Secondaries: taking a more active role
Subhead] News of Pomona Capital’s sixth secondary fund, which has closed at US$821m, US$200m above target, is a testament to the demand for secondaries investments with more funds than ever flooding into the market. And with more money being raised and fewer opportunities emerging from the banks as most have cleared their books following the introduction of Basel II, secondaries players are having to be more creative and proactive in their deal origination. Angela Sormani reports.
While the secondary market was once centered on distressed sellers, it has developed into an integral feature of the private equity landscape and is now widely used as a pro-active portfolio management tool by private equity investors. Vendors are becoming increasingly sophisticated in terms of their liquidity requirements and so now, for a secondaries firm to be successful, it is no longer about buying on the cheap; it must be about creating mutually beneficial solutions.
The maturity of the market has resulted in increased segmentation and differentiation. There are the large players, who must participate in well publicised auctions of large portfolios as well as acquiring secondary positions opportunistically in funds with which they already have relationships, and those that they do not. There are also smaller, established players who participate in these segments of the market, with the exception of the large auction situations. Increasingly important, however, are the niche players, who address specific segments of the market, such as venture or direct portfolios. Because of the market’s fragmentation, both the types of deals and the deal structures used are becoming more sophisticated which benefits sellers and will reinforce their growing demand for liquidity.
A sign of this maturing market is the second spin-out to come from Coller Capital after Greenpark; Headway Capital. Christiaan de Lint, Sebastian Junoy and Laura Shen, all ex-Coller, set up the business last year and closed their maiden fund, Headway Investment Partners, LP (HIP) earlier this year on €52m. A far cry from Coller’s last two fund raisings, each of which entered the billion euro plus territory, but enough for the smaller, specialised transaction the fund is targeting. HIP is purchasing limited partnership interests in venture capital and private equity funds, portfolios of direct investments and minority stakes in single companies, providing a full range of liquidity solutions to institutions and individuals seeking exits from or alternatives for their private equity assets. HIP differentiates itself by focusing on smaller and/or more complex transactions and by creating effective solutions to address the specific needs of each seller.
HIP’s investor base consists solely of family offices and high net worth individuals from around the world, including many veteran investors in private equity. Sebastian Junoy explains their choice of investor base: “There were many factors which led to our specifically targeting family offices as investors. For example, in order to guarantee discretion to our sellers, we felt that we needed an investor base that places the highest value on discretion. In addition, we find that many general partners prefer working with a secondary buyer who can make interesting introductions to potential limited partners.”
In terms of deal flow he says: “The challenge is to find the non-obvious deals. What we thought was missing was a group that serviced the smaller, more complex end of the market. Direct portfolio transactions fall into the complex transactions category; they’re harder to execute than LP partnership acquisitions, they’re a lot more lengthy and there are more parties to deal with in the transaction.”
Subhead] The direct approach
The past few years have seen secondaries directs as an offshoot of the broader secondaries market developing into a niche of their own with dedicated secondaries direct players coming to the fore, the most prominent in the last year being Cipio Partners, Nova Capital Management and Vision Capital. IRRfc, the Phildrew ventures spin-out from UBS Capital, is another such firm. But it has recently slipped off the radar, believed by market observers to be downsizing. There are rumours that the team, which came off a very high base from UBS with a big portfolio and fat fees, now all have different motivations and levels of hunger and so it is believed those left are working out the existing portfolio.
Mark Mifsud of SJ Berwin says: “We are definitely seeing a growth in secondary directs with the acquisition of a number of tail-end companies as part of one transaction. Recently, I have not seen as many acquisitions of the big portfolio partnership interest acquisitions. The difference between a secondary transaction and a secondary buyout is becoming quite blurred. The market is evolving and it seems to me to be focusing more on direct investments rather than partnership interests.”
The Nova Capital Management team has been inundated with deals in this space and is fast making a name for itself on both sides of the Atlantic following the opening of its US office earlier this year and its first US deal; the acquisition of the partnership interests of Atlantic Medical Capital LP, an US$80m portfolio of healthcare assets.
The market in the US is competitive, but not as fierce as Michael Kelly, Nova managing director, envisaged. Kelly says: “There are active players out there such as W Capital, who have done deals and have raised a fund of US$300m, but no-one seems to be doing massive amounts of business. It hasn’t moved to a higher plane as we expected, whereas in the European context activity has increased quite significantly in directs.”
In Europe, Nova’s pipeline is still pretty full with a portfolio of five deals and a sixth pending. The firm’s most recent deal was the Botts Capital Partners transaction. Investors in the firm instigated a change of management following a few years of poor performance. The fund assets were acquired by US secondaries specialist Paul Capital Partners and are being managed by Nova Capital.
Other landmark deals for Nova include the Albemarle transaction, the first hostile replacement of a GP in the UK where 90% of the LPs in the fund voted to replace the incumbent manager with Nova. Also last year Nova acquired a tech portfolio, which was previously managed by West LB, and was funded by HarbourVest.
Kelly says: “We are seeing more interest from LPs wanting to back a direct portfolio of investments rather than backing an unidentifiable pool of assets.” This backs up Mark Mifsud’s experience of actual transactions taking place. In terms of deal flow he says there is more on the venture side, which is where players such as German specialist Cipio Partners operate. Cipio has also recently opened a US office in San Jose, California and has been particularly active in Europe having already realised two of its investments in Toposys and Advalytix.
Werner Dreesbach, a managing partner at Cipio Partners stresses the importance of being able to act on a global scale. He says: “We expect more and larger deals to come to the market with geographically dispersed portfolios, sold by internationally active investors. We have recently opened a new office on the West Coast to cater to these new requirements.”
He sees unlimited potential for secondaries directs. “Similar to venture capital, which has evolved from a cottage industry to a repeatable business model, the secondary direct market has evolved substantially over the last year. The industry overall has become a lot more professional, on both the sellers’ and buyers’ side. Sellers are much better organised and enter sales discussions only after thorough preparation and with comprehensive documentation to support the sales process and buyers have resources and processes in place to react faster to the requirements of sellers.” Most portfolios on the market, he says, are still focused on technology. Over the next two years he expects the market to expand further to cover other industries, such as life sciences.
He adds that while deals are plentiful, there are only a handful of buyers specialising in secondary direct opportunities and he does not anticipate this number will increase much. He says: “While the market will continue to grow, sellers at the same time will become ever more demanding. New entrants without prior transaction experience, who do not have the expertise, resources and track record to carry out comprehensive due diligence efforts, handle complex legal setups and provide firm financial commitments, will face tremendous difficulties breaking into this market, especially if their ability to close within short time frames is not crystal clear.”
Subhead] Problem solving
The normal buying and selling of partnership interests is still core to the secondary market, but secondary players need to be more creative to differentiate themselves and to find deals outside the auction process. Mark Mifsud of SJ Berwin says: “What the secondaries market is doing is being very bespoke. We now use a lot of different structures to meet the buyer’s and seller’s needs.”
A recent example of a secondaries fund introducing a solution to a problem within a private equity fund is Coller Capital’s recent acquisition of Excel Partners. Excel Partners was one of the earliest active investors in the Spanish market. The group was dissolved in acrimonious circumstances in May 2005 and the portfolio was acquired by Coller. Trouble started for the firm in September 2004, when tensions arose between the two founding partners, David Bendel and Jose Maria Lopez de Letona. The disagreement, which is said to have revolved around the strategic direction of the firm, became even worse when a third partner, Ramon Menendez de Luarca, was recruited.
At that stage, investors in the group’s third fund became concerned about continuity and the ability of the general partners to manage the portfolio. Initially, the limited partners attempted to solve the problem themselves by dividing the existing portfolio between the two founding partners. That did not work and it was at that stage secondary investors became involved.
While these negotiations were still ongoing, Bendel spun out to set up his own firm, Minerva Partners. Coller successfully agreed to buy the companies and liquidate the fund and subsequently set up a management contract with Minerva to manage part of the portfolio through to a successful exit. The portfolio comprises Expert Maschinenbau, a supplier of automotive components; Gas Gas, a motorcycle manufacturer; The Real Music Group, a music publisher; Rotographik, an offset printing company; and Unitronics, a network operator.
A landmark deal this year for the secondaries market, and another example of how the market is metamorphosing into a solution provider, is Penta Capital’s admission of three new limited partners to its Penta Fund I. Described by some in the market as a staple transaction, the deal enabled Penta to raise new funds by selling a secondary position in its existing fund.
Tim Jones of Coller Capital says such deals are particularly challenging because it’s very hard to get LPs in a fund to allow new investors into the vehicle. “There are very few deals done like that as they’re incredibly difficult to do and it’s very hard to get investors to vote to do something like that.”
The three new investors admitted as limited partners into Penta Capital’s fund were AXA Private Equity, Bregal and the Goldman Sachs Vintage Funds. In addition to subscribing new capital alongside Penta’s existing limited partners, the three new investors acquired a secondary interest from one existing limited partner in the fund. The total capital committed by the new investors and by existing limited partners exceeded £75m.
Originally raised in 2000, with commitments of £125.5m, the fund’s term has also been extended to allow Penta Capital to deploy these additional resources over the next two years. Steven Scott of Penta Capital said: “We are delighted to have raised additional capital in a very efficient manner from three first-class investors without the distraction of a traditional fund raising exercise. This has expanded and rebalanced our investor base. It provides capital for further investment and positions us well for a wider fund raising when further exits have been achieved.”
Andrew Sealey of fund placement and financial advisory firm Campbell Lutyens, which advised Penta, structured the transaction and raised the new capital. He describes the deal as an arbitrage between the primary and secondary markets; a manager that was looking for an interim solution before going out to fund raise.
Campbell Lutyens is particularly active in the secondary market and is currently advising on a €100m financing to acquire a portfolio of direct buyout assets as well as advising on a number of similar sized sale mandates both of portfolios of fund assets and portfolios of direct private equity assets.
The firm is one of few placement businesses taking advantage of the demand for secondaries. Some players in the placement business have taken the view that so many LPs want secondaries that if they gave a deal to one they’d annoy many of their potential clients and so have decided it’s better for their core placement business not to do secondaries.
Sealey says: “Specialist secondary investors are trying to find less competitive areas for investment because the returns on plain vanilla secondaries are being eroded. We will be seeing more structured and complex transactions with leverage playing a more important part. In addition you are seeing greater linkage between secondary and primary funding where managers are able to exploit a secondary opportunity to raise primary capital. For example, managers are saying: ‘you can come into the secondary conditional on a commitment to the primary’. The secondary is therefore being used as a sweetener to help bring investors into a new fund.”
A fund which has taken a similar approach is Hermes Private Equity (HPE), which has just closed its second direct private equity fund, Hermes Private Equity Partners II (HPEP II), raising £250m, (see lead fund story this issue). The BT Pension Scheme (BTPS), owner of Hermes, committed £183m to the new fund and Hermes also attracted capital from an external investor for the first time. The Royal Mail Pension Plan committed £100m in total to HPE. But its investment will be split with £67m to be invested through HPEP II and £33m in Hermes Private Equity Partners I (HPEP I), the first fund. All new investments will be made through the new fund, with HPEP I making follow-on investments to support existing portfolio companies in their growth and acquisition plans.
Marlene Groen of Greenpark Capital predicts we will see more of these deals as the market develops. “There are more staple deals coming to the fore where new money is being attached to an existing portfolio. This will normally happen when a GP needs additional capital for companies but doesn’t have enough capital to make further investments and it is too soon to exit the portfolio. There are other ways to work around this by splitting the fund into two vehicles, but a stapled deal is more attractive as less paperwork is involved. This is a good way for GPs looking for new money without having to go on the full-blown fund raising trail.”
“I think we will definitely see more stapled transactions. GPs have started to use secondaries to entice investors into their new fund and an investor will purchase a secondary stake in Fund 1 with a view to investing in Fund 2. It is almost becoming a form of due diligence for some investors,” says Mifsud.
Also becoming more important for secondary managers is to have primary capabilities. For example, AXA, Bregal and Goldman Sachs are all active in both the primary and secondary markets. Which begs the question, with so much money available in the primary market will the larger primary private equity houses also start trying their luck in the secondary market? There are rumours that 3i has been involved in the auctions of some secondary direct portfolios that may have made a good strategic fit with its own portfolio and Electra Investment Trust is reported to have pitched for the Botts portfolio that Nova won.
Werner Dreesbach of Cipio Partners says the secondary market may be of interest to a few select primary investors, but on rare occasions. He uses the acquisition of Infineon Ventures as an example where a number of well-known primary investors participated in the sales process and put in bids for the portfolio. But he stresses: “These incidents were and will remain exceptions. Engaging in the secondary market is, simply put, not compatible with the business model of a primary investor, which is typically governed by Private Placement Memorandums and LP Agreements with their investors. We doubt it would go down well with a primary fund’s investors if the partnership suddenly were to manage an additional 15 or 30 portfolio companies following a secondary direct transaction, having previously agreed with its investors to pursue one or two investments per year, per partner.”
Ultimately the way new secondary funds are able to justify their existence in such a competitive market, which is even attracting some primary players, is by doing more complex, innovative transactions. Sebastian Junoy says: “It is a competitive market, there are a lot more players and there is a lot of money out there chasing deals so knowing exactly what you are after is important. I think we will see some LPs that haven’t had the realisations they should have and so we should see more fund extensions and a mixture of primary and secondary money going into transactions.”
Pricing in favour of the LP
Following what looks like a further improvement in exit activities in 2005, LPs are becoming more reluctant to sell interests in private equity partnerships. As a result Stefan Hepp of SCM Strategic Capital Management predicts a continuing trend of declining discounts. He says: “We are in touch with about 100 GPs where we track secondary transactions in LP interests as their pricing is used to determine the fair market value of the partnerships concerned under certain accounting rules that apply to pension plans in some European jurisdictions. Based on that information there seems to be a trend of declining discounts and an increase in the number of transactions which command a premium on top of the net asset value. This reflects, in our opinion, the recognition of the fact that there is hidden value in many portfolio companies held by PE partnerships and that such hidden value is expected to be realised sooner rather than later given the current favourable exit environment.”
He adds that LPs nowadays are more aware that negative IRRs, which are commonly associated with the J-curve effect, can flip very rapidly to reveal positive returns after just a few successful exits. As an example, Hepp describes a VC partnership focused on communications investments and which has suffered after the burst of the technology bubble with a TVPI dipping below 0.4. After two successful exits, this partnership is now on course to post a TVPI in excess of 2.0. Hepp says: “Any investor (there were some) who lost faith in this GP and sold his interest, let’s say a year ago at a significant discount (up to 30%) will now have to answer some serious questions to his investment board or trustees. Experiences like this clearly make limited partners less trigger-happy when considering a secondary sale.”