Exchange Idea Still Fighting Uphill Battle –

Sounds like a good idea, in theory: Create a formal exchange for secondary interests that would ultimately make private investments about as liquid as public ones. After all, there are plenty of limited partners out there who want to cash out of the commitments they made back when the financial marketplace was all sunshine and happiness. The buyside is expanding as well, as several private equity firms have either closed or are in the midst of closing secondary funds. Trident Point Capital predicts that the secondary market, worth $10.9 billion globally since 1990, will be valued at $55.6 billion by 2010.

But despite all that, most market pros don’t believe an exchange is going to happen. In addition to regulatory roadblocks that make it difficult to transfer LP interests (these are detailed later in the article), many players in this market, including sellers, would rather keep secondary investing as private as possible. If it’s not broken, they say, it doesn’t need fixing.

“We think about a secondary market exchange all the time – we’ve been in this business since 1995; and we keep wondering, is it going to go the way of the loan sales market?” says Luisa Hunnewell, a member of the investment team of Willowridge Inc., a secondary fund manager in New York. “We just don’t see it. We don’t see a compelling enough advantage for many of the players.”

Others note that it’s inherently problematic to standardize a market where the due diligence required to invest can be unwieldy and, partly due to the nature of private equity investing, produces subjective answers on how to value underlying assets.

“You’re dealing with private companies where there’s not a lot of information on the underlying companies,” says Tim Jones, investment director at Coller Capital in London. “There’s also confidentiality – most sellers want to keep their transactions relatively confidential.”

NYPPe’s Case for an Exchange

Not surprisingly, the New York Private Placement Exchange sees things differently. NYPPe, a Greenwich, Conn.-based private securities specialist with an online and electronic trading platform, wants to provide liquidity to its clients in any way it can. The company has developed a trading network that streamlines the transferring of restricted securities, even giving the private shares ticker symbols. While practically all the online deal matchmaker companies that emerged in 1999 and 2000 have closed because demand wasn’t strong enough, NYPPe has continued to plug along – but not without changing its focus a bit over the last 18 months. Many of the others, including VentureNetwork, Vcapital and StartupStreet.com, wanted to play matchmaker without necessarily taking on any of the due diligence work or securities law issues associated with these transfers. Not so with NYPPe. When the group got up and running in 2001, Chairman and CEO Larry Allen said, “We’re basically stating outright that we want to be an alternative trading network, and then a stock exchange. We’re already utilizing our broker-dealer status to match buyers and sellers, but we think the market needs to have some central organization where broker-dealers, QIBs and accredited individuals can come to trade restricted securities.”

NYPPe lobbied the SEC, purchased its competitor PrivateTrade.com and spent millions of dollars getting its name, or at least its catchy acronym (pronounced nippy) to roll off people’s tongues. On paper, at least, Allen’s goal to make significant money in this space seemed attainable. The company was well funded by Knight Trading Group, and NYPPe had earmarked up to $25 million to build out an Internet-based trading network. The plan was for the company to act as a back office for the transfers of private securities that took place on the network and license its software to parties interested in facilitating such transactions. NYPPe’s revenue would increase as volume on its exchange increased, as any seller of a private security through NYPPe would pay the exchange a fee of between 1% and 4% of the transaction value.

But what a difference a year makes. NYPPe has by no means given up on its exchange idea, but some of the hurdles that seemed like molehills at one time have turned into seemingly insurmountable mountains.

Relationships Over Efficiency?

One fundamental problem with an exchange is that many investors simply aren’t comfortable doing a deal without as much as shaking hands with the person on the other end of the agreement.

“This is absolutely a relationship business,” says one private equity fund manager. “Nothing against this NYPPe, but I want to do these deals myself, with my lawyer right beside me. I’m just not comfortable selling something so important to an unknown.”

To be sure, one can’t expect a general partner to be gung-ho about a formal secondary market exchange. It’s the private and sometimes inefficient nature of these transactions that help GPs augment their bank accounts. Thus, they have no incentive to encourage the establishment of a formal exchange.

That said, there are some conceptually viable reasons for establishing one, particularly for high-net-worth individual LPs who can’t find a buyer as readily as a bank or corporation involved in private equity. “I could see a role for this with high-net-worth individuals,” says Coller’s Jones. “They may not know quite where to go [when they want to sell].”

Adds Willowridge’s Hunnewell: “A lot of the individual sellers who have come into the market in the last 12 to 18 months are looking to sell. And if they’re selling a $400,000 commitment, an exchange might work for them because they’re selling something so small that it knocks out a lot of the secondary players.”

But even an exchange targeted to that one group of investors would mean major changes in the way private equity deals are conducted. “If it were ever actually able to happen, the industry as it is would pretty much have to see a revolutionary transformation,” says a New York-based lawyer.

There would be standards, and not just the kind that say one fund manager shouldn’t stab his former Harvard buddy in the back over a deal. The standards would include a way to value interests, which in turn would most likely get sellers better prices. Next, while relationships are an indispensable part of the private equity business, one wouldn’t have his relationships solely to depend on in a secondary sell of interests – a wider net could be cast. And lastly: liquidity, liquidity, liquidity. It would be at a seller’s fingertips. “Formalizing that trading process wouldn’t be bad in and of itself,” the lawyer adds.

The Rub

Yet with all these positives, and even if buyers and sellers could get comfortable doing business online, one major roadblock remains: legalities.

Andrew McCune, a partner in the private equity practice at Winston & Strawn in Chicago, says if it weren’t for a few securities laws in particular, the establishment of a formal market would be a great thing. “However, the existence of such a market falls arguably within the reach of these statutes, which were probably not intended to necessarily cover it,” he says. “Without clarification that a market structure in certain ways would not be covered in those statutes, this is all still very problematic,” he says.

The statutes in question are the internal revenue code, the Securities Act of 1933 and the Exchange Act of 1934 together, and the Investment Company Act. “All of them would come to bear on a truly liquid market of a truly open exchange,” McCune says.

Obviously, the private equity market, as deep as it is in terms of dollars committed, is all raised on a private basis pursuant to basically exemptions or exceptions under all of the aforementioned statutes. A true public market is designed so that it does not fit within any of those exceptions or exemptions.

“So you would be taking something that in its initiation was structured to be private and switching it to something you want to be public,” adds the New York lawyer. “You can’t just start treating things differently because you want to. The statutes would come into play and no one would be under compliance with what those new requirements would be.”

In a regular private equity acquisition, attention is given to make sure that it is exempt from securities laws. But when it comes to buying secondary interests, sources say talk of a public exchange would mean treating the market something like the mutual fund market, and the bottom line is, private equity funds don’t want to be subject to all the requirements to which mutual funds comply. Time and money would be at stake.

“Right now these statutes are set up such that it makes it problematic for people to trade interests and still allow fund sponsors to run their funds the way they’ve traditionally run them,” says McCune. “You could change the industry to make it a lot more like the mutual fund industry, and you could do all this, but the problem is I don’t think that anyone is ready to make [a private equity fund], in essence, a mutual fund.”

Those Darned Statutes

Taxes and the Internal Revenue Code – Limited partners commit to private equity funds knowing that it is a flow-through vehicle, which is in and of itself not taxable. However, the internal revenue code says a publicly traded security will be taxed, just like stock. So if secondary interests started trading publicly, the private equity fund would become a publicly traded partnership and would be treated as a corporation for federal taxation purposes. For example, if an LP interest represents 50% of a fund and the fund has $100 of income, a secondary buyer would think he’d buy the 50% interest because he thinks he’ll get 50% interest in $100, but he’d be wrong. The problem is, if the interests were publicly traded, that $100 would not flow through tax free anymore, the fund would pay tax as a regular corporation at maybe 35%, and that $100 would become $65.

The Securities Laws: Currently, LP interests are placed with the assistance of placement agents and there’s no registration statement. Moreover, placement agents do not view themselves as underwriters. The LP interest is a security under the securities laws, so a proposed transfer of those interests on an exchange means the fund sponsor would be engaging in a public offering for which the fund would have to file a registration statement, the placement agent would be an underwriter with statutory underwriter liability, and fees would be owed to the SEC. More specifically, if LP interests were tradable on an exchange, the Securities Act of 1933 warrants registration and the 1934 Act would then come into play, demanding completion of 10Qs and 10Ks, just like all other public companies. That takes the private right out of private equity.

“Fund sponsors are somewhat secretive about their portfolio and their performance, and they certainly don’t like to publicize them more than they have to,” McCune says. “But in a public exchange situation, they’d have to file financial statements for other portfolio investments and make them publicly available as well.”

Investment Company Act – Most private equity funds are not required to register as investment companies under the Investment Company Act due to the provisions of 3(c)(1) or 3(c)(7). Mutual funds all have to qualify under the Investment Company Act and be registered, but private equity funds do not, largely based on those two exceptions from the investment company definition. 3(c)(1) says if a fund has fewer than 100 beneficial owners, even if it’s otherwise an investment company, it’s not considered one. And 3(c)(7) says as long as the owners are qualified purchasers, the fund isn’t an investment company either. Thus, if the limited partnership interests of a fund that was organized in reliance on 3c1, as they all are, were freely tradable and an LP counting as one person sold to 10 purchasers, the number of owners could possibly be tripped over 100 beneficial owners by virtue of sale and the fund becomes an investment company and is note registered, so it is in violation of the Investment Company Act, which has principle liability under it. Similarly, if the one investor sold his interests anonymously on an exchange to an unqualified purchaser, the fund again blows its exemption as an unregistered investment company.

McCune says a stock load of limitations could be put on a public market for trading secondary interests, and that would get private equity funds around the investment company act problem. However, setting those provisions would be enough to frustrate a truly public market because they would obviously limit whom the buyers and sellers are.

To date, NYPPe has reportedly closed more than 200 transfers of restricted securities, with an estimated average size of approximately $150,000 per deal.

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