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Secondary Private Equity Funds: The Perfect Storm, An Opportunity in Adversity

Hope Vaughn, Columbia Strategy and Ross Barrett, VC Experts


The recent growth and maturity of the private equity market has generated significant secondary market opportunities. In a maturing private equity industry, the secondary market has become increasingly viewed as a tool for private equity portfolio management and a source of liquidity, in a relatively illiquid market.

Historically, approximately 2-3% of all private equity commitments turn over in the secondary market. Over $860 billion of private equity was raised from 1997-2002. [1] Based on this data, Landmark Partners, a dedicated secondary investor, estimates the volume of secondary activity generated from these commitments to approach $22 billion or approximately $2 billion annually over the next decade.

Secondary funds have currently raised nearly $14 billion to buy existing primary investments in private equity funds and direct company investments. Transaction projections, compiled by Columbia Strategy, LLC, estimate that between $6 to $16 billion of secondary deals will be completed by 2006. This "dry powder" represents both opportunities and challenges for buyer and seller alike. This article outlines the unique forces driving the current secondary market and the associated transactional risks and opportunities it presents to the private equity industry.

Who is Selling and How Much?

Limited Partners (LPs) of private equity funds seeking liquidity are selling LP fund stakes, particularly in early stage funds. General Partners (GPs) of private equity firms are selling direct company investments (directs) in part or in whole, particularly those who do not have adequate follow-on capital and 'tail-end' funds, which are in the last few years of a fund's life cycle and have yet to fully exit due to the macro-economic slowdown. Finally, corporate and strategic investors are selling both LP and direct investments as a function of divesting non-core assets.

Often, new CEO's are charged with cleaning up the balance sheet, and where better to start then with assets that have not been marked to market price? Foreign banks, which once generously invested in U.S. based private equity funds are currently seeking to reduce their exposure to this asset class in order to focus on domestic issues. US banks and insurance companies have begun reducing their private equity positions to enhance capital positions and reduce earnings volatility. Finally, corporate pension funds, in light of the merger and downsizing activity that has occurred from 2000 to present, have changed their focus. In a merger situation, cash on the books is much more beneficial than illiquid assets, as in many mergers, the parent has divested of the acquired private equity portfolio.

The Perfect Storm: Motivations for Selling and Market Drivers?

This is an advantageous time to acquire private equity secondary interests based on supply, discounted valuations, higher rates of return, the rapid deployment of capital and more important, the quicker distribution of returns. When simply looking at supply and demand, the timing is fortuitous. However, other factors have aligned that make this an interesting time in the secondary market.

Distress.

The single most important driver of secondary direct sales is a poor macroeconomic environment, including liquidity pressures and poor operating performance. With the overall decline in the performance of equities and a three year recession, many LPs are experiencing a liquidity crisis and cannot meet capital calls. Likewise, many GPs do not have sufficient follow-on capital available to protect their current investments from the dilution created now with the preferences put on recent fundraising rounds.

On the corporate front, many corporate venture funds are a drag on earnings due to the write-downs that must be taken in conjunction with the long holding periods required before returns are realized. Responding to such pressures and the corresponding inability to make follow-on investments in their portfolio, corporations are choosing wholesale asset dispositions at heavy discounts to market value. They would rather realize some capital back than merely wait and hold to see their ownership stakes inevitably diluted down by other investors to such small levels as to be essentially worthless.

Higher Returns and Diversification.

Another market driver is that over a long period of time, private equity returns are higher than other asset classes. Generally speaking, private equity has outperformed the other indexes over the past twenty years. Since 1982, there has been a 16.9% return net of all fees and carried interest for private equity (compared to 12.4% (Dow), 11.5% (S&P 500), 11.2% (Nasdaq)). Superior return is the primary reason why private equity is an asset allocation. Diversification is another reason.

Reduced Risks for Buyers.

Private Equity funds typically have ten-year terms, often with limited one year extensions. In most cases, a fund's investments are made through years 1-5, with harvesting occurring in the latter years. The highest level of investment risk is during the early years, or through the trough of the "J" curve, after initial investments have been made. Secondary acquisitions, which often take place after this period, obtain the benefit of reduced risk without reduction of potential return.

Secondary buyers have the opportunity to further reduce risk through pricing based on the analysis of the value and return potential of a seasoned basket of assets. A secondary investor acquires a secondary portfolio where the assets in the portfolio are at a point of maturity since the non-maturing assets have largely been written off. The performing assets are growing and closer to aliquidity event, but still held at conservative valuations, frequently at cost.

Thus, as secondary acquisitions generally occur at a discount from reported values and have a shorter period to investment realization, secondary buyers can receive higher returns with lower risks relative to the sellers of the partnership interests.

Corporate Restructuring.

Another driver of sales is merger and acquisition activity that creates excess corporate baggage and 'orphan funds.' As companies merge, corporate funds are divested, such as in the merger of Wachovia Capital with First Union - a transaction which led to the spin-off of the bank's direct investments in 2002. Likewise, National Westminster Bank sold three portfolios to Coller Capital during a hostile takeover by the Royal Bank of Scotland in 2000. [2] Similarly bankruptcies, such as that of Global Crossings, yield divestitures or spin offs of direct portfolios. Corporate venture funds often fall victim to cost cutting measures, as venture assets are often costly to maintain and operate. As a result, many corporations seek to dilute or remove the cost of the venture program directly from the parent's balance sheet by sale. Today, they have the ability to retain strategic relations with the portfolio through a spin-off of assets as part of an MBO or other private equity sponsored play, where they retain a small percentage of ownership in the new entity.

Shareholder Pressure.

Justifying a private equity program without a euphoric market is a tough argument to make to shareholders and corporate boards. Investors are increasingly pressuring companies to reduce areas of volatility in their business, even at the loss of potential long-term growth, to generate consistent returns. Private equity has created a great deal of volatility in corporate earnings, particularly in banks. Additionally, another difficulty is the ongoing cost of managing a portfolio, which include, at a minimum: dedicated corporate fund managers (who are typically higher paid than their divisional counterparts), reporting, legal, and relationship management personnel, in addition to general administrative costs.

Awareness ofOptions.

The increase in supply of direct assets for sale has helped attract new capital for secondary funds, while concurrently expanding the number of secondary buyers. There are now at least twice as many well capitalized buyers in the market as there were only two years ago, and many secondary specialists have far exceeded fundraising goals; some by more than 50%. Some market participants believe that there has been too much money raised in the secondaries, which they speculate will drive up prices; a thought welcomed by sellers. The development of a formidable yet diverse buy-side has helped initiate very broad market activity that can now meet most sellers' needs. For example, many sellers would rather offload an entire portfolio at once, rather than having to sell bit pieces over time. Other sellers would prefer to only sell rights and minority interests, and again the range of market activity has proven this is also possible. The momentum and acceptance of creating solutions for sellers is creating visibility and comfort, quickly spiraling up the number of sellers, buyers, and deals completed. These options have led to some very notable large spin-offs that have received a good deal of press coverage, such as: Deutsche Bank, Lucent, BTexact Technologies (British Telecommunications plc), Quantum Corporation, Accenture Ltd., Wachovia Corporation, National Westminster Bank PLC, and Pioneer Corporation.

Changes in Regulation

Direct portfolios are being sold by banks, partly in response to new requirements and regulations. Banking authorities are now stipulating an increase in reserves to offset potential private equity losses. Currently, as much as 25% of the value of private equity assets is required. Thus, banks have found themselves over allocated to private equity as an asset class. JP Morgan Chase and Wells Fargo are among recent banks announcing they will trim private equity holdings in response to these policies. Another example includes FleetBoston which said in 2002 that it would reduce its private equity portfolio from $3.6 to $2.5 billion over the next two years. [3]

Asset Allocation Shifts

Microeconomic drivers for sales are primarily related to an asset allocation shift.

The main internal force for sales by financial investors is overexposure, compounded by the coinciding widespread relative decline of public market investments. The unprecedented capital raised for private equity in the late 1990s is naturally seeing a correction. Similarly, strategic sales by corporations are often rationalized because strategic focus has shifted away from an industry or sector once considered relevant, or the relationship benefit of the portfolio has diminished. Many corporations are fully retrenching and focusing on core businesses, leading them to reevaluate their ability to extract any strategic benefits from their direct investment programs. These corporate venture funds made investments for a weighted combination of strategic and financial reasons between 1998 and 2001. As the financial benefits continue to erode, strategic investments are no longer positive NPV projects.

Preemptive Sales.

Venture capital returns in the current primary markets are down nearly 30% over the last twelve months. However, many involved in private equity believe that valuations have not yet bottomed out, making investments subject to even greater loss. As a result, sellers are looking for exits before their investments have reached maturity, and even more hurriedly, before valuations hit rock bottom. Thus, the secondary market is one of inherent inefficiency-where the sellers are motivated for various reasons and the buyers can exploit these inefficiencies in order to have a positive return on investment.

Rapid Deployment and Earlier Return of Capital for Buyers.

Compared to traditional private equity investors, secondary investors are exposed to timing and reinvestment risk over much shorter holding periods due to: (i) the rapid deployment of capital and (ii) when combined with a quicker return of that capital.

Capital commitments in traditional private equity funds may be tied up for considerable periods of time before being drawn down for investment. Until the capital is drawn down, investors earn money market rates of return on that portion of their portfolio they have allocated to private equity. In general, an investment in a secondary fund ensures the rapid deployment of capital. On average, most secondary funds are fully invested by the end of the third year.

The following chart is a checklist for the risks and benefits associated to the buyer and seller. For information on Columbia Strategy, LLC please see www.columbiastrategy.com


BUYER BENEFIT BUYER RISK
Discounts. Secondary transactions generally fetch heavy discounts. Some deals even involve no cash paid at all by the acquirer. The discount provides more appropriate valuations that reflect market value. Transparency and valuation. In direct deals, it is difficult to obtain objective or useful information on each portfolio company. Corporate funds often do not hold board seats, and interviews with management are difficult to arrange. Buyers must have the appropriate networks to be able to obtain perspective on the investments. The valuation process remains highly subjective, especially for venture portfolios.
More consistent returns. Secondaries generate more consistent returns relative to investing in the primary private equity market. According to Jeremy Coller, "The returns are much more consistent. You won't have a 100% internal rate of return, but you won't get that many blowups either."[4] Over the long-term, a 25% IRR is an accepted reasonable expectation. Deal cycle time. Secondary direct transactions can be painstakingly long and costly, with extensive due diligence, legal review, and negotiations. The problem is increased by orders of magnitude with a large portfolio. Often, structuring is required to get around or force transfer approval of portfolio companies.
Less risk. Risk is lowered because investments in the secondary market tend to be more mature, as compared to investments in the primary private equity market. Buyers can gauge the underlying investments after they have been seasoned and gone "further around the track." Also, many poor investments are already weeded out by natural selection. Need for a GP. Many direct deals require a GP brought in, since secondary buyers often view taking on that responsibility as limiting scalability. Corporate fund managers typically lack the acumen or discipline of traditional VCs.
Quicker returns. Because underlying assets are more mature than in the corresponding primary market, capital is invested later and returns realized faster, generating greater returns. A critical point: Secondary investments are often made at or near the distribution phase of a fund's life cycle. Additionally, much of the fixed start-up costs of the portfolio have been already absorbed and built into the discounted valuation. Follow-on financing. Direct investments may require follow-on funding to be successful, in some cases an unlimited amount of future financings .
Non-strategic yet healthy assets. Corporate venture portfolios provide the opportunity to buy portfolios deemed non-strategic. However, these assets may still be healthy, well-performing companies, and often are discounted solely as part of the bundle. Potential easing of discounts. The secondary direct market is increasingly competitive, with aggressive new players. More capital in the market may drive prices up. Additionally, new players and creative structures in the market may mean buyers have to offer better overall proposals, and not just better prices.
Co-invest without management headache. Directs are commonly structured such that the buyer can take a strictly financial role; even as an LP in the case of a synthetic fund. Risk is further managed by the involvement of multiple financial and strategic investors in one synthetic fund. Enough good deals. One nagging question is when the expected flood of deals will emerge, and whether sellers will engage. Many believe there are too few deals and too much capital chasing them. Others believe the only portfolios to be sold are portfolios of dotcom and "me too" investments.
Greater potential for returns. Buyers can quickly accumulate a large portfolio and deploy large sums of capital when purchasing portfolios in the secondaries. In the case of fully-divested directs, the capital buys a percentage of the underlying portfolio company; should it succeed the full return will reach the buyer instead of pro-rata splits with other LPs. Difficult to change strategy. Once a direct portfolio has been purchased, it cannot easily be liquidated should a strategy change be desired. Other secondary buyers will be wary, so the realistic alternative is that the portfolio must be held to maturity or written-off.

SELLER BENEFIT SELLER RISK
Generate liquidity. Secondaries are a reasonable liquidity option, given that few other attractive alternatives exist with the slowdown in the IPO and M&A markets. One alternative in private equity is securitization or "inseuritization", as some call it. However, few, if any, successful securitizations have been completed, with many failures seen. Transparency. Large corporate funds often have a lack of understanding as to the potential financial and strategic value of each individual property within their portfolio often due to investments from different divisions within the same company, shifting executives and changing corporate initiatives. Moreover, objective information is difficult to attain. Many corporate funds do not hold board of director seats, unlike the case of venture capital funds, so access to the internal workings of portfolio firms further is limited.
Follow-on Capital. Secondary transactions usually involve the buyers providing follow-on capital for the portfolio companies, helping to protect investors' positions in the portfolio. Follow-on capital is particularly critical where the investor cannot or will not continue to commit the capital necessary to support the portfolio. Secondary investors can be brought in to sponsor future financings, while the portfolio is still managed by the current team in-house. The buyers essentially become the LP of the fund. Pricing. Often sellers misprice. As a result of poor transparency, sellers are rarely up-to-date on the value of their holdings. Additionally, often by the time a corporate investor sells their portfolio, the original investment team is gone, leaving a knowledge deficiency. The potential value of growth companies also changes substantially from the time of initial investment.
Divest non-strategic and poor-performing assets. VCs have the opportunity to divest assets in the secondary market that are performing below expectations, albeit most likely at a discount. For corporations and institutions, removing the distraction of investments that offer no value frees up resources and allows management to focus on the core business. Huge discounts. Secondary direct transactions can lead to fire sale discounts, up to 40% to 99% of book value. However, discounts are meant to reflect market value, and sellers have seen success substantiating prices of portfolio companies on that basis.
Reduce unpredictable earnings. The long-term unpredictable nature of private investments can create weakness on a balance sheet. With volatility in the stock market, companies are under pressure from shareholders to produce consistent revenue, even at the cost of some potential upside in the future. Loss of substantial upside. If assets are sold prior to harvesting, the seller is potentially giving away the upside for pennies on the dollar. For example, Lucent sold its venture unit to Coller Capital for under $100 million, but a few months later, just one of the portfolio companies sold for approximately $470 million.
Reduce the costs of portfolio management. Secondary sales or spin-offs allow "outsourced" management, often gaining more professional and aligned fund managers at a lower cost. In particular, corporate development and strategy managers are freed up to build key relationships with portfolio companies and external, strategic players. Potential to sell strategic holdings. In selling a portfolio, strategic investors can inadvertently make new technologies available to competitors that in hindsight may have been key to their core business. (See Buzz of the Week, Four Horsemen of the Apocalypse).
Shift asset allocation. Strategic investors can swap or actively buy/sell assets, to exit sectors or markets where allocations exceed the requirements of the strategy. Loss of the ability to increase ownership. In some secondary deals, sellers may lose all rights, financial and strategic as a result. The ability to benefit from a successful portfolio company may be hamstrung.
Improve returns. Recent research substantially proves that a combined approach, between strategic and financial investors, has the highest likelihood of success for direct private equity investments. These findings encourage strategic investors to partner with financial investors to support their current investments and make new investments going forward. Negative publicity and loss of confidentiality. After completion of a sale, publicly-traded sellers have seen press coverage of their transaction that can be interpreted as negative by shareholders. As a result, many corporations attempt to keep the sale of their private equity business confidential, as it may indicate that the company is seeking cash, was unable to maintain a profitable portfolio, or wasted shareholder money by 'jumping on the bandwagon' during the bull market.
Retain a percentage of ownership. Assets can be spun-off for investors who want to divest, but don't want to relinquish long-term upside. Often, current revenue is booked through sale of partial interests, and a percentage of ownership is retained. Transaction process and timeframe. The due diligence, negotiation, and legal procedure in deals can take from three months to a year. The preparation and transactional process is resource consuming, and may go awry in many different ways, thus requiring close management and dedicated resources.
Keep valuable companies under the corporate umbrella. Spin-offs are also structured in the secondary market to allow the seller to retain strategic interests and rights to the portfolio. The buyer commits fresh capital and may pay the seller a consideration. Conflict of Interests. Numerous conflicts of interest arise in internal teams leading corporate asset sales. Often, the team managing the sale of the transaction is included in the spin-off itself to manage the portfolio on an ongoing basis, while creating personal incentives for managers that are different than that of the parent corporation, which they may have a fiduciary duty to.
Deal Structuring. The financial and deal structuring often required to successfully execute these transactions is typically lacking among many corporate investors. Therefore, sellers must rely upon investment banks and intermediaries to ensure that the implicit and explicit needs are met.

[1] VentureEconomics

[2] Charles Fleming, "UK: Deals and Deal Makers - Secondary funds go hunting for private-equity holdings," The Wall Street Journal, January 6, 2000.

[3] Kelly Holman, "Carlyle to Launch Secondary Fund," The Deal, May 14, 2002.

[4] Chana Schoenberger in "Vulture Capital," Forbes Magazine, January 7, 2002.

For information on Columbia Strategy, LLC please see www.columbiastrategy.com