Bullish buyers, shy sellers

?The only thing worth talking about in private equity at the moment is secondaries.? This statement, coming from a US placement agent, perhaps only mildly exaggerates a view shared by many in the private equity market about the prospects for buying and selling of limited partner interests in private equity funds ahead of their reaching maturity.

At a time when many investors perceive primary private equity and venture capital funds as coming with a significant health warning, or even shun them altogether, a quick glance at some of the secondaries managers who are currently raising money confirms that their product is indeed a hot topic. Among the most established players looking for capital is New York-based Lexington Partners with a $2.5bn proposition, while Landmark Partners is raising a $750m fund. Coller Capital in London, advised by placement agent Credit Suisse First Boston, is at an advanced stage with its fourth fund, which observers believe is headed for a final close at a number significantly north of its original $1bn target.

Elsewhere in Europe, Paris-based fund of funds manager Fondinvest has launched its third secondary fund aiming to raise at least €250m. Pomona Capital is looking for $450m for its fifth fund, which is being placed by Merrill Lynch, and Greenpark Capital in London, advised by placement boutique Denning, is expecting to close its $200m debut fund within the coming months. Earlier this year, Paul Capital Partners announced a joint venture with Axa Private Equity that has $1.3bn to invest in secondary private equity interests. The majority of firms raising money are now pitching for significantly larger amounts than they had raised for their previous funds.

These names are attracting significant interest from a buyside alive to the opportunity embedded in other investors' adversity, and driven by a desire to more actively manage their private equity allocation.

In addition to the specialists, diversified private equity houses such as The Carlyle Group, which is raising a $500m secondary fund, are increasingly keen on participating in the market. Investment banks such as Deutsche Bank, CSFB and Thomas Weisel Partners are also marketing relevant product.

Why secondaries, why now?
There are in fact several features accounting for the attractiveness of secondaries funds to the buyside. One is that secondaries transactions offer LPs access to mature, well-diversified and often high quality portfolios of private equity fund investments. This means that capital deployed in a secondary fund will not be tied up for up to a decade and secondly, and better still, there's some valuable track record to indicate what a general partner has achieved and what therefore can be reasonably expected of it going forward. In the past capital has therefore come back quickly and returns have been high, averaging between 28 and 30 per cent per annum according to estimates.

At this point, however, the market, whose origins date back to the early 1990s, remains relatively small, highly inefficient and deeply opaque. As a result, it is difficult to establish how much capital secondary partnerships have invested to date. Estimates for 2001 for example range from $1.5bn to $2.5bn. That year, according to London-based house Campbell Lutyens, which is increasingly focusing on secondaries advisory work, saw some $3.5bn of new capital being raised by specialist funds. In addition, several primary fund of funds such as Adams Street Partners, Hamilton Lane, LGT Capital Partners, Pantheon Ventures and Harbourvest Partners have on average allocated around 10 per cent of their capital to secondaries as well, and captives such as BancBoston and Goldman Sachs have also been visible as buyers of others' private equity assets in recent years.

What is beyond doubt is the fact that the market is growing, which in itself is hardly surprising. Investors are increasingly aware that private equity's notorious lack of liquidity is becoming less of a law of nature. Practitioners also point out that secondary expansion is a function of growth in the primary market. As allocations to primary funds increase, so does the trading of limited partner interests in general partnerships. ?In recent years, primary private equity investment has predated secondaries activity by about five years, and up to three per cent of each year's commitments to general partnerships has typically been recycled in the secondaries market five years down the road,? says Marshall Parke at Lexington, the largest dedicated buyer with $6bn under management.

A much debated question facing the industry at this stage is to what extent and how quickly the three per cent ratio is going to increase. Some $220bn of primary capital was raised in 2001, so plugging 3 per cent into the formula would yield the prediction that in 2006 just under $7bn worth of transactions will be completed in the secondaries market. Says Parke: ?Using historical turnover rates, we anticipate a market of approximately $18bn in commitments changing hands over the 2002-2006 time period.?

?Secondaries investing is like shooting fish in a barrel at the moment?

Will this be sufficient to absorb the amount of capital that is likely to be available for secondaries then? Some believe that transaction volumes will grow faster, with forecasts at the top end predicting a target figure of $20bn per year by 2005. Given that in 2000, at the peak of the private equity boom, some $220bn of primary capital was raised, this would imply nearly 10 per cent of year 2000 commitments being transacted in the secondary markets in 2005. Geoff Clark, a managing director at the private equity group at Goldman Sachs, says annual turnover of general partnership interests could indeed rise to a 10 per cent plus level in a few years time. Parke agrees that growth could accelerate: ?An extended period of higher turnover rates, such as we have seen in the secondary market recently, could result in higher volumes coming to market, but this is just speculation at this point.?

Investors in private equity are taking a considered view on what lies ahead. Some limited partners are sceptical about the amount of money flowing into dedicated funds at present, and are beginning to wonder whether the recent increase in capital supply and greater competition for purchasable assets are a threat to the future investment performance of secondary buyers. ?There is a perception now that too much money is being raised,? says a head of investor relations at a secondary specialist who is currently involved in fundraising. ?Three months ago, institutions were telling us that they had no money for new private equity allocations, but that they'd definitely put some money into secondaries. Now some are saying they're beginning to have some reservations about secondaries as well.?

Colin McGrady, a co-founder of Dallas-based sellside advisor Cogent Partners, also believes that more competition will put pressure on buyers to maintain historical performance levels. ?The large pool of capital of the secondaries market today will inevitably eat into the profitability of dedicated funds who will have to bid aggressively for assets in the market.?

Unsurprisingly, the dedicated buyers themselves are much more optimistic, pointing to what they describe as a very I benign business environment that is driving fundraising activity more than anything at this point. Timothy Jones at Coller Capital says there are excellent prospects for those with capital and know-how: ?Asset prices are heading one way, and this presents a great business opportunity at the moment. Deal flow is so strong that for buyers the most crucial thing right now is to stay disciplined. There is no rush to close deals.?

?The biggest headache for a buyer is to come up with a price that turns the vendor off?

Clark, who runs Goldman's Secondaries and Structured Private Equity business, agrees that the deal flow is impressive: ?Our back log of potential transactions has tripled over the past six months.? Meanwhile Laurence Allen at the New York Private Placement Network (NYPPE), another group offering advice to liquidity-seeking investors in restricted securities, puts it more emphatically: ?Given the number of motivated sellers out there, secondaries investing is like shooting fish in a barrel at the moment. We have no concerns at all about return on investment in the mid-term.?

The advent of intermediation
What practically everyone in the market place agrees on is where the deals are actually coming from. Active portfolio management is the phrase of the moment that holds out the promise of a sharp increase in secondary activity, whereas distressed selling is not seen as giving the market much to work on at all. In other words the secondaries end of the market, unlike its primary counterpart, is still seen as a seller's market.

Which explains why, despite the widespread excitement among buyers, deals are still closing at a relatively slow pace. The main obstacle, say buyers, to achieving a greater completion rate more quickly continues to be vendor's over-inflated expectations on price, which are fuelled by artificially high NAVs and lagging reductions in book values at the general partner level. And although the gap between public and private valuation is currently closing, pricing private assets remains a very big issue.

Lacking familiarity with the process can also keep sellers from going through with a transaction. Fear of selling at an exaggerated discount and the embarrassment that comes with it is widespread. ?The buyers typically understand the value of what they are buying better than the sellers,? notes Andrew Sealey at Campbell Lutyens.

The growing number of active intermediaries, in itself a sign that the secondaries market is maturing, is greeted by the buyers with mixed feelings. On the one hand, competent advice and representation means sellers are more likely to enter a sales process and go through with their decision to sell an asset at a reduced price. This last point is important, because, according to Francois

Attal at H2 Advisors in New York, who represents potential sellers of private equity interests in secondary transactions, ?there have been a lot of false sellers who did not realise how inefficient the secondary market can be and how significantly an astute buyer looking for arbitrage can discount.?

For vendors to get cold feet half way through a negotiation can cause immense frustration among buyers. ?The biggest headache for a buyer is to be asked to look at an asset, do the due diligence and come up with a price that prompts shock and turns the vendor off,? says McGrady at Cogent. If intermediation can help reduce the likelihood of a seller aborting, then buyers stand to benefit.

The downside is that intermediation, aiming to maximise vendor returns, can narrow the arbitrage potential for the purchaser and lower the discount at which an asset is ultimately bought – which obviously limits the popularity of intermediaries. ?Buyers do not always welcome seller representation; what they want is to keep the level of transparency in the market at a minimum. However, they would probably concede that buyer representation increases the chances of a deal being completed,? says Sealey.

Part of what secondaries managers dislike about representation is the prospect of the number of potential buyers to grow further. Attal at H2 Advisors says the firm is getting calls from a potential new buyer every two to three weeks. And McGrady believes that the limited partners themselves are going play a more important role as potential purchasers of private equity assets going forward. ?LPs will go from making allocations to dedicated secondary funds via co-investing to ultimately trading private equity interests directly. We've counted some 300 institutions globally with a documented interest in buying limited partner positions directly.?

Specialist buyers unsurprisingly dismiss the idea of a possible rerun in secondaries of what happened in primary private equity in the 1980s when institutions began turning their initially funds of funds based exposure to the asset class into large direct investment programmes. Occasional one-off transactions notwithstanding, they question whether limited partners will have the stomach and the resources to deal with the complexities of secondaries trading.

Where limited partners are least likely to compete with dedicated secondary operators is in the market for large transactions where assets worth more than $100m are traded. This is going to remain the domain of the small group of well-capitalised specialists and captive funds that have effectively formed an oligopoly and divided the deal flow among them.

How much business this group is going to be able to do in this $100m+ segment is difficult to predict. The most likely types of vendor to be offering large portfolios are insurance companies that are watching their solvency ratios, and banks keen to make sure they comply with the capital requirements stipulated by Basle II. M&A activity in financial services is also a potential stimulant of assets coming to market.

Among the banks that the market counts among possible sellers of very large positions are BancBoston, which has announced plans to significantly reduce exposure to private equity, Deutsche Bank, Dresdner Kleinwort Wasserstein, JP Morgan Chase, First Union and Abbey National, which is thought to have already received several enquiries regarding its private equity portfolio.

?There is a perception now that too much money is being raised?

Pension funds ; struggling to tion mix back in line after the public market downturn are also expected to remain an important source of deals, although much of what they will be looking to sell could be smaller positions. The volume of assets that pension funds will ultimately sell to address allocation issues is going to depend in part on what is going to happen to public market valuations going forward. ?If public markets recover and equity valuations go up, the pressure on allocations could reduce. But for the foreseeable future this contributes significantly to the volume of deals we are seeing in the secondaries market,? says Marleen Groen at Greenpark Capital.

More sophisticated secondary structures
The institutions that are rumoured to be mulling potential billion dollar plus transactions at the moment are holding enough assets to satisfy the appetite of even the largest dedicated buyers almost single-handedly. To get them, as well as the smaller vendors to the table to start negotiating in earnest, however, buyers are acutely aware that they will have to be able to structure transactions increasingly creatively and in ways which allow the vendors to meet their objectives. Their confidence in the market's potential notwithstanding, most practitioners accept that the days of the straightforward, exclusively negotiated sale at a steep discount are over.

Increasingly sellers are asking for more sophisticated solutions to their specific requirements. Keen on retaining part of an investment's potential upside, they often expect the counter parties they are dealing with to be able to structure swaps and carve-outs, work an earn-out element into the transaction or offer some kind of profit share.

At the same time there are new kinds of investment opportunities arising, and a number of firms have already demonstrated that there is more to secondaries than dealing in limited partner interests. Several sources interviewed for this article referenced Coller Capital's acquisition of Lucent's venture portfolio as a showcase transaction that is likely to be replicated going forward.

A similar pioneering transaction that closed earlier this year was the $110m acquisition of the private equity portfolio of Wachovia by newly-established private equity manager Peachtree Equity Partners, in a deal funded by Goldman's $1.1bn Vintage II Fund.

Clark at Goldman believes that this kind of synthetic secondaries transaction will be an important aspect of their investment approach going forward. ?The acquisition of a portfolio of direct company investments, whether with or without management teams, is difficult to execute and requires deep due diligence.

?LPs will go from making allocations to dedicated secondary funds via co-investing to ultimately trading private equity interests directly?

Synthetic secondaries can be considered for corporate venturing programmes and bank holdings, and can be a catalyst for private equity market consolidation over time by facilitating earlier liquidity for general partners,? says Clark.

The ability to innovate and meet the market's requirements as it matures will be critical for buyers to consolidate their positions in an increasingly competitive environment. Many seem to be embracing the task with enthusiasm, even though most appear to have little time for the idea of applying securitisation techniques to the private equity process as a further liquidity alternative. Some regard this as complacent though: ?Private equity securitisation may be at an early stage of its development, but I think secondaries investors are missing a major bend in the road if they ignore it,? says Allen at NYPPe.

The coming years will clarify to what extent CDO technicians, limited partners and other non-traditional buyers can indeed challenge the pre-eminence of dedicated secondary buyers as providers of liquidity. At present, the capital they have to deploy, the reach many now have into the LP community and the inevitable lag between the innovative and the commonplace gives the secondary story a very comfortable lead. Is this likely to change? Yes. When? Watch this space.