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Secondary investing: the PE industry’s silver lining?

As many GPs struggle to raise capital there’s one corner of the private equity industry where funds are regularly coming in with commitments over their target. The flood of secondary positions currently for sale may seem to merit the spiralling fund sizes, reminiscent of the late 1990s, but should alarm bells be ringing?

Louise Cowley looks at some of the issues facing this growing market.

Specialist funds that buy both portfolios of direct investments and LP’s positions in funds have existed on the fringes of private equity since the 1980s but enthusiasm for secondary funds is now booming. The current high level of interest in secondaries can be seen as part of the natural evolution of private equity, explained to a large extent by the exponential growth of the primary private equity universe. As the asset class matures investors expect liquidity, a demand the secondaries market has expanded to meet.

The secretive nature of the secondaries business makes assessing the size of the market a challenge. Lexington Partners estimates the total volume of partnership sales between 1990 and 2001 to be $13.8 billion, including the assumption of estimated unfunded commitments. It is generally estimated that, allowing for a time lag of several years, around three per cent of each year’s commitments to the primary market are recycled in this way. With this in mind, when you look at the spike in private equity raised in 2000, the increasing size and number of secondary funds seeking capital seems to make sense.

The three per cent calculation has given rise to predictions of huge activity levels to be expected in coming years. Already Coller Capital has recently closed a record $2.5 billion secondaries fund and there are a number of other funds likely to challenge this before too long. Michael Granoff, president and CEO of Pomona Capital, says: “The number of deals is going to increase over the next year but there’s not likely to be a tidal wave.” There’s no shortage of possible homes for this money, however, as investors adjust their asset allocations to cope with the depressed markets there are a number of large institutional portfolios up for grabs.

Spoilt for choice?

So why are funds investing in secondary private equity positions exceeding their targets at a time when venture capital and buyout funds alike are finding it difficult to attract money? Secondaries are still a relatively fresh concept in what is itself a young industry. As the deals are clandestine in character (only a handful of acquisitions have ever been disclosed) it has taken some time to raise their profile. The market is steadily becoming more efficient and there are now hundreds, if not thousands, of fund managers that have first hand experience of a secondary deal. As a result it is gradually becoming easier for secondary funds to do due diligence and get the information they need.

However, it’s no coincidence that secondaries have come to prominence now. Granoff believes the strategy of secondary investors resonates now more than in boom times. Speaking of investors, Granoff says: “People are struggling with what’s going on, and are thinking about how to deal with it, asking is there a silver lining?” The dawn of the new millennium saw the end of a run of years when no one thought about the downside of investing in private equity. The secondary fund managers’ value approach to buying discounted assets, of which there are currently plenty available, now offers the opportunity to mitigate risks and take advantage of the downturn. Investors also favour secondaries for their shorter investment horizon and as a way of diversifying their portfolio.

The prospect of falling returns elsewhere in the industry has pushed would-be investors further into the arms of secondary fund managers. In terms of returns secondaries can’t match the best primary funds in a really good market,” says Henri Isnard, co-founder and managing partner of ARCIS. But we are no longer in a rising market. Isnard adds: “Secondary funds should do quite well compared to the best primary funds in a difficult market.” Tim Jones, investment director at Coller Capital, believes secondaries can increasingly stand up to primary returns and are moving away from being seen as a form of investing similar to distressed debt. With more buyers in the market secondary deals are becoming more acceptable, although there is still some way to go before they are wholly accepted as an asset management tool.

The growth in the market is also being driven by the sheer volume of investors looking to sell assets and exit or reduce their private equity interests. The main driver behind secondary sales at the moment is the re-allocation of assets by institutional investors. The collapse in value of listed equities means institutions need to realign their public and private market investments. As an alternative asset and one that has demonstrated extremely volatile earnings, private equity is one of the first areas where investors look to reduce their exposure.

Banks, one of the biggest investor groups, are experiencing stresses of their own. Falling revenues and the onset of the Basel II banking accord means they are taking a long hard look at their books and reducing their private equity commitments. With portfolios from the likes of UBS, Abbey National and Deutsche Bank dangling in front of the secondaries industry, it comes as no surprise that in terms of volume the banks offer the most deals. Solvency issues and the need to create liquidity means insurance companies offer rich pickings too. Corporate sellers, historically driven to market by a change of strategy or personnel, are also prompted to sell by the general economic downturn.

Macro economic trends are affecting everyone and secondary fund managers agree that there are sellers from every category of limited partners on the market. Normally idiosyncratic events, such as new regulations or a merger, means one group is likely to dominate the deal flow but there are now more deals from more sources. In part, this is a result of the influx of less experienced investors in the late 1990s, when private equity congratulated itself on broadening its investor base.

General partners are also turning to secondaries, facing a fund raising squeeze and ever extending delays to exits, some GPs are selling their older portfolios. This provides them with the much-needed realisations that boost fund raising efforts. Jones says that although it was never an issue for GPs to allow transfers to secondary funds, they did sometimes ignore or look down on them. Increasingly these specialist fund managers are seen in a more positive light and as a source of help for GPs. Coller has already done a couple of deals like this, although none have been disclosed, and Jones cites a change of strategy or an imminent fund launch as the main motivators. “GPs may feel they’ve got everything they can out of their old books but they often still have value,” he says.

If you look at the assets that are on the market and the reasons why they’re being sold, it doesn’t look like deal flow is likely to dwindle in the near future as the primary motive, the continuing economic gloom, shows little or no sign of lifting. However, the reasons there are so many private equity assets on the market now will also mean that fewer new commitments to primary funds are being made. And this means that at some point down the line there will be fewer secondary deals to be done. Isnard is dubious about the timing of a boom: “The slow down of the primary private equity market will catch up with secondary funds.”

Buyer beware!

Although only a fraction of the deals will ever become public knowledge, it’s worth considering what type of assets are currently on the auction block and what secondary funds prefer. Ask any investor what type of deals they’re looking for and they’ll tell you only the best’. Most secondary fund managers will also tell you that the best assets are not always found in the places you’d expect, a point rather sorely illustrated by performance disclosures from CalPERS and UTIMCO. Granoff says; “There are three types of portfolios; the good, the bad and the ugly. We’re not interested in the bad or the ugly; you just can’t make money from them. We’re not a bottom-fisher, we don’t want distressed assets: we need to buy assets that will grow.”

Joanna Jordan, one of the founders of Greenpark Capital and in charge of operations and investor relations for the firm, says: “With the deal flow at the moment we can afford to be selective. There are a lot of less attractive, later vintage tech funds out there that are largely undrawn and so more like a late primary investment.” When considering deals Greenpark looks at the amount funded as much as the maturity of the fund. Isnard is similarly wary of undrawn-down commitments. The totals for capital raised in recent years are staggering but a large proportion of this money has not been drawn down and so distorts the size of the potential secondary market.

Isnard questions how much of these commitments will ever be invested: “The current market in non-paid in commitments will disappear over the next two years as funds will call the money, or reduce the size of investors’ commitments, or even a few investors may default.” Such deals can scarcely be called secondaries, as they can’t be analysed in the same way. The investment decision has to be based on the manager, not on the assets, making it more like a fund-of-funds investment. Another reason most secondary investors avoid undrawn investments is because they threaten the time scale of returns. If a commitment is only 50 per cent paid in you save very little time.

Jordan maintains that the quality of assets is generally good but when choosing investments the emphasis is always on exit-ability, where she believes buyouts fit the bill. Accordingly, investments from Greenpark’s first fund are likely to be heavily weighted in that direction. However, she says recent tech funds may become more attractive further down the line. Decisions ultimately depend on the quality of the management team, as well as the assets, and Greenpark avoids firms that are moving away from their key competencies.

Many of the assets on the secondary market are inevitably technology-focused venture capital funds and while some of the specialists are giving them a wide berth, Jones says Coller Capital is very interested and will look at 1999 and 2000 vintages. However, there’s a lot to be taken into consideration in this type of deal. As well as rigorous due diligence it is important to know if the other GPs that have invested in the portfolio companies can continue to finance them. Jones’ advice is to be selective and expect longer holding periods. This is not always the case: for example, Coller Capital has already sold Celiant, a company acquired a year ago as part of the Lucent portfolio, for $470 million.

Jones is less enthusiastic about buyout funds, which he believes are more likely to be affected by the current credit crunch. However, he does concede that the higher visibility of such companies can make them easier to value, especially if they are past the cash-burn stage.

The consensus is that while there are plenty of good quality assets on offer to secondary players there’s also a lot that quite deservedly aren’t going to be funded. The fact that Coller Capital has only done one deal since Lucent highlights this. “You need to know when to invest. It seems too easy at the moment, like it was with dot.coms, and that can be damaging,” says Jones. He is concerned that secondary investing is seen as easy to do. Money can be invested fast at what appears to be cheap prices but there’s a danger that the amount of capital available could outweigh quality deal flow, something that will almost certainly lead to a shakeout of the new players.

Jones says: “There’s a lot of deal-chasing going on, people will do deals to prove themselves rather than because they’re the right deals to do.” While there will be some clear wins in secondary investing, in some cases it will be pot luck if the capital rushing in to the market is deployed well or not.

Most of those on the market to buy secondary fund positions or direct investments believe that how you find a deal makes a big difference to its likely quality. “Although there is a lot of deal flow about you still have to find the best deals, and those aren’t necessarily the ones that arrive at your door,” says Isnard. Jordan says that reputation and having a high profile in the industry helps attract deals but is only part of Greenpark’s approach to deal sourcing, which relies on an international network of relationships with GPs and investment advisors.

Like many secondaries Pomona tries to avoid competitive deals. “Pro-active deal sourcing can have a tremendous effect,” says Granoff. He also emphasises the importance of building close relationships with sellers. When the potential buyer knows the vendor they understand their motives and this helps them to meet the seller’s needs, which often include discretion and a time frame, and secure the deal.

As the secondaries industry grows intermediaries are keen to get in on the action. Investment banks, placement agents and other intermediaries are driving the market’s increasing efficiency but secondary funds remain lukewarm about the role they play. Most are happy to work with them, if they can find the right kind of deals. “Intermediaries certainly help sellers with the price and help buyers get information and sort out the deal structure,” says Isnard.

Coller Capital has only ever done one deal through an intermediary but Jones is open to the idea, although he believes that as a disconnect between the buyer and seller intermediaries can prevent the development of an all-important relationship. Deals that are over $100 million are likely to be done through an investment bank. Jones says that of the banks in the market only CSFB has made a successful stab at secondary auctions. Part of the reason is the amount of valuation work involved and time taken contacting the different parties. Also, as there’s still just a handful of secondary players, only one auction can be run at a time or they will compete against each other.

An evolving market

While the secondaries market isn’t exactly overrun with newcomers, increasing awareness of the concept and its present popularity will attract more players and bigger capital pools. Granoff says that while the supply/demand equation has not changed dramatically, and that a bigger market warrants more players, he is still concerned about competition: “That is the reason we have focused since inception on being in the least competitive part of our market. It is why we tend to be out bid by the same people today as we did five years ago.” At the moment there are probably enough assets on sale to limit the impact of any additional competition due to new players. The secondaries market is also split by size so not all the teams are competing with each other anyway.

Some players, reminded of the things that went wrong in venture capital, are unnerved by the large funds that are being raised by other secondary specialists and have limited the size of their current funds, in spite of the demand. Jones believes that with a 30-strong team the $2.5 billion raised by Coller Capital is the right sum of money in this market. “A $1 billion fund would leave you stuck in the middle now doing deals at $80 million to $100 million where the most heat is.” He says that unlike buyout investing, where firms moved onto much larger deals, secondary investing is scaleable.

Fund-of-funds investing has always been a good accompaniment to secondaries and a number of fund-of-funds are now upping the amount they are prepared to invest in this way. Fund-of-funds are not seen as a real threat by many secondary specialists, although they will provide competition in some areas of the market. They often get the exclusive right of first refusal on funds they’ve already invested in but they aren’t turning over rocks to find deals in the way dedicated secondary funds do. “They’re more reactive than proactive in the way they find deals. Fund-of-funds are followers not leaders in this market,” says Granoff. Also the fact that they say they’re increasing their secondary allocations doesn’t guarantee they’ll do the deals. Jordan sees fund-of-funds as a positive force in the market, pointing out that they also invest in secondary funds: “They can be a deal flow opportunity for us as they sometimes need help on more complicated deals.”

Limited partners are another group that could provide secondary funds with competition. Jones says that although LPs get offered assets or fund positions they are not always an ideal buyer, as they tend to be restricted in terms of staffing and therefore move very slowly. He comments that when Coller Capital bought Shell’s $265 million portfolio in 1998 it was competing with LPs that seem to have left the market and now invest in secondary funds instead.

LPs’ direct involvement in the industry, even if it is more talk than action, can be useful as they are in an ideal position to bring deals to the secondary funds they have invested in. Jordan notes that there has been a demand from LPs for co-investment: “This is attractive to investors because it can reduce their overall investment cost.” Secondary funds operating at the larger end of the deal spectrum also compete with securitisation as a way of taking assets off balance sheet. Jones sees it more as a distraction to potential sellers and says investors looking at this are not Coller Capital’s natural partners.

With fund-of-funds upping their allocations and names like Carlyle and 3i also toying with the idea of secondaries, established players are keen to emphasis the risks and level of skill involved in finding and structuring deals. Isnard says: “Today valuation is the most difficult risk to evaluate. Negotiating a deal to closing is also hard. Before, I would have said that finding deal flow was one of the most important challenges.”

Company valuation has always been hard but with the IPO market shut it’s even more difficult. Players need to be close to the assets and understand the cycle and market conditions. When calculating valuations Jones says Coller Capital ignores general partner valuations completely but they still cause problems for secondary funds. According to Jones, the biggest inhibitor to secondaries is the lack of disclosure of company valuations. As well as providing detailed information and accurate reporting, GPs could improve the transfer process and take secondaries into account in partnership agreements.

Most secondary funds agree that GPs still value over optimistically or don’t change valuations often enough, meaning that although LPs are more realistic than a year ago there can still be surprises. Granoff says: “The more honest you are with sellers the easier it is to negotiate with them. It helps if you sit down and explain to them why this is the valuation.” Although there’s still a gap in expectations, GPs’ net asset values are coming down and institutional investors are increasingly realistic.

Ironically, valuations have become more difficult at a time when their accuracy is paramount. Historically, private equity assets have been under valued, but Isnard says, the opposite is now true, as they tend to be valued higher than public companies. Private equity has been slow to catch up with falling public market valuations and it could be another couple of years before it rebalances. Isnard warns that you have to be careful buying at these prices; as valuations come down your discount could disappear. Jones agrees that caution and skill is needed: “In a downward market you have to be good at valuing accurately as you aren’t going to benefit from the upside.”

Buying a secondary position tends to be a very long process, specialists warn that deal execution is not easy in a progressively sophisticated market. Numerous technical and legal issues like pre-emption rights and transfers means there are a lot of moving parts in a deal and with the multiple needs of sellers rarely the same, creative structures are increasingly in demand. It’s important to understand the seller’s motives and the drivers behind the sale in order to structure the deal in an appealing and accommodating way. Secondary funds need to offer a personal service, often with a lot of handholding to get the seller to completion.

“Price is only one of their [the seller’s] objectives, there’s also accounting liability and technical considerations,” says Jones. Structures often have to consider the accounting impact of the disposal, as the real issue can be exiting private equity in a way that’s not visibly painful to shareholders. Secondaries especially need to be flexible when taking on direct assets where they might have to put together a vehicle or team to manage them. For example, the Lucent deal was a partnership, which provided a home for the team and continued support for the portfolio companies.

Adams Street Partners first invested in secondaries in 1986 and by the end of June 2002 the firm had committed $310 million to 60 secondary partnership interests. Initially investments were made from two dedicated secondary funds. In 1996 Adams Street raised a fund-of-funds programme, the Brinson Partnership Fund Program, which invested up to 40 per cent of its US allocation and 25 per cent of the non-US allocation in secondaries. This year’s $900 million fund-of-funds programme, and the one planned for next year, will have a similar secondary component.

ARCIS Group was established in 1993 and comprises ARCIS Capital in London and ARCIS Finance in Paris. The group has over EURO400 million under management and is now raising its third European fund. ARCIS focuses on the small to medium end of the secondary market and has completed over 140 secondary transactions, with more than 400 secondary positions purchased. The firm is also the European advisor to Venture Capital Fund of America.

In March this year AXA Private Equity and Paul Capital Partners (see full entry further down) formed an alliance with $1.3 billion available for secondary private equity transactions. Within the framework of their alliance, AXA and Paul Capital have already executed over 20 secondary acquisitions representing $640 million in investments over a period of three years. The portfolio consists of interests in more than 170 private equity funds, mainly in the USA and Europe.

The Carlyle Group formed a new asset management group last year with plans to raise a secondary fund, as well as a primary fund-of-funds and a fund-of-hedge funds. The group, which manages some $13.5 billion, is seeking around $500 million for its latest venture.

Coller Capital recently closed its fourth fund. At $2.5 billion it is the largest ever dedicated to secondaries. Based in London, the firm was formed in 1990 and advises in excess of $3.5 billion of committed capital. Coller Capital will consider deals ranging from portfolios of over $1 billion to $1 million positions. The firm has completed a number of high profile deals including participations in the $265 million portfolio of the Shell Pension Trust in 1998 (a deal that it lead – not co-led as suggested in an earlier report in EVCJ), the $1 billion NatWest portfolio in 2000 and Lucent’s corporate venture portfolio of technology investments at the end of last year.

Credit Suisse First Boston also manages a dedicated secondary fund of $830 million, DLJ Strategic Partners Fund, which was raised in 2000. It has been reported that the bank is raising a second fund of $1.25 billion for this market.

Fondinvest Capital was created in 1994 as the fund-of-funds business of CDC Participations in Paris. It launched its first secondary fund in 1996. CDC IXIS Private Equity sponsors its funds, providing a quarter of the capital. Last October the firm launched its third secondaries fund, Fondinvest 6, which held a first closing of EURO170 million towards a target of EURO250 million. At the end of last year Fondinvest had EURO400 million of secondary funds under management.

Three ex-Coller Capital executives launched Greenpark Capital in 2000. The firm is not far off wrapping up its debut fund, which is targeting $200 million by year-end. Greenpark Capital is based in London and targeting deals of between $5 million and $50 million or up to $100 million in non-auction situations.

Goldman Sachs’ private equity group includes the GS Vintage Funds, which invest in secondary positions. Earlier this year GS Vintage funded Peachtree Equity Partners, a $110 million private equity fund, formed to acquire the private equity portfolio of legacy Wachovia Corporation.

Advisory and asset management firm Hamilton Lane has been acquiring secondary private equity interests for its clients for about three years. Deals have ranged in size from $1 million to several hundred million and include a participation in the NatWest transaction. The firm does not have a vehicle dedicated specifically to the market but is currently raising Hamilton Lane Fund V, a fund-of-funds vehicle that will also invest part of its total in secondary positions. Established in 1991, Hamilton Lane has initiated over $23 billion of private equity investments.

HarbourVest Partners recently closed its fourth fund, which will invest outside of the US, at $2.8 billion. Of this $2.326 billion will be invested in fund-of-funds and secondaries. The firm has purchased $1 billion in secondaries since 1986 and currently has over $1 billion of available capital specifically targeted at secondary purchases. Acquisitions range from $250,000 in a single fund to over $1 billion when dealing with a portfolio of assets.

Landmark Partners was formed in 1984 and began investing in secondaries in 1989, starting with venture positions and moving on to buyouts and mezzanine. Currently raising its eleventh fund with a target of $750 million, Landmark Partners manages assets of around $3 billion in private equity secondaries, as well as over $1 billion in real estate secondaries. The Connecticut-based firm’s last secondary fund, Landmark Equity Partners X reached a total capitalisation of $583 million last year.

Lexington Partners was formed in 1995 through the spinout of the New York office of Landmark Partners. The two groups still co-manage six secondary funds with committed capital of $1.2 billion. Lexington independently manages four secondary funds totalling $2.6 billion, as well as a $1 billion fund dedicated to direct investments in buyouts. The firm has purchased around 407 partnership interests and led some of the largest deals in the industry, acquiring assets from JP Morgan Chase, Lucent, St Paul Insurance, and NatWest. Lexington Partners is currently raising a fifth fund of around $2 billion.

Swiss-based LGT Capital Partners started making opportunistic investments in secondaries in 1998. The alternative asset manager does not have a pool of capital dedicated to secondaries but can invest up to EURO100 million a year in small- to medium-sized venture and buyout deals. LGT does not invest this much every year but reports a recent increase in secondary activity. The group manages around EURO2 billion of private equity assets with a further EURO1 billion in hedge funds.

Pantheon Ventures has been investing in secondaries since 1987, initially through the listed Pantheon International Participations vehicle. In this time the firm has invested around $1 billion in the asset class, buying portfolios and individual LP positions of up to $200 million. In 1999 Pantheon raised a limited partnership fund, Pantheon Global Secondary Fund, with $418 million dedicated to the market. Recent deals include the purchase of a majority stake in Quantum Ventures, the corporate venturing division of Quantum Corporation. The company manages assets of $5.5 billion including funds-of-funds, segregated accounts, the secondary fund and PIP plc. It has offices in London, Brussels, San Francisco, Hong Kong and Sydney. Pantheon expects to come to the market with a new fund in the first quarter of 2003.

Partners Group has included secondary investments as part of its range of alternative asset investments since 1998. It has invested over $600 million in buyout-related secondaries to date. Transactions are normally up to $50 million in size although the group also participates in syndicated deals. Generally secondary commitments to individual partnerships do not exceed $20 million and direct investments are limited to $5 million. As a primary fund-of-funds specialist Partners Group also has an interest in younger funds that are only 50 per cent or 30 per cent drawn down. There is no dedicated vehicle; next year secondary investments, made through a variety of products, are likely to total between $300 million and $400 million. The group also helps investors find buyers for their private equity assets as part of portfolio restructuring programmes.

Paul Capital Partners was founded in 1991 and now has $3 billion under management, $2 billion of which is devoted to secondaries. The firm is currently investing Paul Capital Partners VII, an $800 million fund closed in August 2001. The firm targets transactions in the range of $10 million to $150 million. Deals include the recently announced purchase of a EURO24 million portfolio from Inversiones Ibersuizas. Paul Capital Partners has offices in Paris, Basel, San Francisco and New York, it also has a fund-of-funds business and invests in healthcare royalty assets. The firm expects to begin raising its next secondary fund in the second half of 2003.

Pomona Capital has just closed its fifth secondary fund at $581 million, well above the $400 million target. Founded in 1994, Pomona currently manages over $1.3 billion in five secondary funds and three primary fund-of-funds. The firm has purchased secondary interests in over 80 venture capital and buyout partnerships in the US, Europe and Israel. It looks at deals ranging in size from $10 million to hundreds of millions. Pomona has a strategic partnership with the ING Group. The group has offices in New York and London.

Private Equity Investors was founded in 1992 as a continuation of the secondary business started by Chuck Stetson in 1986. PEI’s main office is in New York with affiliate offices in San Francisco and Tokyo. The firm currently has $120 million dedicated to secondaries and also manages primary funds-of-funds. PEI, which has purchased over 100 interests in 89 private equity partnerships, focuses on buying US assets from domestic as well as European and Asian sellers. It has also acquired interests in over 50 companies through the wind-down of 17 investment partnerships by purchasing the remaining assets in the funds. The firm anticipates raising a fourth fund next year.

This is not intended to be a comprehensive list of players in the secondary market.