Secondary market in private equity: An asset class in expansion Charles Soulignac, CEO of Fondinvest Capital, outlines why

Over the past six years private equity has experienced an aggressive growth, both in terms of capital under management and amount invested, and the private equity industry is now considered as a recognised asset class. In the same way, secondary markets in private equity, though very recent, with their specific techniques and particularities, have demonstrated their various advantages and are growing at an important pace.

Genesis of secondary market

The secondary markets date back to the global economic crisis of 1987, which produced a large lack of liquidity among lots of financial institutions, especially those with “illiquid” assets such as private equity. In the late 1980s, in the US, this lack of liquidity created a new market for opportunist investors: the acquisition of secondary interests in private equity funds or in companies. Even if secondary investments remained not very numerous until 1993, this created the foundations of a new component of the private equity industry.

In Europe, originally, fund managers used to react negatively to secondary funds as they saw in secondary activity the fixing of a price transaction. Little by little, they started to appreciate the contribution of the buyer when he is professionally recognised in the market.

Attractiveness of the secondary market For a seller

The sale of interests in private equity by investors is motivated by:

*Evolution in strategies of asset allocation

Reallocation of assets

Changes in the management staff

Financial restructurings

*Limited expertise in private equity

*Need for liquidity

*Long holding period in primary investments: 10 years usually

*Non-satisfactory performance of some funds

*Too small residual amount of investment

*Reallocation to a new fund

The objective of the seller is to make an arbitrage between lower performance and liquidity. The sale of interests by private equity managers is motivated by an efficient management of the residual investments within the fund:

Avoid distributing the assets

Ease the management in case of a low unit amount per investor

To secure a level of performance already realised with no extension of the holding period (protection of the IRR).

For a buyer

As far as an investor in secondary interests is concerned, for example a private equity fund-of-funds manager, acquisition of secondary positions offer the following advantages:

*Secondary market positions can usually be purchased with discount on reevaluated net assets, especially if the purchaser is experienced and has developed a proprietary deal flow

*Investments in secondary acquisitions are more mature than in primary transactions since secondary acquisitions invest in funds in which significant amounts have already been invested, which eliminates the risk of “blind” investments, typically present in recently raised private equity funds

*It offers acceleration of financial returns, which gives more security to the investor

The buyer’s objectives are first based on performance IRR and multiple but also on the notion of return on cash in a shorter period.

Secondary acquisitions require rigorous analysis of both management teams and underlying assets. The detection of interesting, risk-adjusted and profitable investment opportunities needs specific capabilities from the investor. Competitive secondary managers need substantial experience in investment in funds, as well as in direct private equity investments, a long term-based and close relationship with general partners so that they can ensure successful secondary transactions.

The different players

Requirements in terms of capital & resources, deal flow and ability to evaluate private equity portfolios still limit the number of professional teams specialised in secondary transactions. Only 20 or so can be considered as real secondary players worldwide.

It is possible to classify the secondary players into two categories:

*Funds-of-funds :

Specialised managers: only a few managers like Fondinvest Capital offer pure secondary fund-of-funds. This requires a high degree of experience and seniority: little by little these players have established their own databases of private equity managers, funds and portfolios and are able to deliver, with high confidentiality, competitive bids on a short time basis.

Non-specialised managers: A larger number of fund-of-funds occasionally invest part of their assets in secondary transactions but most of them remain focused on primary investments.

*Institutional investors and pension funds: they are large financial institutions with important capital resources and highly professional teams. They see in secondary transactions an opportunist way to create value and add performance to their traditional private equity portfolios. They have a good knowledge of private equity as most of them have experience of co-investing in funds.

*Intermediaries appointed by the sellers in order to organise the selling of private equity interests at best terms appeared a couple of years ago and little by little have been holding an important position in transactions.

Different types of intervention

There are two main types of transactions. The first one is based on auctions. The seller or its intermediary organises the sale of a portfolio of interests in private equity approaching a certain number of potential buyers, pre-selected or not. These transactions concern mega transactions involving hundreds of million of euros. These transactions are often linked to mergers, a total change in investment strategy or corporations focusing on their core activities.

The second type of intervention is the detection of secondary investment opportunities. This concerns more limited transactions in size. Thus, Fondinvest Capital, a secondary player specialised in mid-market transactions worldwide, invests in secondary transactions on a proprietary deal flow basis, that is to say with no competition. This requires long experience in investment in funds, technical expertise in valuation transactions, seniority in relationships with general partners, limited partners and a high degree of confidentiality.

Evolution of capital under management

Private equity has become a recognised asset class by institutional investors. The amount of capital raised during the last ten years culminated with $110 billion being raised in 2000 in the US ($7.9 billion in 1990) and EURO47 billion in Europe (EURO5.8 billion in 1990).*

During the second part of the 1990s, the secondary market grew at rapid pace, with funds raised reaching $2 billion in 1998 and $1.6 billion in 1999.**

The worldwide secondary market is estimated to be worth between $10 billion and $17 billion in the next five years and the European market between EURO4 billion and EURO6 billion. This represents three per cent to five per cent of the total committed private equity capital each year.

Significant growth of the secondary market

As with all financial markets, private equity remains a cyclical industry. After a five-year period of constant and significant growth (1995-2000), 2000 has been the year of a downturn, with investors facing a slowdown on stock markets, slowing the euphoria of flows of funds into the industry and showing the market the way back to fundamentals.

Secondary markets follow the same cycles, with just two to five years’ time lag, compared to the primary market. This explains the recent impressive growth of secondary transactions, in connection with private equity programmes launched in 1997 to 1998: the growth in assets in private equity markets has already resulted in increased secondary transactions. Mechanically, the secondary transactions should continue to increase in the next three years. It is not surprising to see significant transfers in venture capital funds, for this evolution is linked to the unprecedented expansion of venture capital between 1997 and 2000.

Thanks to this dynamism, fund-of-funds managers specialised in secondary transactions are in a position to offer satisfactory returns. However, they must confront price increases for their secondary acquisitions especially in auctions and face new entrants attracted by profitability perspectives of private equity secondary transfers, who are less experienced and sometimes not as rigorous in terms of pricing or in analysing investment opportunities. That competition between buyers could alter the future performance of current secondary programmes linked to large auctions. Secondary transaction activity has to be considered as professional as primary private equity business. Investors who choose to allocate funds to secondary programmes have to select the specialised, recognised and experienced secondary team with a strong private equity background that will be able to offer good opportunities in several markets, providing good performance. In that sense, focusing on the managers specialised in mid-market transactions with large proprietary deal flow without competition will probably prove successful in the next three years, as the race for performance still gains the upper hand over the race for volume.

For further information, please contact Charles Soulignac in France at +33 1 58 36 48 00 or

*Venture Economics

**Private Trade