It’s not “Mr. Smith Goes to Washington” exactly, but about 20 secondary private equity buyers have been fighting a good fight in the halls of the U.S. Congress, and like Jimmy Stewart’s character in the Frank Capra classic, they’re winning. With the help of attorneys and Washington lobbyists, the group of secondary private equity buyers managed to exempt private equity firms from a proposed tax code change that could discourage secondary sales.
The initial proposed change involves Provision 754 of the Internal Revenue Code. Under the change, private investment partnerships would be required to document records for limited partners gained through a secondary sale. Having to account separately for secondary buyers would add thousands of dollars in cost to private equity firms and harm the secondary market. The provision, which was passed by the Senate in May, is a small part of a large bill that includes a plethora of tax changes and economic issues.
The secondary group managed to get a change made to language in the U.S. House of Representative’s bill known as the “American Jobs Creation Act,” which passed the House of Representatives on June 17. The new language exempts private equity investors from the mandatory 754 bookkeeping.
The bills passed by both the House and Senate need to be reconciled in a conference committee, which is no small task for two very different bills in a presidential election year. The committee has yet to be formed. Lindy Paull, a managing director with PricewaterhouseCoopers who led the lobbying effort, says its unlikely a final version of the bill would be agreed on by both House and Senate before Congress adjourns for its summer recess. She expects the law to be finalized during the fall.
“It’s like betting on a horse race,” says Willowridge President Jerry Newman, one of the leaders of the lobbying effort. “Anything can happen. We’re reasonably confident that they’re on board in Washington. Are there any absolutes in this business? No.”
Both bills contain controversial elements unrelated to Provision 754 that could cause a prolonged political battle or stymie the legislation entirely. Still, those involved with the secondary buyers’ lobbying efforts say that politicians and staffers alike in both houses and both parties are sympathetic to their cause and are confident that the compromise bill will contain the preferred language of the House bill. The task that the secondary buyers are undertaking now is to refine the definition of a private equity investor, which would broaden the scope of the exemption.
“It’s not clear if this was an anti-abuse measure or if it was a matter of tax policy,” says Michael Sutton, an attorney with Testa Hurwitz & Thibeault who has worked with the secondary coalition on the issue. “It might have been thrown in with anti-Enron type tax shelter provisions but I don’t think it’s necessarily that.” Another benefit to the government, besides curbing corporate abuse, is to generate tax revenue. Sutton first saw a draft of the bill this past fall and quickly realized that the issue was one that the venture capital and private equity communities would take an interest in.
A group of about 20 secondary firms came together to begin lobbying for private equity firms to be exempt from this provision. New York-based Willowridge and Boston’s HarbourVest lead the group. PricewaterhouseCoopers has been lobbying on behalf of the group with the help of the National Venture Capital Association (NVCA).
Jennifer Dowling, vice president for Federal Policy and Political Advocacy for the NVCA, says that legislators and their staff were not aware of the implications on VCs or private equity markets. “They were looking at what they considered to be the correct pure tax approach and had not considered the practical implications of this for our industry,” she says. “Many of them were not very familiar with our industry. A lot of what has been going on has been an educational effort.”
“We found the reception to be very sympathetic,” says Paull of PricewaterhouseCoopers. “The proposal was directed at abusive partnership transactions. There have been no indications of any abuse in [the secondary private equity] industry or in the private equity fund-of-funds industry.”
CSFB Raising 3 New Funds
Starting what could become a wave of venture capital secondary grabs after a long ride on the buyout bandwagon, Credit Suisse First Boston (CSFB) says it plans to raise CSFB Strategic Partners III, a group of three secondary funds totaling $1.85 billion, later this year.
The new triumvirate of funds will be anchored by an LBO-focused fund targeted at $1.5 billion. This will be supplemented with a real estate secondaries fund with a target of $200 million that CSFB hopes to meet or exceed. And CSFB will raise a secondary fund focused on venture assets that it hopes to close between $150 million and $200 million.
CSFB announced this past December that it closed on $1.9 billion in two secondary funds. CSFB Strategic Partners II, which will invest in fund positions for buyout and mezzanine funds, closed with $1.6 billion and had a target of $1.25 billion. That fund is now between 75% and 80% invested. The investment banking giant also closed on CSFB Strategic Partners II RE, a $300 million co-investment fund focused on secondary real estate investments.
While CSFB was not forbidden to invest in venture secondary deals by its previous fund’s mandate, almost all of its venture exposure in its current fund comes from portfolios it picked up with larger transactions. CSFB avoided venture assets generally, following the conventional wisdom that venture assets do not provide stable returns on the same order as buyout funds and are more difficult to evaluate. But things have changed lately and deal flow may be catching up or starting to make inroads on the venture side.
“We have been seeing good deal flow in venture over the last four years now,” says Stephen Can, managing director of CSFB Strategic Partners. “The last six months we have started to get interested again for a couple of reasons. A lot of these venture companies are now at the point where they’re at break-even cash flow. You can evaluate them and you can see the potential for some value in these companies with a public market that’s accepting of realizations and public valuations.”
In the last six months, CSFB has bought two stand-alone venture capital fund positions and executed a “synthetic” transaction in purchasing a portfolio of direct assets.
Can says that his group will begin going to its current limited partners by the fourth quarter of this year. If there’s still room after the current LPs have a chance to invest, then CSFB will seek new limited partners. The group may expand the size of the fund, depending on investor interest. “Depending upon the deal flow we see it could evolve into a bigger fund,” Can says. “Will it be a huge fund? No. Does it have the opportunity to grow? It could. It depends on the product quality and the velocity of the market.”
In addition to raising the new fund, CSFB’s secondary group will bring on three additional investment professionals this year, expanding its staff to 16. CSFB will also open a new office in the next six to 12 months either on the U.S. West coast, in Japan or in continental Europe. CSFB opened a London office in the first quarter.
CSFB announced this past March that it was uniting all of its alternative assets, private equity, along with its private fund group and hedge fund groups into one division named the Alternative Capital Division. CSFB also said it launched a new investment fund focused on leveraged finance assets.
Other secondary venture enthusiasts include W Capital Partners, which recently closed on a $250 million new fund. Earlier this year, London-based secondaries firm Nova Capital Management found some proper VC secondary guides. Nova announced last week that it added two senior executives to specialize in venture capital secondary deals and portfolio management.
Lexington Raising $500M
Lexington Partners is raising a new fund that will purchase secondary interests in middle-market buyout funds. The New York-based firm believes that there has been a recent dearth of middle-market deal flow, and it hopes to capitalize on that void by acquiring limited partner stakes in younger funds that have invested less than 50% of their committed capital.
“This is a custom-tailored product,” explains Duncan Chapman, a general partner with Lexington. “It’s an opportunity that reflects what has happened in the past three years, in that there has not been much for the high-quality funds to invest in.”
The fund, which is -named Lexington Middle Market Investors LP, is being marketed with a $500 million target capitalization. It has already received a $150 million cornerstone commitment from the New York State Teachers’ Retirement System. A minimum investment of $10 million is required (according to Lexington’s SEC filing), and a final close is expected by year-end.
Lexington still plans to raise its sixth general secondaries fund next year, which follows a $2 billion fifth general secondaries fund that closed in 2001.
Zurich-based strategic advisor and placement agent firm Palomar Capital has hired David Chamberlain as a new managing director. Chamberlain was most recently a managing director with investment manager Unigestion and was in charge of its private equity group. He will lead a new secondary private equity practice at Palomar.
Palomar, which was founded in early 2003, has until now been focused primarily on credit securities and primary private equity funds. It’s entrance into the field of secondary placement agents marks continued interest in the space.
Other secondary private equity placement agents and strategic advisors have been increasingly active in secondary purchases themselves. For example, Allen Capital Partners, an affiliate of the New York Private Placement Network, is seeking $250 million to acquire private equity limited partnership interests for Allen Capital Partners X. And New York-based secondary advisory firm Columbia Strategy has an affiliate, Morning Street Partners, which is raising a fund.
Dan Primack contributed to this report.