LPs in private equity funds can be a skeptical group when it comes to unrealized returns.
The increased focus on cash-on-cash returns became apparent to me at the annual meeting of a well-known growth equity fund. One of the fund’s star portfolio companies presented a detailed account of how they had grown revenue and EBITDA in a very difficult economy. The fund had already distributed roughly half of its cost basis in the investment and had written up the value of the company by threefold. During cocktails, while speaking with the representative from a mid-sized college endowment invested in the fund, I remarked that the company was still quite conservatively valued. The limited partner responded, “I’ll believe the valuation when I see the exit.”
In the age of fair-value accounting, more and more LPs are looking at cash-on-cash return as the key measure of a fund’s performance. While cash distributions are the ultimate goal of any fund, an over-emphasis on realizations can sometimes lead to premature exits. When strategic acquirers are not available, private equity funds may turn to other private equity funds for exits (“sponsor-to-sponsor” transactions). According to Prequin, 27 percent of buyout exits in the first half of 2010 were to other sponsors, up from 19 percent in the first half of 2009. While a sponsor-to-sponsor transaction will certainly generate realizations, the selling private equity fund will generally be forgoing all future upside to an investor with similar return targets. This can be especially heartbreaking when the company is at an inflection point such as the implementation of management changes, a financial restructuring or a major pending transaction.
As an alternative to selling full ownership in a portfolio company, fund managers should consider selling minority interests in one or more of their best portfolio companies to a secondary private equity firm in a direct secondary transaction. In the last two years, secondary funds have been among the few highlights in the relatively weak private equity fundraising market. According to Thomson Reuters, secondary funds raised a record $16.4 billion in 2009, nearly double the amount raised the previous year. While the pace of fundraising in the secondary market has slowed somewhat in the first half of 2010, there is still a record amount of capital in the market. As the market for LP interests has become more competitive, many secondary funds are looking for creative ways to invest in quality assets at reasonable prices. Direct secondary transactions can provide a means for secondary funds to deploy capital and general partners to generate cash-on-cash returns and maintain future upside exposure.
Case Study
Perhaps the best way to illustrate the process and opportunity of a direct secondary sale is to consider a recently exited
The general partner considered multiple sale options to provide distributions to their LPs, de-risk their portfolio and validate their valuation. The fund was hesitant to sell one of their best companies at what they believed to be an inflection point. Moreover, strategic buyers had difficulty dealing with the complex accounting, leaving a sponsor-to-sponsor transaction as the likely outcome. The GP believed that the company could be restructured in several years in order to reveal its true profitability. Selling to another private equity fund would merely transfer that benefit to another fund.
VCFA and the fund considered a secondary purchase of a minority interest in the company as an alternative to a full sale. After a preliminary indication of interest, we began to diligence both the investment and the manager. We performed a site visit, interviewed management and customers, and engaged an outside consultant. We focused our analysis on whether the company was truly at an inflection point. We also spent a great deal of time with the fund manager and the relationship we developed became a key component of the deal. While the diligence was thorough, it was far less than what would need to have been done in a full sale process, taking about three months from the initial conversation to the close.
After the diligence had been completed and an agreement on price had been reached, VCFA created a single-investment private equity fund that assumed a minority ownership interest of the fund’s investment. The fund manager continued to control all voting rights related to the interest and was granted a carry incentive to continue to preserve the incentives. VCFA’s cash payment resulted in a distribution to the LPs of the selling fund of a multiple of the total cost of the investment, with the fund maintaining a large percentage of the future upside.
In the months following the direct secondary sale, the company struggled through some acquisition integration issues. Had the fund not been able to execute the direct secondary sale, they might have been pressured for a substantial write-down. Nevertheless, in roughly a year, the manager was able to fix the operational issues and raise additional financing to restructure the company. With the key issues resolved, the company began a sale process with an investment bank. Ultimately, a strategic buyer acquired the company for cash, generating a double-digit multiple return for the fund and an expected 2x return for VCFA.
The example described above became a winning transaction for all involved. By selling a minority interest in the company, the selling fund was able to validate its valuation, make a substantial distribution, and still maintain the vast majority of its investment. Although the LPs might have maximized their value by never selling, they were able to substantially de-risk their investment. Finally, VCFA, the secondary fund, was able to generate a reasonable risk-adjusted return. In order to determine whether a direct secondary sale is the best option, GPs should consider the advantages and related disadvantages of a direct secondary sale.
Advantages:1) Preservation of upside. The primary advantage of a direct secondary sale is that the selling fund will preserve the upside in a transaction. From the GP’s perspective, dilution can sometimes be minimized by creating a profit sharing mechanism or shadow carry in the new vehicle. From the LP’s perspective, it may be helpful to think of a direct secondary sale as de-risking activity similar to how hedges can be used in a public portfolio. Most LPs are happy to sacrifice some future upside in order to preserve existing value.
2) Faster process. A well-constructed investment banking process can sometimes take a year or more to complete, with no guarantee of success. The process can be distracting and de-motivating to management teams, especially those that are unfamiliar with private equity exits. Secondary funds will diligence a transaction by focusing on both the GP and the portfolio company. Due diligence can often be further compressed when there is a pre-existing relationship between the secondary fund and the selling fund. The process is similar to a co-investment process—diligence on the company is important; diligence on the fund manager is critical.
3) Preserves fund control. Most direct secondary transactions can be structured so that the selling fund maintains control over the investment. This allows continuity with the manager and minimizes disruption within the portfolio company. By contrast, even when a fund retains some residual investment in an exited portfolio company, there is generally no control over the company. The change in ownership can lead to management flight as well as disruption to the operating business.
Disadvantages:1) Conflicts of interest. In some cases, a direct secondary sale can create slightly different incentives for the selling GP and LPs. For example, a secondary transaction could potentially put a fund into carry before it would otherwise. In order to minimize conflicts, we believe it is a best practice to seek advisory board consent prior to pursuing a transaction.
2) Still a distraction. Even though a direct secondary sale requires less effort than a full sale process, it can still be a substantial time investment. If the sole goal of a fund manager is to validate a valuation, there may be more efficient means to this goal. For example, a fund might consider increasing the amount of information it delivers to its LPs about the investment. In some cases third-party valuation reports written by investment banks or consulting firms can help to support the valuation.
3) Dilution.
The primary disadvantage to the direct secondary sale is that the fund may be forgoing an attractive incremental return. While it may seem counter-intuitive to facilitate dilution in a strong company, the concept is not new. Many private equity funds (venture especially) encourage their portfolio companies to raise additional capital from outside investors. Economically, this dilution is the same whether the capital is received by the investors or the company.
A Hybrid Option
GPs with large unrealized returns face a dilemma: Should they sell now and forgo the potential for even greater appreciation or hold for a full sale while risking a future negative event? A partial direct secondary sale presents a hybrid option, allowing GPs to de-risk a portfolio while preserving future upside. Perhaps most importantly, it can also assuage skeptical and anxious LPs who are focused on cash-on-cash returns. Every fund management decision requires a calibration of risk and reward. GPs should carefully consider whether the dilution, distraction and possible conflicts resulting from the direct-secondary process outweigh the benefits.
David Tom works in business development at VCFA Inc., a buyer of interests in PE funds on the secondary market. Reach him at dtom@vcfa.com.
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