you didn’t need to pay anybody to find us. So it didn’t make a lot of sense. So I think in the end the opportunity for intermediaries to add value is pretty limited.

NEWMAN: But to the extent that we see some opportunities that we haven’t seen before, we welcome it. Can someone make a living being an intermediary in this business? We’re talking about 1 or 2 percent turnover in the primary market and maybe five or 10 buyers out there. It’s not that hard to find us. But to the extent they can scoop up things that we haven’t seen before, we welcome it.

TUTRONE: My perspective is a little different. But I actually do agree that it’s a narrow group of buyers for the most part, especially on these big transactions. And they probably know where to go. The investment banks can add some value in some situations: Number one, if the private equity staff is very lean or it’s recently become very lean. And someone in the corporation needs to handle the sale on a day-to-day basis. And there are a lot of logistics that go into these things. I think the investment bank or even some of these private guys that have sprung up could be helpful there. Quite often, especially with these larger portfolios, the corporation needs or wants someone to tell them that, in fact, the deal that’s being struck is fair and is market-not NAV, but fair and market. And there’s a lot of concern that I found in talking to these corporations, not just taking the discounts now to NAV, but are they actually being taken advantage of given the marketplace and given the narrow group of buyers. And I think a banker will help there. I also think the other area where an intermediate may be helpful is actually shaking loose some of these assets. It’s a lot easier for someone who’s not a principal to go in and explain the grim realities of the marketplace to a potential seller and why discounting NAV may, in fact, be a good deal for them, than it is for someone who is on the buying side.

MORGAN: I’ve seen quite a few intermediaries actually enter deals. I don’t think there’s much value added. But one case is the auction situation where someone says get me the best price and let’s do it on a competitive base. And there is a finite number of buyers who are able to close, and have the capital and resources to analyze and officially price a transaction. And that’s one set. But the second is more along the lines of what you were talking about in the sense that very often corporations say we’ve got a banking relationship. This is a large amount of money. You know, maybe the management team is going with the assets. So we really can’t trust them to effectively price this. We’re the corporate treasurer’s office, we really don’t understand these private equity alternative investments. And therefore, we need to hire a banker somewhere along the process in order to close the transaction. That’s the second case where I’ve seen bankers involved.

TUTRONE: And I also would say that I hope these advisors don’t always come to a conclusion that an auction’s the right answer, because quite often in a situation it’s not. Because of course you know what they say to someone who only knows how to use a hammer where everything’s a nail. And I really don’t think this is the type of situation where everything is going to be a nail. Sometimes the right thing to do will be a negotiation.


ETTELSON: What do you think the potential impact of the recent Freedom of Information Act developments will be on the secondary interest market, and how it may affect the transparency upon which you depend in valuing their securities? Some of the requests do go directly to the portfolio company information valuations.

ALFELD: What that would mean for the GP community is they begin to limit that information that is available to those LPs. So they may bifurcate their LPs into those that are subject to Freedom of Information Act. And you will only get X and the rest of your LPs may get something else. So that may be built into the documents up front. That’s what I would anticipate. As it impacts the secondary market our concern would be, does it in any way impact what GPs are willing to share with us? Does it create some sort of tension that seller has something different than the buyer? But I think in the long run of it I don’t think it will have a real impact to us.

GRANOFF: Overall, it’s interesting. We have the University of Texas as an investor, and they were the first ones to really have this issue get hot. And they talked to us about it and what we thought was going to happen. And my sense was that there are really only two [types of] people making the requests for the information. The first were competitors. I said we’re going to be actually first in line, right? We’d love to see all this information. And the second are people like journalists looking for a good story, [who want to know] why some Texas buyout mogul is flying to work in a helicopter while the poor bus driver’s retirement account is declining. And my sense is that goes away over time. So in some ways I think we’re caught up in the heat of the moment. If I were the governor of Texas, maybe I would have hired a commission to look at the issue for a year and report back to me. And after the sort of Enron thing had ebbed a little bit, it could be that the answer to this question of access would be different than it turned out to be today. That being said though, I think that the issue raises a good point, which is, the issue of the slippery slope is a serious issue. So I think that people crying crocodile tears because they don’t want their performance numbers to come out, if you were the only one you’d have a complaint. But if everyone’s are coming out, well, we live in a competitive, transparent world. And I don’t think that’s such a bad thing. But I do think when it gets to the issue of how deep can you drill on this and company information, things like that, you are getting into things that are legitimately very confidential.

NEWMAN: There’s two components to this. There’s the information on the returns and there’s the information on specific companies in the portfolio. Information on the specific companies in the portfolio, if it gets in the public press or the wrong hands, or it gets in the competitor to one of these companies, it can be damaging. And that’s not good. Information on returns, is it private? You know, everyone thought these were private equity funds with, you know, 100 investors or less. And no one ever wants to read their name on the front page of the press.

ETTELSON: To the extent that flow of information may be impacted by what’s currently going on with Freedom of Information Act disclosure issues, it would seem to put more pressure, potentially in the future, on what information the general partner is willing to share with you as a purchaser. When you go to a general partner to get the consent for a transfer, and it’s a sale between the limited partner and you, the general partner usually has no obligation to provide you with any information. To what extent do they and any issues arise out of that?

de WEESE: Leaving the obvious transparency aside for a moment, I am always pleasantly surprised at the amount of cooperation that general partners give to secondary buyers. From early in the history of the secondary markets there was a certain ambiguous relationship between primary GPs and secondary buyers. But especially over the last couple of years, the benefit of being able to provide liquidity to an LP has become pretty obvious to most GPs.

ETTELSON: Avoid a potential default.

de WEESE: Yes. Obviously, any GP is interested in trying to keep a good relationship with their investor base. And so we get good cooperation from GPs when we’re trying to value their portfolios. In terms of transparency, I’d say most of what we get is verbal. We spend lots of time on the telephone talking to primary GPs. They’re not providing us a lot of hard copy information, nor do we need that information. So I don’t see that actually getting the due diligence done is going to be impacted by this in a serious way. I do think that transparency is the order of the day. And it’s going to get more transparent in the private equity business.

NEWMAN: Like David said, we’ve always been pleasantly surprised by the cooperation of the GPs. That being said, as these funds have gotten larger and larger and these partnerships in these particular funds are no longer three, four, five people, but are now 10, 20, 30 people, often when you are talking to either the CFO or a particular GP, the comment is, That’s not my deal. That’s another partner’s deal. And if you want specifics, you need to talk to that partner.’ At the end of the day, we’re not going to get access to all 10 or 15 partners in the deal. So actually, it’s getting a little bit trickier to get the information or a little harder to get the correct information from the GP because of the extent that you can get to the right GP in a particular fund.

ALFELD: The challenge too is often with something that may be in the auction requirement. How many of the characters does the GP want to have to deal with? How much of their time if it’s an auction that involved the lawyers? It depends on your own relationship with them.

de WEESE: I think that’s one of the problems with the fund’s option, if you like, in selling private equity. Because if there are potentially 8 or 10 or 12 different buyers, the general partner’s got a lot of things to worry about today in terms of his portfolio without worrying about talking to 10 different buyers. What we find is that auctions tend to put you at kind of an information deficit mode. And when you don’t have enough current information, you continue to be conservative in your pricing, which is kind of a contradiction as to why you think that an auction is going to optimize your price. And I don’t think it always does for that reason. Because GPs just don’t want to do exactly what Jerry’s saying. How many different partners are they going to put on the phone? And some of those buyers may be competitors. Some of those buyers may be conflicted in other ways. And so the GP has no control over that process. They usually end up saying, the last annual report is the one everybody gets. And unless you’ve got good databases yourself, it kind of gets tough to do the due diligence.


ETTELSON: Over the next 12 to 24 months, what new trends or issues should people be on the lookout for?

GRANOFF: There are never any new trends or issues. It’s all about looking at the assets-looking company by company in every fund and thinking about what’s going to happen to each company when. And the circumstances change, but the work is the same and doesn’t. That’s the nature of the secondaries business.

TUTRONE: I do think that a couple of these larger transactions will happen. They’ll break loose. My view is just very short term some of these big deals break loose. One of the neat things in this business you can’t get a lot of diversity and buy a big portfolio so you can actually afford to put a large percentage of your money into this fund if it’s the right deal, whereas if you’re the direct guy when you wouldn’t want to put over whatever, is it over 10 percent of your fund in the deal. So I think that can be a watershed event. But I think once one happens and one guy takes the pain and people see the transaction, you might see some others to follow. But I don’t think it’s going to change fundamentally what the people at this table do every day.

ALFELD: Look at the depth of what’s happening in the secondary market. You know, initially it’s really portfolio buying. And there is more direct buying today. There are more corporate venture programs that are being orphaned and taken out. So that activity has increased and will continue to increase over the near term. I think it will dry up in the next two to three years. But it’s a riskier endeavor, because you’re more concentrated, and you’re really underwriting that team and those assets. And therefore, you need to be much more cognizant of what your risks are in those sort of ventures. It’s something we’ve done on a selective basis, but very small sorts of teams. Goldman Sachs is kind of cute, suggesting they did synthetic secondary transactions-whatever that’s supposed to mean. But we’re pretty sure others have done those kinds of transactions in the past, spitting out a team and the assets that go along with that.

de WEESE: One of the changes occurring in the market is that the secondary market has become pan-legitimized over the past number of years. Partly it’s the press. Partly it’s the fact that people are motivated or compelled to go to the secondary market. But I can recall talking to people in the period 95, 96, 97. And it was the first time that anybody ever mentioned secondaries to them. And they never heard about it. And the person you were dealing with was going to do this transaction. He’s expecting to be in for 10 years. It was a one-off event.

I see now, as you go, a willingness to come back to the market again and again, to sort of look at it as a legitimate tool to manage their portfolio. That’s not just an event of this year and next year. I think it’s something that is a change in the marketplace more broadly.

GRANOFF: It’s a good point. There are couple of major trends going on in the secondary business over a long period of time. And one of them is that selling is becoming a commonplace, accepted way of managing your portfolio. When we started in the business, some of us who have been doing it a long time, it was something to be embarrassed about. You didn’t want to talk about it. And now it’s becoming much more commonplace. It’s like dealing with any other asset you have. And that is resulting in more sales. The corollary to it is something that was touched on when you asked the question about GPs. When we started, GPs, who are generally not an ego-challenged group, said…no one would ever sell an interest in my fund. But they realized over time, that if you managed enough money for enough people over enough time, that there will be turnover. And actually it isn’t about you at all. And, in fact, when people are selling, they are selling for their own reasons. And they are selling their interest in not just your fund but my fund as well. The next step, I think, was for GPs to realize that not only is it not bad, maybe it’s good. Maybe having some liquidity available is a good thing. Maybe it brings more people into the business. And capital is the lifeblood of the private equity business. And maybe there are people who will invest in private equity going forward because they think there’s some alternative, liquidity alternative to being locked up for ten years that will bring them into the business.

ALFELD: It’s become a true portfolio manager profile that’s been accepted. And you now have the action. And you’d rather have the action, but not have the action to buy, sell or hold. And obviously, that should be a good thing. And it’s been accepted. Michael pointed out from the GPs’ side, we experienced that all directly. The first transaction we did, in part, was successful because there was a shell corporation around the holdings. So we didn’t have to get consent for transfer of those interests. We did that after the fact. But the GP community was very hesitant. They were worried about where you’re coming in to shake the tree and just disrupt their existing LP base. Alan Patricof spoke at our 96 annual meeting. And he said just what Michael related, which was we didn’t want to see this happen. We were fairly anxious about it. And, in retrospect, we realize it’s done quite a bit for us, which is, we can now replace these funds [and] say to our investors, if you ever need to get out, you can. So it’s actually drawing capital back into the marketplace.

MORGAN: I think the industry has matured, but there still is a speakeasy quality to it-how deals come and are sourced. And outside of the public auction marketplace, it’s still an inefficient market, which is one of the hallmarks when it began as to why it was so attractive. Sellers still want confidentiality many times. So few of these deals actually hit the papers. And when people come out and say, well, let’s develop [an exchange], it was not successful in the process, either electronically or trying to act as a broker on transactions. So it’s totally legitimate. And it’s a good portfolio management tool. But it still has some of its early hallmarks of being a quiet group.

GRANOFF: We only hope it stays that way.