Blue Light Special in the Private Equity Aisle: The big discount store known as the secondary market is getting crowded. If you’re a general partner, should you be worried about your LPs selling –

Selling your private equity interests on the secondary market was once the social equivalent of putting your children up for adoption because you couldn’t afford to feed them. It was a path traveled by investors desperate to leave the asset class and cash out completely. Now it’s an accepted part of private equity life, as routine as making room for new foodstuffs in your kitchen cabinet.

While ideally most venture capital and private equity funds will be held dearly and until final closure by their LPs – and every portfolio will be lucrative for every VC – the fact is that if you are a general partner in a private equity fund you’ve had (or will soon have) one of your LPs resell a stake in your fund on the secondary market. General partners, who must approve the transfer of partnership interests, need to know the ins and outs of the secondary space. The secondary market of today is not what it was five years ago, and it may be vastly different five years from today. While it is more open and familiar than it once was, the secondary market is growing more complex and getting crowded with new buyers.

The Market

Think of the secondary market as a Sam’s Club, the giant discount store where members buy in bulk for guaranteed discounts. Large and long-term secondary players have been accustomed to cruising the aisles of the private equity market and getting what they want by winning an auction. Now, however, things are starting to change. Secondary buyers are finding more shoppers clogging the aisles. What’s more, they have found the buying process becoming more complex and competitive.

Like its primary investment counterpart, the secondary private equity market is a Goliath compared to what it was five years ago. Secondary private equity investors raised more than $4.2 billion for new funds in 2003 and more than $5 billion in 2002, according to market researcher Thomson Venture Economics (publisher of Venture Capital Journal). William Sanford, an associate with New York-based secondary advisory firm Columbia Strategy, estimates, that more than $9.25 billion changed hands in secondary deals in 2003, up from $3.4 billion in 2002. Columbia cautions, though, that publicly acknowledged deals are in the minority, and that the actual number of deals may be much greater, considering that the majority of secondary deals are not disclosed. The firm also estimates that 2004 has seen about $911 million in secondary deals so far.

The large pool of capital dedicated to secondary deals has some people debating not so much whether or not too much capital has been raised for the market, but whether those firms that have raised enormous funds will be able to put their money to work effectively. Take the largest single secondary fund to date, Coller Capital’s $2.6 billion Coller International Partners IV, which is reportedly already half invested. Are these funds too big for their own good? Jeremy Coller, CEO of London-based Coller Capital, isn’t quite sure himself. “We don’t know if it’s the right size or not,” he says. “I’ll be able to answer that question in a year or two. It’s an experiment by us and our investors.”

The big rush to do deals that investors were expecting a year or two ago has been slow to materialize. A spate of large deals over the past year offers hope that the deal flow will catch up to the rate of fund-raising.

In a recent market survey of private equity professionals and affiliated executives conducted by Columbia Strategy, 53% of respondents said that the secondary market has become more important to their investment strategy. Of those that were interested in secondary investing, almost 40% were either unsure or unprepared as to the best way to evaluate a secondary portfolio.

Even with the increased popularity of secondary deals, it’s important to understand that the market is still a fraction of the overall private equity market. In 1996, secondary funds represented 1.54% of the total capital available of U.S. private equity funds, according to Thomson VE. As of 2002, the figure had increased to just 1.77 percent.

Where there has been a noticeable change is in the size of secondary players. Six years ago, funds larger than $500 million each had a total of $1.1 billion in committed capital, while funds with less than $500 million each had $4.4 billion committed to them, according to Thomson VE. Today, the smaller funds have a total of $5.2 billion committed to them, and the larger funds boast $9.4 billion in commitments.

The Buyers

Large firms founded for the explicit purpose of doing secondary deals dominate the secondary market. They’re looking to give primary limited partners and portfolio holders a quick exit and hold on to the portfolio for future profit. The space has seen some record-breaking funds over the last two years. The top two players in the fund-raising arena are Coller Capital Partners and New York-based Lexington Partners. While Coller Capital is the current record holder, Lexington is not far behind with the $2 billion fund it closed last summer. Other big players include Credit Suisse First Boston, Goldman Sachs, Boston’s HarbourVest Partners and Paul Capital Partners of San Francisco and Pantheon Ventures of San Francisco. HarbourVest began 2003 with approximately $3 billion available for secondary deals, though not concentrated in one single fund. Meanwhile, CSFB closed two secondary funds totaling $1.9 billion at the end of 2003.

While the big players grab most of the attention, the majority of secondary deals get done by smaller shops, like the following New York-based firms: Pomona Capital, Private Equity Investors, VCFA Group and Willowridge. These smaller firms with funds of less than $500 million far outnumber the handful of behemoths.

Investors say that there is room for both small and big players in the secondary market. The larger and smaller firms and funds can keep to their respective markets and still perform reasonably well and will not run short on opportunities. This also serves to help sellers. A seller with a lot of interests might sell them as one large portfolio or take them to smaller firms as groups of smaller portfolios. Both will find buyers, and both groups of buyers are happy to let the other’s market alone.

With a reputation for good returns at lower risk than standard private equity investments, the secondary market is attracting more buyers whose impact on the market place is not yet entirely clear.

The most significant change in the makeup of buyers is the arrival of traditional limited partners like pension funds that are buying secondary interests directly. They are going around the middlemen like Coller and Lexington (see sidebar, next page). “Two thirds of our deals are led by or include a non-traditional secondary player,” says Ian Charles, a vice president with research and advisory firm Cogent Partners of Dallas, Texas. “That wasn’t happening a year or two years ago.”

But while these buyers do not have the cost of capital that traditional secondary firms have, they also don’t have the resources to compete in the long term for large volumes of deals. “It takes a lot of work to deploy capital,” says Dayton Carr, founder and managing partner of Venture Capital Fund of America (VCFA), an early player in private equity and VC secondary buys. “Last year we saw over 100 deals. LPs have primarily done deals in funds they’re already in. One big group I know of, a consulting firm and fund-of-funds, has been doing secondary deals for five years but has only done 12 deals.” These programs may be dependent on partnerships with traditional secondary firms like VCFA, which has done analysis for such groups in exchange for access to deals.

What About VC Portfolios?

Long-term secondary buyers have shown little interest in buying venture capital limited partnership interests over the past few years. For the most part, they tend to focus on stakes in buyout funds. Buyout portfolios are seen as more stable because they are made up of more mature companies in less volatile sectors than the high-risk and high-tech startups that populate VC portfolios. Too many people got too burned with venture, say industry observers and insiders. “What we’re seeing in the industry is that venture is hurting people,” says Coller. “We’re quite lucky in that we have quite a small venture portfolio and we’re also lucky that it’s done well.”

Even VCFA, an established buyer of venture capital assets, is embracing buyout assets like never before. Previous dedicated secondary funds have been focused on buying secondary venture capital assets. The most recent U.S.-based dedicated secondary fund that the firm closed was VCFA Venture Partners III, which closed in 2000 with $100 million and is 75% dedicated to buying venture capital assets. The firm’s next fund is expected to be 90% invested in the assets of middle market leveraged buyouts. “In the venture world there are lots of venture-backed portfolio companies that aren’t doing well,” explains Carr. “There’s a lack of fundamentals and overvaluation. The valuations are going down, but some of the problems remain.”

Over the past couple of years, the quality of venture portfolios was so poor that VC funds were marking down their portfolios 25% per quarter for three or four quarters in a row, according to Private Equity Investors.

There are some signs that interest in venture portfolios is picking up. Several funds in the midst of being raised plan to focus their efforts on VC portfolios. London’s Nova Capital Management recently hired two new senior executives to focus exclusively on European and U.S. venture capital secondary deals.

Some secondary players, including those not particularly interested in venture capital, say that venture capitalists and their portfolio companies have cleaned up their act, and that the venture funds of today are going to do very well a few years down the road on the secondary market. “We’re seeing a lot more venture that’s fairly valued,” says Anthony Roscigno, a partner at Landmark Partners, a mid-sized secondary shop based in Simsbury, Conn. “On an ongoing forward basis, we’ll be about 65% buyouts, 40% venture based on the pipeline today,” Roscigno says.

“We’re in a period of choppy waters now,” adds Coller. “It looks like the question that is on everyone’s mind is: Is this the start of a new bull market or is it a bear market really? If it’s the start of a bull market, then you want to fill your pockets with venture assets today.”

The Sellers

Sellers once looked upon the secondary market as an escape hatch, but now they see it as more like a gardening tool that they can use to trim their private equity exposure when the public markets or other forces throw their public/private equity allocations out of whack.

As the industry has matured, sellers have gotten more sophisticated and they have become less willing to take steep discounts if they don’t have to. With specific mandates as to their asset allocations, many institutional investors found themselves over-allocated in private equity when their public portfolios depreciated greatly during the tech bust. In theory, this would have forced otherwise happy private equity investors to sell PE stakes on the secondary market, but that didn’t quite happen. Public pension funds were largely unwilling to take the steep discounts that secondary buyers were expecting. It was less of a hassle to hang on to the private equity they had. The improving public equity markets have worked to correct much of this, and some pension funds and university endowments find themselves with room enough to even slightly increase their private equity investment.

With the ebb and flow of who takes an interest in private equity limited partnerships, different classes of investors may enter and leave the market in greater numbers. Examining the new sellers coming into the secondary market is a study in who overloaded on private equity in the last five years. Individual limited partners were big sellers for a couple of years, but most agree that those sellers have for the most part washed out of the system. Banks have been big sellers of secondaries over the past couple of years and secondary investors see them as continuing to be active sellers. For example, Deutsche Bank has been holding the world’s biggest private equity garage sale for about a year, spinning off entire entities in deals like the behemoth buyout secondary that created MidOcean Partners last year.

A lot of current and upcoming sales of private equity assets by banks are being driven by regulations like FIN 46, according to Larry Allen, managing member of the New York Private Placement Exchange in Stamford, Conn. The Financial Accounting Standards Board (FASB) issued Interpretation Number 46 (FIN 46), which requires a company with controlling interest in an entity to list that entity on its balance sheet. The rule was set up to combat special purpose entities that were used as cloaking devices by the likes of Enron.

The Upside

There are good reasons why the secondary market has become so popular. For one, the transactions are less risky than direct private equity investments. The assets in question have already been poured over by venture firms and other private equity investors who made the primary investments. Also, the assets are sold at a discount, the price the primary investor pays to get out early. These discounts range anywhere from 20% to more than 90%, depending on the condition and desirability of the assets. VCFA reports that it averages discounts of 49%. With the increased competition for deals, the discounts are expected to be more in the range of 40% and 80 percent.

Another plus for sellers is that they may start to see better prices due to what some perceive as an overhang in the secondary market. “There’s a lot of money out there that’s been raised, but based on the numbers I’ve seen, it’s still not enough to purchase all the secondary interests that are going to become available over the next few years,” says David Tegeler, a partner with Testa Hurwitz & Thibeault, a Boston-based law firm that specializes in private equity matters.

Gregory Garrett, a partner with Chicago-based Adams Street Partners, adds that part of the upside on the secondary front is that the overhang in the primary market is getting smaller. “There’s a large capital overhang in both venture and in buyouts that is slowly getting worked off through a combination of fund-size reduction, new investments and smaller new funds being raised,” he says.

Another reason to consider a secondary purchase is for the opportunity to become a limited partner in a fund you weren’t able to get into when it was being raised. Establishing relationships in the private equity world is key to succeeding as an LP or a GP. LPs want to be invited guests when top-tier funds begin fund-raising. Getting in as a secondary buyer after a fund has been oversubscribed is a way for a potential LP to get on the guest list for the next time a firm raises a new fund.

The Downside

Unlike behemoth discount stores, newcomers to the secondary market won’t find a friendly geriatric greeter in a blue vest welcoming them. As the secondary market shed its shame, it acquired the burden of being known as a bargain basement. Investors have clamored to get in on lucrative secondary deals, thinking of them as the Sam’s Club of private equity. But while buying in bulk saves you money, it gives you a lot to carry to the car. Managing a portfolio of venture capital-backed companies requires the work of many general partners. Thus, a firm saddled with a cumbersome portfolio of venture-backed companies may not be able to bank on selling it quickly. In particular, large secondary buyers aren’t very interested in buying portfolios of direct venture capital investments.

Increased competition among large secondary firms with more and more money to put to work increases the likelihood that buyers will get burned. The auction process naturally awards deals to the highest bidders. New entrants to the secondary market will also find that the better deals will go to a handful of well-known names because sellers are as adamant as ever about dealing with a few discreet buyers. “The barriers for entering this business have gone up over the last year,” says a general partner at a secondary firm. “GPs don’t want to deal with opportunistic buyers.”

New players must also understand that none of these secondary deals can transpire without the approval of a general partner. The highest quality funds are often invitation-only for primary investors and no less exclusive for secondary investors. A few private equity funds, both venture and buyouts, have stated that they won’t permit a secondary sale to a buyer who is not already a primary limited partner (see sidebar, next page).

New Ways To Deal

The current secondary climate requires buyers and sellers to make deals that are more complex and nuanced than a traditional auction or straight purchase. As secondary buyers seek large groups of assets to buy, they’re finding that sellers are looking for more than just a quick deal through an auction. Along with the more progressive use of the secondary market as a portfolio management tool, sellers are becoming more demanding and expect more nuanced deals.

One could argue that the shot heard around the world last year was HarbourVest’s deal with New York’s UBS. The key element to making the deal was that HarbourVest and UBS formed a joint venture specific to the transaction, named Tresser, to acquire the partnerships. The deal nets HarbourVest 52 limited partnership interests in both venture capital and buyout funds. The commitments that UBS made in the portfolio total $1.3 billion.

“It would be nice if you could go out and buy simple limited partnership interests and then go home, but it’s a bit more complicated these days,” says Fred Maynard, a managing director with HarbourVest. “It is a direction that I think the secondary market in general is being forced to go with the large amount of capital that’s come into the sector. You have to think about these things creatively and be willing to incur the cost of the time and the effort.”

The HarbourVest-UBS deal “is going to be a bellwether deal for the industry,” says NYPPE’s Allen. “This is a structure that will be used by other financial institutions in the future. This is going to be part of the future of the business: to be able to customize deal structures to meet the financial, tax and regulatory needs of sellers.”

(The HarbourVest-UBS deal wasn’t the first of its kind. In its deal for Bell Labs’ portfolio, Coller Capital joined with Lucent’s New Venture Partners and BTexact Technologies, the research and technology development unit of London’s British Telecom, to form NVP Brightstar, an independent corporate partnership based in Ipswich, England.)

Employing things like joint ventures and other creative structures is much tougher to do when a firm must employ several hundred million dollars with each transaction. As a result, secondary strategy lends itself to slightly more complex transactions. HarbourVest Managing Director John Begg says that buyers are responding to demands by institutional sellers. “Large institutional sellers are not going to be willing to take very large discounts; they’ll simply keep their portfolios,” he says. “Traditional secondary buyers who have not been particularly creative have simply not been able to deploy their capital.”

Secondary investors should be prepared to offer “an a-la-carte menu of structuring alternatives- including profit shares, deferred purchase-price alternatives, cash-flow or total-return swaps, funded-unfunded splits and partial securitizations,” Geoffrey Clark, managing director of Goldman Sachs private equity group, wrote in a report published last year.

The Road Ahead

The secondary market has grown by leaps and bounds and is bigger than ever before. It has grown to welcome new buyers and stands ready for new sellers while still retaining its preference for more established investors. It offers private equity holdings of all kinds for sale, but currently partnerships in buyout funds are the hottest sellers. The market is prepared for an influx of very large deals, and at the same time is requiring more ingenuity to get big deals done.

Secondary investing is not something that anyone can do, and the Who’s Who of the secondary market is a short list, so potential buyers beware: Secondary purchases are not the quick-buck answer to allocation problems, even if they may appear to be.

While the aisles may be more crowded and the venture capital items aren’t selling as briskly as most would like, everyone agrees that the secondary market is doing brisk business and that venture capital portfolios will fetch higher prices in the coming years. It’s a lot harder than shopping at a big discount store, but when did you ever get a $100 million discount at Sam’s Club?