Secondary Sales of Private Equity Interests

Brett Byers

The Advent of Secondary Private Equity Fund Interest Transactions[1]

Ideally, an investor in a venture capital fund remains a committed investor for the duration of the fund, as most investors no doubt intend at the time of their commitment to a fund.[2] Because a typical private equity fund has a limited life, returns profits and invested capital to its investors promptly on realization of investments, has restrictions on management changes, and has a very limited scope of permitted activities, the need for transferability is minimal. Further, the success of the private equity fund vehicle is, in part, due to limitations on transfers and entry of investors into the fund, which promote confidentiality for portfolio companies, reduce time and effort spent on investor relations, and allow the fund managers to focus on successful and active investing.

Nonetheless, during the 10+ year life of a private equity fund, the circumstances of investors change. For an investor, changes in asset allocation, cash flow needs, management, ownership, strategy, and regulations, can result in a need for early liquidity. After observing several such situations, Dayton Carr and Arnaud Isnard of Venture Capital Fund of America (VCFA) raised the first private equity fund in 1986 to purchase private equity interests (interests in private equity funds and private operating companies) on a secondary basis from investors needing liquidity. In Europe, the first such secondary fund was raised jointly by Arnaud Isnard, now heading up his own firm, ARCIS Group, which advises VCFA in relation to purchases of U.S. private equity interests from European sellers, and Jeremy Coller, also now heading up his own firm. Others followed, and there are now a number of firms worldwide that operate in the same fashion, as well as others that buy private equity interests from investors on a limited basis as part of a larger strategy. Most, if not all, of the established secondary buyers (listed at the end of this article) buy assets from investors worldwide, but primarily purchase investments in funds and companies located in either the U.S. or Europe.

The Process and the Players in Secondary Transactions

Many limited partners in private equity funds are loath to hint to the fund general partners that they may be a seller of their fund interests until a deal appears achievable or, in some cases, a signed deal is in hand. As a result, sellers often first explore the possibility of a secondary transaction with potential buyers prior to discussing the issue with the fund general partner. In certain cases, such as a situation where a limited partner wants to sell its interest to avoid the remaining capital commitment, the general partner is often among the first to know of the desire to sell, as the limited partner may initially seek to have its unpaid commitment waived. In the latter case, the general partner often tries to find secondary purchaser of the interest in question to reduce the risk of a limited partner default, which may reduce the amount of capital committed to the fund, potentially to the detriment of the fund and the embarrassment of the general partner.

For private equity portfolios under $100 million, many secondary sales by limited partners are accomplished by way of negotiation with a single buyer. Negotiation with one buyer enhances confidentiality for the seller and the fund, gives the buyer the incentive to complete more diligence and thus become comfortable with a higher price, and allows the transaction structure to be crafted to meet the seller's needs. In addition, use of a single potential buyer reduces the burden on the fund general partners, whom the buyer may desire to speak with as part of its due diligence process (in limited, but rare, cases, the buyer may request to meet with the management of several underlying portfolio companies). For portfolios over $100 million, secondary sales are often accomplished by way of an auction, but with the number of buyers limited to three or four to minimize the due diligence burden on the general partners and to provide incentive for buyers to join the auction and perform diligence. In recent years, multi-hundred million dollar sales have been completed by Shell, Raytheon, Bank of America, J.P. Morgan Chase and NatWest, among others, in each case by way of an auction.

Intermediaries have had an increasing role in secondary private equity transactions in recent years. For large transactions (portfolios in excess of $100 million), traditional investment banks often act as intermediaries. A number of secondary intermediary boutiques occupy the sub-$100 million transaction market, although the vast majority of deals in that range are completed without an intermediary. Intermediaries in secondary transactions generally limit themselves to contacting potential buyers and to administering due diligence, the negotiation or auction process, and the closing. A very few attempt to add further value by providing a proprietary analysis of the portfolio, but it is not clear that such analysis is particularly meaningful to experienced secondary buyers, who have much more expertise and experience than the intermediaries, in general. Intermediaries generally charge a transaction fee in the range of 1% to 5% of the sale price.

Secondary Transactions: Typical Economics

Typically, private equity fund interests sell at a discount to the latest fund manager valuations for a number of reasons. It has long been noted that even public closed-end mutual funds tend to trade at a discount to net asset value over the long term. Causes of this discount include that an investor in a closed-end mutual fund generally cannot force liquidity of the underlying assets and that a fund structure adds an additional layer of fees and expenses. Thus, owning an interest in a fund is, in at least some ways, not as good economically as owning the underlying assets directly. Of course, with a private equity fund that owns illiquid assets that are not readily saleable, a deeper discount is likely warranted. Because the fund and its investments are private, liquidity remains an issue for a buyer and it is much harder for a buyer considering purchase to obtain information on a private equity fund and its investments. For venture funds, perhaps the difficulty of valuing early stage companies results in larger discounts. Private equity funds also typically have a higher fee and expense level than a closed-end mutual fund, and also impose a carried interest.

Over the long term, discounts on secondary sales of private equity funds have generally been between 20% and 50%. It is not particularly meaningful to get more precise than this, as the discount for a particular fund can vary widely based on many factors specific to the fund, such as fund sector, fund type, specific portfolio company status, market conditions for the sector, or the fund management team. While discounts appeared lower in the late 1990s, this was really a reflection of a rapidly rising market, in which the latest quarter's fund reports were not reflective of increases in value subsequent the date of the reports but prior to the transaction. Similarly, the massive discounts (over 50% and sometimes nearly 100%) prevailing currently in early 2002 for information technology private equity fund interests of recent vintage may merely result from the sticky nature of private equity valuations and the recent dramatic downward adjustments in the public markets. If the underlying companies in an information technology private equity fund with company valuations based on year 2000 financing rounds were re-valued to reflect early 2002 new financing round valuation metrics, what seems like a steep discount may become a small discount or even a premium.

The fund manager's valuation methodology can have a significant effect on the discount for a secondary transaction. If a fund uses a more conservative valuation methodology, the discount will be lower, with all other factors kept the same. Thus, since a number of leveraged-buyout funds keep valuations at cost until liquidity occurs, discounts tend to be lower for LBO funds in the aggregate. As of recent, however, the discounts for some LBO funds have increased because of such funds' recent forays into telecommunications and other information technology investments.

If a fund has a remaining capital commitment, a seller should note that a secondary purchaser may view the discount as applying to the total commitment, rather than merely to the amount paid-in to date or the latest fund manager valuation corresponding to the paid-in portion of the commitment. As a result, potential sellers of partially paid-in interests may need to take a very large discount to the latest fund manager value to sell. Of course, given that the fund default provisions will generally result in a defaulted interest being wiped out anyway, selling at any price may be worth it to avoid the remaining commitment obligation. Indeed, some sellers of interests with little paid-in capital have recently been willing to pay a buyer to take an interest, so as to avoid the embarrassment and potential lawsuit resulting from a default, or merely to preserve a good reputation and maintain a positive relationship with the fund manager.

The sale of interests in fund-of-funds creates additional challenges, as fund-of-funds often add management fees (typically 1% of the commitment per year) and an extra level of carried interest (often 5% for recent funds). Secondary funds have the option of buying interests in the same funds held by funds-of-funds. Thus, a secondary buyer will only buy a fund-of-funds interest after the application of an additional discount, perhaps amounting to an additional 15% of the total commitment. This additional discount may be an even higher percentage of the latest fund-of-funds manager value, if the interest is not fully paid in or if the fund value has deflated.

Legal Issues in Secondary Transactions: The Documents

Once a price and any other business terms are reached between a seller and a buyer, typically the two parties sign a purchase and sale agreement specifying the price and the assets. The purchase and sale agreement will also specify various closing conditions, such as consent of the fund general partner to the transfer (required by virtually all funds), waiver or satisfaction of any rights of first refusal (present in the fund documents of a minority of funds), and waiver of penalties relating to any defaults by the seller (such as a late capital call payment). This agreement will also generally specify that the purchase price will be adjusted for contributions paid and distributions received after the date of the most recent fund financials but prior to the closing.

Once a purchase and sale agreement has been signed, the fund's general partner is generally notified by the seller. The buyer then, if an experienced secondary purchaser, typically will shepherd things through to the closing of the purchase. In most cases, general partner consent for an established secondary buyer is not a problem, except for a very few funds that do not allow transfers to those other than current limited partners. A newer private equity firm that has not yet had a secondary transfer may need a little extra hand-holding by the seller, the buyer, or, if present, the intermediary before consent is given. Nearly every long-established and substantial private equity fund group has had transfers, however, and thus may be able to grant consent more quickly than a smaller or more youthful firm. If a fund has a first refusal requirement that provides that any limited partnership interest must first be offered for sale to the other partners on the same terms, this requirement must be fulfilled unless waived (and permitted to be waived) by the fund general partner, potentially resulting in a delay of the closing of a transfer.

There are several documents related to the mechanics of the closing. While many partnership agreements require that a legal opinion regarding the transfer be rendered, it is extremely rare that a general partner or its legal counsel requires this in conjunction with an actual transfer. Many general partners, however, do require the buyer to complete a subscription agreement or otherwise make certain representations. If the value of the fund interest may be impaired by a past or continuing default by the seller, the buyer may require that the general partner sign a waiver of the default (which waiver may be contingent on the buyer remedying any continuing default promptly in conjunction with the transfer). In all cases, an assignment and assumption and general partner consent document must be signed by the seller, the buyer, and the general partner. All long-established secondary buyers have form assignment and assumption documents, but some general partners (or their lawyers) prefer to use their own legal forms.

A buyer will require certain representations and may require certain covenants, each of which can either be in the purchase and sale agreement, or in the assignment and assumption agreement. A buyer will require certain representations by the seller about full ownership in the interest and lack of liens and encumbrances. A buyer may require that, if the fund requires returns of past distributions, the seller shall remain liable. Out of concern that venture funds may bear some of the pain of shareholder lawsuits relating to past distributions, a buyer may also require that the seller be liable for any future losses that the fund bears in relation to shareholder lawsuits corresponding to past distributions.

Once all three parties have signed the assignment and assumption and general partner consent document, the closing of the transfer can occur. At this point, payment is made. The entire transfer process (including negotiation and buyer due diligence, signing of a purchase agreement, and the closing) can be completed in a period as short as several weeks, but several months is more typical. Generally, if the seller is committed to selling, has a reasonable price in mind, and has a streamlined internal decision-making process, transactions occur more quickly. The presence of a right of first refusal will slow the transaction, and the timing of general partner consent will affect the time to the closing. Also, if the buyer is not an experienced secondary purchaser, the transaction time likely will be longer.

Some secondary transactions are structured in a manner other than a simple sale of assets, creating numerous additional legal, tax and accounting issues. Such more complex structures may involve a sharing of the assets and the proceeds, contingent future payments, creation of a new structure to hold the assets, or insertion of a team to manage the assets.

Legal Issues in Secondary Transactions: Fund Concerns

For the general partner and its legal counsel, there are a number of legal concerns that are addressed by the completion of a subscription agreement (or equivalent representations) by the buyer, and, in rare cases in practice, a legal opinion relating to the transaction. Some of the legal constraints that are most important are the Investment Company Act of 1940, the publicly traded partnership tax provisions, the Securities Act of 1993, and Employee Retirement Income Security Act (ERISA).

The legal issues are generally the same faced by the fund with respect to a new investor at the time of the fund formation, with the exception of those applying directly to transfer among investors. For example, requirements with respect to pension fund investors under ERISA, exemptions from investment company status under the Investment Company Act, and accredited investor status under Regulation D of the Securities Act of 1933 all apply just as they do to an investor in a newly-formed fund. One set of constraints that is unique to transfer consists of the legal constraints imposed by the private re-sale exemption under the Securities Act of 1933: the so-called Section 4 (1 and 1/2) exemption. In general, the major limitations resulting from this are that an intermediary not act as an underwriter but instead as a finder, and that the potential buyers must be contacted in a non-public manner. Thus, no public advertising may be used in locating potential buyers and only a few sophisticated potential buyers of substantial financial means may be solicited.

Another major legal issue in secondary transactions stems for tax regulations. Section 7704 of the Internal Revenue Code specifies that a partnership the interests of which are "readily tradable on a secondary market (or the substantial equivalent thereof)" shall be considered a publicly traded partnership and thus taxed as a corporation. A fund can avoid publicly traded partnership status by falling within certain safe harbors found within treasury regulation õ1.7704-1. In general, a safe harbor is provided if there is nothing similar to a secondary market, all transactions are exempt under the Securities Act of 1933, and there are less than 100 partners. However, this safe harbor does not provide relief to those many funds that now have over 100 limited partners because of their reliance Section 3(c)(7)[3] of the Investment Company Act of 1940 to avoid classification as an investment company. One safe harbor from publicly traded partnership status for such funds found in Treasury regulation õ1.7704-1 is available if interests representing no more than 2% of the fund's share of the capital or profits are traded in any one fiscal year.

The fund general partner or its legal counsel will often need to take on certain additional administrative tasks if the fund has a right of first refusal associated with transfers of limited partnership interests in the fund. The general partner may have the legal power to waive the right of first refusal process, but doing so may create the impression among other limited partners that they are entitled to a waiver if they then have the need for a transfer. In some cases, the general partner has the responsibility to send out right of first refusal notices. Even if the seller instead has this responsibility under the terms of the fund documents, the general partner will need to provide limited partner contact information to the seller, and perhaps will need to provide other guidance on the nature of the notice and the process. If one or more limited partners accept the right of first refusal, the fund general partner likely will have the responsibility of negotiating the division of the interest among the various buyers. Perhaps because of this administrative burden, most funds do not provide for a right of first refusal.

An issue that has become of significance starting in late 2000 is that of limited partner defaults. Starting in late 2000, many limited partners, both individuals (many of recent wealth) and corporations, developed cash flows pressures often related to deflated public and private equity stock portfolios and, in the case of corporations, degradation in the corporation's core business. As a result, hundreds (if not more) of limited partners have sought, during 2001 and 2002, to reduce their remaining capital commitments. Most funds are reluctant to forgive remaining commitments for fear of an avalanche of other limited partners requesting forgiveness. Thus, limited partners generally seek to sell their interests to avoid the remaining commitments. Nonetheless, other than for select funds, selling an interest that is only partially paid in is quite challenging, and, in the current environment, is often not possible. Sale of an interest that is less than 50% paid in is more akin to finding an investor for a new fund, and investors in new funds are quite scarce in the environment present in early 2002. As such, general partners may be forced, in some cases, to exercise the generally harsh default provisions found in the fund legal documents. These provisions come in many flavors, but they often result in complete or near complete forfeiture of paid-in capital.

Sale of Direct Interests in Private Operating Companies

Virtually all of the devoted and experienced secondary buyers not only buy interests in all varieties of private equity funds (including LBO, distressed debt, and mezzanine private equity funds as well as venture capital funds) but also buy direct interests in private operating companies. Because of the lack of an established fund management team overseeing these direct interests, these portfolios are more difficult to market than fund interests, and are often sold at a larger discount than fund interests. One variety of seller is a venture capital fund itself at the end of its term (venture capital funds typically have 10-year terms, but these terms are typically extended for several years before final wind-up). Some fund general partners take great pride in personally achieving liquidity for each and every portfolio company via an IPO or sale of the company, and others would only sell at a very rich price. Nonetheless, certain funds will, as a matter of course, sell off the remaining private companies in a portfolio after several extensions of a fund. Doing so permits the fund manager to focus effort on recent funds where management efforts generally have more influence, which often have more dollars in play and where the internal rate of return is more readily influenced. Another common sort of seller is a corporation with a private equity investment arm, generally selling because of strategic changes or as result of a structural or management change. In this case, a secondary buyer may merely buy the assets, or may retain the investment team, setting the team up as the general partner of a new fund formed to hold the purchased assets. Less common than purchase from a venture fund or a corporate investor is the purchase of private company equity interests from individuals, either angel investors or company founders. Angel investors tend to have very small interests, generally not large enough to warrant the attention of an institutional secondary buyer, and the adverse selection problem of a company founder selling out reduces the interest of buyers in such potential transactions.

Recent Developments: Online Private Equity Exchanges?

In the heat of the dot-com and B2B exchange boom, several online private equity exchanges were also born. As this author has been quoted in the Red Herring saying, however, such exchanges were "dead on arrival." [4] While eBay is a great online exchange, selling interests in private equity is quite different from selling used Pez dispensers and other collectibles. Here are a few reasons why an online solution for private equity transfers is not in the cards:

  • private equity is far from a commodity
  • the value of a private equity interest to a secondary buyer can rarely be determined by merely examining the financial statements of the fund (i.e., due diligence discussions with the general partner or other parties are generally necessary, as is extensive analysis)
  • securities law and tax law place substantial constraints on the marketing of an interest
  • few buyers of private equity interests exist and they can be readily identified by a seller
  • trust of a buyer is quite important when selling an asset for millions of dollars
  • discretion and confidentiality are very important when dealing with transfers of private equity interests
  • often complexities in structuring transfers require special attention
  • with, at most, a few bidders, an online solution offers little over use of the telephone, electronic mail and the facsimile machine
  • given the due diligence, trust and custom structuring issues for a private equity transaction, the exchange engine itself is really not terribly important

Some of these private equity exchanges envisioned a substantial increase in trading of private equity interests as a result of the existence of their exchanges. Nonetheless, several factors counsel against this. First, secondary transactions require substantial due diligence and analysis effort and expertise, making it unlikely that those who are not skilled experts in the area will enter the market, even if an online marketplace exists. The effort and expertise is quite different from that related to investing in new funds, as a skilled secondary buyer is primarily focused on the value of underlying companies (which may be carried by the fund at a value quite different from cost). In contrast, an investor in new funds is far more focused on the quality of the fund management team and the fund management team's track record. Second, as set forth in the bullet items above, an online exchange is of very limited value in stimulating transfers. Finally, trading is really not an important trait for a private equity fund interest, given its very limited nature and duration, as described in the first paragraph of this chapter. Indeed, as described in the first paragraph of this chapter, limited trading is likely a key contributor to the outstanding financial performance that is associated with many venture capital funds. In order to see the lack of importance of ready trading for a venture fund and how ready trading may detract from value, one need only compare the publicly traded venture entity meVC with traditional, highly-regarded funds such as Matrix, Sequoia and Kleiner Perkins. The meVC fund has vast investor relations and securities law reporting responsibilities and is likely very challenged in its efforts to attract top-flight venture capital professionals who are key to producing superior rates of return for investors.

For the reasons set forth above, the entrants into the private equity online exchange arena have largely, if not totally, dropped their online efforts and are now attempting to succeed as traditional intermediaries between potential sellers and buyers of private equity interests. This is, nonetheless, a difficult path, as traditional investment banks typically have the upper hand in gaining the intermediary business for the sale of private equity portfolios in excess of $100 million, if any intermediary is to be used at all. For smaller transactions, fees will necessarily be smaller. Moreover, because sellers and buyers have traditionally dealt directly with one another in most transactions, it is unclear how an intermediary can successfully insert itself. An intermediary must earn its commission by either lowering the seller's net proceeds or raising the buyer's gross purchase price. Further, it may be difficult for an intermediary to gain secondary transaction expertise, as professionals with substantial secondary investing experience are in short supply and are resident primarily, if not exclusively, within the firms that act as secondary purchasers. In the current market, where would-be sellers are plentiful but transactions are comparatively few because of the necessity of steep discounts in light of market changes, an inexperienced intermediary may merely insulate a potential seller from the views of buyers, thus closing the curtains on the potential for a transaction.

Recent Developments: Securitizing Private Equity Interests

Recently, two firms in Europe have ventured into securitizing private equity portfolios, using insurance to limit risks and/or splitting up the investments in private equity portfolios into different tranches of securities with separate risk and return characteristics. Nonetheless, this would appear primarily to be a risk management trick, and, if it is a method of selling a private equity portfolio, it is only available, if at all, to holders of very large and well diversified portfolios. J.P. Morgan Chase recently put its effort in this arena on hold after a lack of marketing success. One does not need to look far for past disasters with the "toxics" end of the CMO securities spectrum, which address a market that appears far more predictable than private equity. This would seem to counsel that securitizing private equity portfolios and insuring private equity returns could result in some very negative and unforeseen outcomes, particularly when markets as a whole turn radically, such as recently.

Selected Secondary Private Equity Purchasers
(includes all devoted secondary buyers with 10+ years of experience known to the author)

Venture Capital Fund of America

509 Madison Avenue
New York, NY 10022
Tel: (212) 838-5577
Fax: (212) 838-7614

100 Pine Street
San Francisco, CA 94111
Tel: (415) 296-0660
Fax: (415) 296-0990

14, rue de Bassano
Paris France 75116
Tel: 011-33-1-47-23-88-62
Fax: 011-33-1-47-23-88-55

BancBoston Capital Inc.
175 Federal Street, 10th Floor
Boston, MA 02110
Tel: (617) 434-2509
Fax: (617) 434-1153

Coller Capital Limited
London, W1G 0TT
United Kingdom
Tel: 011-44-20-7631-8500
Fax: 011-44-20-7631-8555

HarbourVest Partners, LLC
One Financial Center, 44th Floor
Boston, MA 02111
Tel: (617) 348-3707
Fax: (617) 350-0305

Landmark Partners Inc.
10 Mill Pond Lane
Simsbury, CT 06070-2429
Tel: (860) 651-9760
Fax: (860) 651-8890

Lexington Partners Inc.
660 Madison Avenue, 23rd Floor
New York, NY 10021
Tel: (212) 754-0411
Fax: (212) 754-1494

Paul Capital Partners
50 California Street, Suite 3000
San Francisco, CA 94111
Tel: (415) 283-4300
Fax: (415) 283-4301

Copyright ¸ 2002 by Brett Douglas Byers. All rights reserved. No part of this chapter may be used or reproduced in any manner whatsoever without written permission.

[1] Brett Byers has been a Managing Director with VCFA since 1998, operating in VCFA's San Francisco office. Brett practiced corporate law at Mayer, Brown & Platt and Wilson Sonsini Goodrich & Rosati, representing, among others, private equity firms in fund formations and investment transactions, including two secondary funds in investment transactions (VCFA and Coller Capital). Brett also has served as general counsel to a pubic semiconductor company, and served in management and engineering roles in the semiconductor and computer industries. Brett Byers holds a J.D. from Yale Law School and a B.S. in electrical engineering from Cornell University.
[2] There is perhaps one significant exception: Commercial banks often invest in a venture capital fund, or, more commonly, an LBO fund, to make loans to portfolio companies. Once loans have been made to the underlying portfolio companies, some commercial banks may sell certain private equity fund interests. Fund subscription documents generally require investors to represent that they have no present intention to transfer their interest.
[3] Known as the qualified purchaser exemption, it was enacted into law in 1996.
[4] See "Trading Private Equity Publicly May Not Fly, by Julie Landry in the September 15, 2001 issue of Red Herring.