Though the stock market has been on the rise of late, most investors in venture capital aren’t expecting their fortunes to change anytime soon. The killer combination of a Scrooge-like IPO market and the lack of corporate buyers has closed the exit doors for most venture funds, leaving them with little or no opportunity to improve returns anytime soon.
Against that backdrop, a growing number of banks and corporations have decided they no longer want to be in the venture capital business. High-net-worth individuals-jokingly referred to as “the former high-net-worths”-are also getting out, often having to conduct lightning-quick sales in order to avoid capital calls.
The result has been a surge in secondary fund raising over the past 18 months, as well as a surge in deal flow that market pros expect to continue for the next couple years. Columbia Strategy LLC, which tracks the secondary market, is projecting $10 billion to $13 billion worth of limited partnership and direct portfolio transactions by the end of 2003-that’s more volume than the last three years combined.
“Clearly some large portfolios have [already been sold], but there is going to be a deluge of financial sellers” over the next several months, says Scott Myers, managing director with Cogent Partners, an investment bank focused on secondaries. “There are tens of billions of dollars left to be washed out of the system.”
With so much money invested during the boom years of 1999 and 2000, it’s not surprising to see more capital changing hands in the secondary market. During those two years alone, investors poured $161 billion of venture capital into U.S. private companies, according to PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association.
But mathematics aren’t the only factor at work here. Anthony Romanello, director of investor services for Venture Economics, points to the increased pressure on corporate earnings as well as new bank regulations from the Federal Reserve that increased the threshold for capital set-asides from 8% to upwards of 25% of a bank’s private equity portfolio market value. “There are really twin pressures-one is from the Wall Street analysts and the second comes from the new regulations that require banks to set aside more capital to cover losses because of the risk,” he says. “Banks would rather be deploying their capital in fee-generating businesses than have their money tied up in set-aside limbo to cover potential private equity losses.”
Meanwhile, though they don’t get as much attention, there are still plenty of high-net-worth individuals looking to sell. “What really drives their interest in selling is when they get the next capital call notice,” says Cliff Meijer, a principal with Thomas Weisel Global Growth Partners, a $115 million secondary fund. “That’s usually the alarm that goes off.”
Exit En Masse
In March, DB Capital Partners, the venture arm of Deutsche Bank, made secondaries a household term when it sold its private equity portfolio of 80 companies to seven buyers from five countries for $1.6 billion, making it the single largest secondary deal ever done in the private equity market.
But the DB Capital transaction is no lone ranger, nor is it the last of the Mohicans. Van Wagoner Capital ($130 million last September) and Accenture ($138 million last August) have done sizable transactions, and sources say Fleet Bank is expected to be the next big seller in the secondaries market. “We see movement from Fleet Bank,” said one secondaries pro. “They inherited a big portfolio from BancBoston and they already had their own. The bank has really scaled back on staff and a lot of people suspect they are going to sell it off.” (Fleet could not be contacted by press time.)
Jeremy Coller, founder and chief investment officer for London-based Coller Capital, which closed a $2.5 billion secondary fund last November, suspects several more corporate and bank private equity portfolios will be sold soon, including assets from Intel and IBM. “There are plenty of portfolios left that are going to be offered,” he says. (Intel and IBM could not be contacted by press time.)
Coller would know. In late 2001, Lucent sold 80% of Bell Labs’ venture capital portfolio to Coller Capital for $100 million. Then a little less than a month later one of the portfolio companies, Celiant, a wireless amplifier maker, was sold to telecom equipment company Andrew Corp. for $470 million. Although Coller chalked the transaction up to pure luck, the firm yielded almost twice its initial investment and gave it enough confidence to try its odds again. Just recently it bought 77% of British Telecom’s venture incubator for about $100 million.
Not surprisingly, the biggest reason for corporations exiting the market has to do with the low returns they’ve endured for the last two years. Since returns aren’t expected to improve much anytime soon, there’s little reason to hold on to the portfolio and watch it continue to drain earnings. “For corporations, they’re now just an administrative hassle,” says Thomas Weisel’s Meijer.
In many cases, when corporate sellers finally pull the trigger, they’re happy to let the public know. When EDS sold its portfolio of 16 companies last April, the company took the historically unusual step of issuing a press release.
Fund Raising Vaults
With so many assets up for sale, the number of buyers has increased to meet the demand. In raising its $2.5 billion fund, Coller easily surpassed the initial $1 billion target, thus dwarfing all other global secondary funds. (Coller counts influential investors like CalPERS, the State of Michigan, General Motors and Barings among its limited partners.) Harbourvest Partners has raised a $1 billion fund, while Goldman Sachs is raising its second secondary fund, GS Vintage Fund II, and already has $1.2 billion. Credit Suisse First Boston, which raised an $832 million fund in 2001, is said to be fundraising again. In 1992 only $127 million was raised for secondary funds, according to Venture Economics.)
One reason for the enormity of these funds is the mammoth size of many direct portfolio sales. “It’s our belief that you will continue to see large transactions,” says Tom Bradley, a partner with Pomona Capital, which closed a $580 million secondary fund in December. “There are a lot of transactions in the secondary market that are never reported on, so the opportunity is greater than one thinks. Secondaries are even buying secondary direct portfolios, which means buying a basket of investments from corporations that are looking for liquidity. The opportunities are there.”
But even with those opportunities, some believe there’s too much capital on the buyside. “Once the excess from the bubble is worked out of the system, the supply will begin to shrink,” says Timothy Brody, a manager with Willowridge. “How many banks are still out there that have to sell their portfolios?”
The same concern is raised about corporate sellers. “Corporate VC is not going to completely go away, but there is going to be a smaller universe [of corporations] that will continue to make investments,” says Meijer. “There will be a bit of cyclicality to their involvement.”
Pension Funds the Key
Since the future participation of corporations is so cyclical, and since the Fed’s regulations make future bank involvement less likely, market pros say it’s the rest of the market-specifically, pension funds, foundations and endowments-who will give the market staying power.
Historically, these investors haven’t been active sellers, but that’s starting to change. According to Cogent’s Myers, five of the biggest foundations and endowments in private equity have already done secondary sales-including a few mammoth transactions-and three of the other five are strongly considering it. “Three deals we’ve represented have been on the order of $200 million to $400 million,” he says. “In each case [the investors] were recycling the capital into new relationships.”
But others argue that the public pension funds, in particular, can’t be counted on for significant participation, in part because of the political hurdles (i.e., getting their board’s approval) and, at least in some cases, because of the fear of selling at the wrong time. “A secondaries sale would require all kinds of political capital,” says Jerrold Newman, president of Willowridge Inc., a New York-based secondaries firm that manages $100 million. “It takes a lot of signatures…and the willingness to risk that they sold just before the market took off.'”
Moreover, Newman says, a pension fund can achieve the same type of impact by reducing its forward commitment. “If someone is an investor in the asset class year in and year out, the easiest way to get into balance is by reducing forward commitments and not reinvesting distributions,” he says. “Instead of committing $50 million, they commit $25 million.”
The most likely time for a pension fund to sell, Meijer says, is after an asset allocation review. “One scenario that has best chance is after an asset allocation review if the consultant recommends a PE allocation below the existing level,” incorporating unfunded commitments,” he says. “That’s the only way we’ll see a lot of product [from public pensions].”
Ultimately, the pension fund community’s future in secondary sales-and the future of the secondaries market as a whole-will be determined by how many investors use it as a portfolio management tool, and not just a way to unload when the market goes south.
“Institutional investors are looking at private equity differently,” says Cogent’s Myers. “It’s not a buy and hold forever’ trade anymore… and they’re more willing to move capital around.”
And while not everyone shares Myers’ optimistic view, no one disputes the notion that increased deal activity and fund raising have made secondaries a vibrant and viable segment of the private equity market.
“When I applied for a job here in 1999, I searched for secondary funds on Google, and only two or three entries came up. Now if you do a search tons come up,” says Willowridge’s Brody. “In the 1990s, this was a sleepy little market, but now there is competition.” (Brody isn’t exaggerating about Google: As of mid-June a search on the phrase secondary funds’ yielded over 1.5 million results.)
But to sustain that momentum, some believe the market needs more standardization. Prices are all over the map, and the level of transparency into general partner funds prior to a sale also varies. “We would like to see a more formal and systematic mechanism for the exchange of secondary LP and direct holdings…as well as improved methodologies for the strategic assessment, portfolio segmentation and valuation of these assets for sale,” says Dr. Peter Holden, a partner with Columbia Strategy.
Secondary buyers counter that view, arguing that those inefficiencies are what makes the business profitable. That helps to explain why the most players in this space don’t support an exchange. However, some of those same naysayers concede that an exchange could work for the smallest transactions, which typically come from high-net-worths.