The direct route

“Scarce capital, slower returns and political uncertainty are the immediate future for our industry,” says Jeremy Coller, founder and CIO of secondaries house Coller Capital. “GPs will need to adapt quickly to investors’ changing requirements.”

Players like Coller, which recently bought the US$1bn private equity portfolio of NatWest from RBS, will be hoping to cash in on these changes, which, according to the firm’s latest ‘Global Private Equity Barometer’, survey is going to hit the industry hard. Respondents, made up entirely of LPs, expect 28% of venture capital firms and 23% of buyout houses to fail as the current financial crisis plays out. On the LP side, it is predicted a tenth of all private equity investors will default on fund commitments in the next two years.

Though the outlook is bleak, when a manager fails all is not lost – an LP can look to ‘direct’, or ‘synthetic’ secondaries to divest from their positions. This allows LPs to unlock capital, make a strategic change, reallocate resource or enhance portfolio management capabilities.

Replacing management

Direct secondaries funds buy entire portfolios from LPs or corporates and replace the management team and run them directly. GP paralysis can be a significant barrier to exit for LPs. Some funds don’t go out of business or merge fast enough.

Tom Leader, investment partner of Nova Capital, a direct secondary firm with over €880m in transactions, said: “In this market we may see more LPs become activists and more strident for change.”

Direct secondaries are unlike a typical secondary transaction where the management team stays in place and ownership of the assets changes hands from an LP to a secondary fund. In a direct secondary transaction, the entire portfolio is bundled into a special purpose vehicle (SPV), which is then managed by a new GP and can acquire leveraged lending from its own debt provider.

The black art

Pricing the portfolio is considered a ‘black art’ and often uses a market value solution which has a close relationship to aggregate individual asset valuations, but with some risk-adjusted discount for benefits of a multiple asset transaction, such as reduced execution risk, selling costs, financing risks and speed to market.

Financing for these types of transactions comes from both equity and debt. To date, many transactions have been financed with 100% equity as underlying assets often carry leverage. Sources of this equity include secondary funds, special situation investors, rolled-over primary investors and captive funds. On the debt side, there can be multiple, simultaneous LBO structures, such as HoldCo acquisition debt, rollover of existing debt for equity replacement, and LP-level portfolio leverage.

Due diligence on these deals can seem light. The deals are often done with a mix of full due diligence on key assets and a liability driven approach on others.

As direct secondary funds are typically acquiring assets from underperforming funds, legacy portfolios or non-core disposals, the seller often delivered poor performance or lost interest. There are significant operational challenges, which require hands-on operational capabilities not just financial skills.

The direct secondary market is still very young; the first deals were completed in 2000 and 2001. There are 10 major players in the space in Europe, which can roughly be divided by investment size: The mid-cap range includes Nova, Vision, W Capital and Chamon, whilst the small-cap groups are London & Oxford, Shackleton Ventures and Equitis, and in the venture range there are Tempo, Cipio, Saints and Azini.

The development of the direct secondaries market is an expression of the maturation of the secondaries industry. Once viewed with a certain level of suspicion, it has established itself as a legitimate method of LP portfolio re-organisation, and the interest in direct secondaries is poised to grow dramatically as GPs and LPs across the private equity spectrum struggle with their investments.