Cover Story: Making An Entrance – Can Online Exchanges Find Their Place in the Secondary Market? –

Financial markets seem to develop in fits and starts, slowly gathering speed and then hitting subtle, sometimes unseen, inflection points that propel them forward to new heights. The venture capital market is no exception. For most of its history, VC was a cottage industry. Then almost overnight, VC came of age and was established as a much sought after asset class.

The same kind of phenomenon could be happening in the secondary market for limited partnerships. After spending much of the last decade lurking in the background, the dramatic rise of fund-raising activity over the last couple years, coupled with a recent drop in fund performance, has sparked more activity and interest in this option from investors. At the same time, some large secondary sales in the past year, including Chase Capital Partners’, now J.P. Morgan Partners, sale of more than $1 billion in limited partnership interests, have helped validate the effectiveness of the secondary market as an avenue to a real liquidity event.

Indeed, market pros say secondary volume has been increasing rapidly of late and should continue to expand. The market downturn of late 2000 and early 2001 has made liquidity an increasingly important issue for private equity investors, some of which are now bumping up against their alternative asset allocation levels due to the falling value of their public equity holdings. Wealthy individuals, whose net worth became considerably smaller as the Nasdaq plummeted and dotcoms went bust, have also been scampering to secondary fund managers, looking to unload small LP interests in private equity vehicles and salvage what is left of their portfolios.

“The primary market has achieved a certain state of maturity where the secondary market serves more than just a one-off need. Now it allows you to manage assets in an active manner that isn’t just in or out,” says Brent Nicklas, managing general partner of Lexington Partners. In fact, Chase Capital Partners undertook the sale because the firm was looking for liquidity in order to free up capital to invest in new third-party private equity funds.

Lexington, which led the syndicate that purchased the Chase Capital Partners portfolio, is in the midst of raising its $2.5 billiontargeted fifth vehicle that will focus primarily on venture capital, buyout and subordinated debt secondaries.

To be sure, compared with the overall venture market, the size of the secondary market is still pretty small. Secondary fund managers estimate that anywhere from 0.5% to 4% of capital committed to a vintage year changes hands in secondary transactions. (Volume estimates vary depending on whom you ask.) But as the venture pool continues to increase, those partnerships available for sale increase proportionately. So for the 2000 vintage year, when venture firms raised a record $105 billion, this means anywhere from $420 million to $5.25 billion worth of limited partnership interests will eventually be sold in secondary market-transactions. Of course, that potential is much greater when considering all the funds raised in the last five years.

Building An Exchange

Until recently, selling one’s interest in a limited partnership was a relatively rare event. There was limited liquidity in the market, and the LPs who did invest in private equity were in it for the long haul. But now, with the investor base having grown, and with many of those investors looking to reduce their allocations to private equity – some are required to do so – the need for developing a formal exchange to trade these interests has emerged.

A few groups such as the San Francisco-based PrivateTrade, New York-based New York Private Placement Exchange (NYPPe) and San Francisco-based Round1 Private Capital Marketplace Inc. are betting the future of the secondary market lies in the establishment of an orderly Web-based market. Formal marketplaces represent a fairly radical departure from the existing practices of the secondary marketplace, where a small number of secondary funds generally purchase LP interests in negotiated transactions, or participate in quietly held auctions run by investment banks.

The closed, quiet and inefficient nature of the market has historically resulted in deep discounts for buyers, who have, in turn, generated premium returns for their investors. Indeed, J.P. Morgan Partners, in an effort to avoid steep secondary market markdowns for additional limited partnership interests the firm is looking to shed, has floated, and is currently re-working the terms of an $800 million securitized offering Porter Global Private Equity Ltd. (See story on page 12.)

The need for liquidity on the part of LPs and their desire to manage their LP interests the same way they manage assets invested in other financial products demonstrates the need for an orderly, centralized exchange of LP interests, says Kathleen Powers Dunlap, chief executive officer of PrivateTrade. “If you believe in private equity as an asset class…and then you look at other asset classes where the size of the secondary market is a multiple of the primary market, private equity is the glaring exception,” she notes. PrivateTrade is focusing on institutional investors, whom Powers Dunlap says hold 85% of private equity assets, as potential users of its marketplace.

“This is academic that this is going to happen,” says Laurence Allen, chief executive officer of NYPPe. “All the other asset classes in a sophisticated investor’s portfolio have secondary market liquidity and last year only $2 billion of venture capital traded in secondary transactions.” For its purposes, NYPPe defines the VC asset class as consisting of interests in private equity funds, hedge funds, restricted securities of Securities and Exchange Commission reporting companies and non-SEC reporting companies.

The primary benefit of an orderly secondary market exchange for sellers would be the ability to get several independent valuations of the interest up for grabs, which should result in sellers receiving a higher sale price than the current system produces, say Allen and Powers Dunlap. “Our biggest value-added service is that we know more about the buyside than anybody and can look at the institutional investors and provide a robust analysis on potential buyers,” says Powers Dunlap, noting that nearly 300 different groups have signed up as members of PrivateTrade. For his part, Allen says his team of 23 professionals maintains relationships with over 4,000 investors.

Beyond achieving better prices and providing more insight into the world of secondary buyers, both groups argue they outperform placement agents in their ability to service customers of all sizes, many of whom might not be big enough to interest placement agents in their business. Most importantly, the methods the marketplaces have put in place to complete a trade are a sizeable upgrade over the current system, the two CEOs argue. “When a placement agent or others conduct a secondary, it is not always clear how the sale will be conducted. We have put in place a clean, clear, secure, easily defensible process that assures people who take their fiduciary duty seriously that they can achieve the highest and best price,” notes Powers Dunlap. NYPPe has a five-step process which prepares potential sellers for listing their position and paves the way for sales to be concluded quickly when trades occur, Allen says. “We are creating standards for our industry,” he adds.

Hurdles to Success

Identifying a perceived marketplace need and building an orderly market do not, by themselves, guarantee success. Prior attempts to establish secondary marketplaces have failed because they could not attract liquidity or deal flow, market players note. The future of the current market builders rests on their ability to attract deals and investors with capital. However, there are a number of potential obstacles to success coming from all the affected parties – LPs, general partners and secondary funds – including a lingering belief that the current secondary market for LP interests simply works well enough as it is.

LPs, as a group, seem surprisingly ambivalent toward the idea of a central marketplace that would call for sellers to post LP interests for sale on a Web page – even private, password protected, members-only Web pages like those set up by PrivateTrade and NYPPe. “The exchange concept is interesting, but it seems to remove the relationship from a relationship business,” says Barry Gonder, senior investment officer at the California Public Employees’ Retirement System (CalPERS). Other LPs expressed similar concerns. “It is totally inconsistent with the asset class to say what the world needs is a liquid market in private equity. This would further erode private equity’s attractiveness, because the more efficient it becomes, the more relationships are hurt,” says one endowment fund manager.

“If I were looking to sell my private equity portfolio I would go the traditional route,” says Ronn Cornelius, director of private equity at Pacific Life Insurance Company. “This is a negotiated transaction, like selling a company. It’s an intimate thing you don’t just post it.” Both PrivateTrade and NYPPe officials say they are aware of these concerns and can accommodate sellers who do not want to post their transactions on PrivateTrade’s and NYPPe’s Web sites. In fact, PrivateTrade has yet to put any deals on its Web site, and the two sales it is currently working on are both taking place offline.

Moreover, some LPs think a liquid secondary market would drive down the returns that cause people to invest in private equity in the first place. “It is an illiquid assets class and you expect a premium because of this,” says Chris Ailman, chief investment officer at the California State Teachers’ Retirement System (CalSTRS). “If it becomes very liquid, you can’t expect the asset class to generate the same returns.”

Still, the motivating factors behind the new markets resonate for some. “I think it’s a great idea. It will give investors a sense of what something is worth…the secondary market should not be a private market, it should be a public one,” says Michael Gutnick, senior vice president of finance at Memorial Sloan-Kettering Cancer Center. However, neither PrivateTrade, NYPPe nor Round1 is a completely transparent public market – only the final buyer and seller know the terms of transaction conducted through PrivateTrade. On NYPPe, which offers a couple of different methods for liquidity, the seller sets the price or dictates the terms of an auction and can decide whether or not to make the terms of a sale public or known to other bidders. Eventually, NYPPe does hope to make its market as transparent with as much pricing information as possible, says Allen. Round1 will build a custom marketplace for an LP wanting to sell a partnership interest, or a whole portfolio. At that point it is up to the seller to decide how to run the auction and what information to disclose once the sale has taken place.

Existing secondary funds, many of whom have spoken with PrivateTrade or NYPPe and even registered as users, on the whole appear to be taking a wait and see approach to the new exchanges.

“Does the marketplace need it? I don’t know,” says Tim Jones, an investment director with secondary firm Coller Capital. “I am not convinced there will be a lot of transactions, and exchanges work best when you can easily monetize an idea – but secondaries are very complex.” Nonetheless, Coller will keep an eye on the new exchanges, Jones adds.

Some secondary funds believe the exchanges are simply superfluous, since the major institutions and GPs already know the handful of established secondary buyers. “I think the current system works fine. The bigger sales offer plenty of competition, now,” says Dayton Carr, a general partner at secondary buyer Venture Capital Fund of America. In fact, Carr and other marketplace players expect the competition to increase as more private equity firms and investment banks try to seize a piece of this growing market by raising new secondary funds a prospect not everyone involved with the market sees as overwhelmingly positive for secondary firm’s IRRs. “If there is a risk, it is people who see the historic returns for secondaries, but don’t understand the business, come piling in and start bidding up prices,” says Lexington’s Nicklas. “The question is will new entrants have the same discipline and return goals that have gotten the market to where it is now.”

Unwilling Partners?

Perhaps the thorniest issue facing nascent partnership exchanges is that most GPs prefer to pick and choose the investors in their vehicles. Moreover, most GPs, in their private placement memorandums, reserve the right to approve sales of LP interests in their funds or require that their existing LPs have the right of first refusal. GPs are also nervous about the sensitive financial and other information they provide to their LPs becoming available to any party interested in buying a secondary in their fund.

“I think we would be a little apprehensive about one of our LPs putting their interest up on one of these exchanges, given who we invite to invest in our funds,” says Noel Fenton, general partner at Trinity Ventures. “We also provide a certain amount of sensitive information to our LPs, and if strange people started showing up, it might discourage us from being as open as we’ve been.”

Both PrivateTrade and NYPPe believe they have incorporated GPs’ concerns into their trading process. NYPPe encourages sellers to contact their GP groups before they post a position for sale and PrivateTrade brings GPs into the beginning of the sale process, allowing them to screen potential buyers, to make sure they are acceptable from a tax and legal standpoint. However, this seems to run counter to current market practice: Often times, LPs don’t alert GPs of their interest to sell until they have located a willing buyer, many secondary fund managers note.

PrivateTrade has not yet heard of a GP who is reluctant to let an interest be transferred, once the GP knows the buyer is qualified, Powers Dunlap says she believes most GPs will be willing to accept a quality buyer who preserves the partnership’s tax status. “We have more than one law firm saying that GPs cannot unreasonably withhold an LP’s right to sell,” adds NYPPe’s Allen.

However, some GPs maintain that they can block a secondary sale. “There are few partnership agreements where LP interests are freely transferable. There is some level of approval most times,” notes Jay Rand, a partner at law firm Morrison & Foerster LLP.

Despite the legal difference of opinion between GPs and the nascent exchanges, the question is ultimately a business decision, says Powers Dunlap. “If an LP needs to sell, a GP can stonewall him, creating ill-will and being left with an investor who won’t grow with the fund, so at the end of the day most will be willing to take a quality buyer who preserves their tax status,” she says. Rand agrees. “Suing an LP who refuses to fund their commitment takes time and cost money…and it is unrealistic to expect to see cash anytime soon, so firms would probably be best served to approve transactions in this case,” he adds.

According to some GPs the whole debate is moot, since there is not much of a need for a formal partnership exchange. “There is a good market for this already. Four telephone calls can get you there,” says John Baker, founder of Baker Capital Corp. “We can get an LP who wants to sell their interest in our fund independent bids from three to six different groups.” While noting that there are some GPs who may be able to help LPs sell their partnership interests, both Private Trade and NYPPe say their exchanges actually aid the large group of GPs. A group that would rather not expend effort trying to locate a buyer for an LP looking to sell an interest, they say.

While the exchanges may boast about the number of potential marketplace members or users they have identified, many of those people probably have never purchased a secondary before, a number of secondary buyers say. The current group of secondary funds in the market has already demonstrated their ability to execute transactions successfully. This means major institutional LPs looking to sell large chunks of partnership interests already know who the buyers are that can do these deals, says Jerold Newman, president of secondary player Willowridge Inc.. However, Newman, too, says he will keep his eye on the exchanges and use them, if they have the right kind of deals for Willowridge.

However, the fact that a relatively small number of buyers are active in this market speaks to the concern the exchanges are trying to address: whether the sellers are getting a fair value for their limited partner interests.

But in any event, the possibility of success for a secondary exchange rests with deal flow.

If the exchanges can get attractive investment opportunities, they will survive because major secondary players will use the exchanges to get access to these deals. If the exchanges do not get deals or do not get the kind of deals investors find interesting, their future appears less certain.

At the moment, many secondary players believe the exchanges will have the most appeal for individuals who may not know who the big secondary players are. “The sellers are likely going to be small deals from high-net-worth-individuals or family offices,” says Anthony Roscigno, a general partner at Landmark Partners Inc.

While large numbers of individuals who recently invested in VC are now looking to get out of the asset class, the total value of the positions “are not very attractive to the majority of established secondary funds who look to buy whole portfolios, says Nick Harris, another general partner at Lexington. “They are not a big factor in the secondary business.”