Big deals, little deals

The secondaries sector has evolved from a cottage industry with a small circle of players and relatively modest-sized funds to a market with billion-dollar funds and a swarm of new entrants jockeying for position.

The various players are driven by different motivations. The established specialists wielding often gargantuan funds are interested in buying up often large portfolios of private equity partnerships from large institutions. They like mature portfolios with interests in scores of underlying portfolio companies. This strategy allows established players to acquire ownership of the underlying assets at a discount and at a stage where a more accurate estimation of return can be taken.

The newer players – funds of funds, pensions, endowments – are interested less in buying discounted assets than they are in establishing or expanding relationships with favoured GPs. For them, the glut of immature partnerships for sale is an opportunity to make capital commitments to good private equity groups while avoiding the two to three years of deal stalemate that marks most recent vintages.

?What we're seeing is a bifurcation in the secondaries marketplace,? says a fund of funds manager.

The presence of both veterans and newcomers in today's secondary market has created new opportunities for sellers, but added complexity to an already complex process. Market observers disagree on the extent to which the two types of buyers step on each others toes.

Whatever the motivations of its many participants, the secondary market has clearly emerged in recent years as a major component of the private equity market, as evidenced by the commitments secured by dedicated pools of ca ital. Last October, UK-based secondaries veteran Coller Capital closed Coller International Partners IV on $2.6bn, making it the largest global secondaries fund ever raised.

Other dedicated participants include Goldman Sachs, which closed its second fund, Goldman Sachs Vintage II, on $1bn in August 2001 – more than double the $435m the firm raised for its first fund in 1998 – and Lexington Partners, which closed its fifth fund, Lexington Capital Partners V, on $2bn in July. Credit Suisse First Boston's secondary unit has more than $800m in committed capital, while New York's Pomona Capital closed its fifth fund on $582m last December. A smaller, also highly regarded firm is Greenpark Capital, which earlier this year closed a $200m secondaries fund aimed at providing liquidity to fund investors mainly in Europe.

But secondary investing is no longer the exclusive dominion of entrenched specialists. Amidst the dedicated houses listed above are numerous other market participants. International fund of funds managers HarbourVest Partners and Pantheon Ventures for instance, whose core competency is primary fund investment, have long ranked among the market's most active acquirers of secondary positions. Both houses trace their first involvement with this type of transaction back to the 1980s. ?There is a synergistic relationship between our primary and secondary investment strategies?, says Elly Livingstone, London-based head of European secondary investment at Pantheon Ventures. ?Both parts of the business benefit from the other's relationships, market knowledge and access to information.?

It's a view that makes sense to most fund of funds proprietors. Indeed, ask any fund of funds manager today whether he or she is interested in secondary deals, and you'll probably hear a resounding ?yes!? Most funds of funds will be looking to invest in secondaries at least on an opportunistic basis, and some are currently raising capital for dedicated secondary funds, such as Partners Group in Zug, Switzerland and, not for the first time, Fondinvest Capital, which is part of Paris-based CDC Ixis Private Equity.

Many funds of funds, in fact, have been aided in their fundraising efforts for primary vehicles by promising to allocate a certain amount of capital and time to secondaries – an area viewed by many investors as representing the best opportunity in today's private equity market.

New kid on the block
One of the newer, smaller players is TD Capital Private Equity Investors, the private equity fund of funds arm of Canada's TD Bank Financial Group. The firm closed its TD Capital Private Equity Investors fund of funds on $350m last December. The fund, which is slightly more than halfway invested, was raised with a specific allocation to secondaries investment of 20 per cent.

Stuart Waugh, a managing director at TD Capital, says his group's strategy should not be confused with those of the titans of the secondary market. ?The traditional players tend to look for more mature portfolios, ones that are 70 per cent to 80 per cent invested, and treat them as stand-alone investments,? Waugh says. ?We would distinguish ourselves pretty dramatically from that. First, we're looking at younger funds, typically 20 per cent to 50 per cent drawn. Secondly, we're looking to secondaries not only as a means to earn our investors an attractive return, but equally importantly, as a way to access core general partners or fund sponsors who we want to be with for the long term but who aren't currently in the market.?

Waugh says his firm and others are looking for opportunities in the secondaries market because they offer both a shortened and more secure investment cycle: ?You're accelerating your own investment pace, because you're getting exposure to more mature underlying portfolios. By buying in at a later stage in the J-curve, you are able to provide some upside to your investors. It also gives you a free look at 20 percent to 30 per cent of the portfolio, because that's typically the extent to which these funds have been drawn. You're able to see to what extent the declared investment strategy has actually been implemented in the fund over that portion of the investment cycle.?

For newcomers to the secondary market, a commitment to an underinvested, vintage-2000 fund is equal to, or better than, a commitment to a vintage 2003 fund. Says Waugh: ?If you're comfortable making a primary investment, as we are, on the basis of due diligence of a management team, an investment strategy, and the prior track record, then being able to augment that traditional primary due diligence with evaluation of an existing portfolio has to make you even more comfortable with the merits of the investment decision.?

The big guys
Non-traditional buyers like TD Capital are responding to a surge of selling activity from all kinds of investors, many of whom are looking to unload just one or two partnership interests.

Ultimately, though, these small or one-off deals don't meet the mandate for the traditional secondary buyers (although most of them say they will still look at them), and as a result most of them have not bid aggressively in this category. Instead, the established players continue to have an edge in the large portfolio lift-out deals.

?Much of what we do tends to be proprietary, negotiated transactions, but when we see competitors and we're bidding on large portfolios, there are a handful of players we run into,? J. Christopher Kojima, a managing director at the Private Equity Group at Goldman Sachs, says. ?We don't see as many of the newcomers. Many of the new players are smaller in size, so when we're talking about portfolio assets in the multiple hundreds of millions of dollars range, there's a limit as to the number of potential buyers who could make a stand-alone acquisition without partnering.?

Frank Morgan, who heads London-headquartered Coller Capital's newly launched New York office, also says his firm does not typically go head-to-head with the non-traditional players in the secondaries market. ?They may well seek to compete in assets we're looking at, but historically that hasn't been our primary competition, and where it has happened it generally has been in cases where in our prior funds we have brought in co-investors to help with a larger purchase.?

?Some of the newer entrants don't have the level of capital that we and other established players have,? Morgan adds. ?That sometimes is an issue for the seller in circumstances where they want certainty of closure and not to worry about assembling some syndicate of unrelated parties in an attempt to close a transaction.?

Indeed, few institutions have the resources to challenge the handful of players that focus on large deals. ?This is a hard business to do well,? Geoffrey Clark, a managing director at the Private Equity Group at Goldman Sachs, says. ?We're finding a lot of institutions or firms are putting up a flag and trying to get into the secondary sector, but by and large we don't see many of them. My guess is the established players tend to see the predominant portion of the sourcing opportunities.?

Doctors and dentists
Some of the non-traditional secondary market participants say they are more than happy to patrol the small deal market, where they feel better value is to be found. A partner at a major US fund of funds firm, which invests in secondary deals opportunistically, says the end of the market overlooked by the big players is the better place to be. He says the larger firms are constrained by the sheer size of deal they must stick to. ?All the big players are awash in capital,? the fund of funds partner says. ?I actually think the more interesting area is finding smaller managers going after the ?widows and orphans? market? – smaller partnership interests that current owners are wanting to sell.

The same fund of funds professional says he sometimes calls the small end of the secondary world the ?doctors and dentists? market, a reference to the many high net worth individuals who are looking to unburden themselves of private equity and venture capital commitments made during the market bubble. ?A lot of these people don't understand what they're selling,? he says. ?It's a million-dollar piece of something. They have no fiduciary duty and so they just want to sell. These smaller deals are well under the radar screens of the big guys.?

While smaller secondary players stand a good chance of discovering great, under-the-radar-screen deals, the fund of funds partner admits that the size and history of the established secondary firms gives them an edge in the realm of proprietary data. ?They have a competitive advantage with information,? he says. ?Many of these firms have huge databases that allow them to look at the prices of, say, 300 funds. They have an instant ability to plug in numbers and come up with what discount they can apply.?

Coller Capital's Morgan agrees. He says his firm and other established secondaries specialists will continue to dominate the market because of the economies of scale they are able to wield. ?We have amassed a great deal of data and analysis of a large number of funds in which we have invested or reviewed for possible investment,? Morgan says. ?That gives us a tremendous advantage in being able to respond quickly and to price appropriately pools of assets that come to market. For that reason, I think a number of these transactions where non-traditional secondaries players have participated, they have elected to do it on a co-investment basis with a dedicated secondaries player.?

Mosaics take shape
While veterans and newcomers say they don't see each other very often, some market insiders say this segregation is eroding. Colin McGrady, a managing director at Dallas based secondaries advisor Cogent Partners, says the newer players are beginning to win deals that until recently would have been the domain of the established firms. ?Increasingly, we're seeing migration, where non-specialists are going up against specialists in auction situations.?

Lawrence Penn, a director at secondaries advisor Camelot Group in New York also says he sees newer secondary players and established ones interact, but usually only on small transactions. ?A small guy who really wants to get into a good partnership may well have to fight a big established firm for it?, he says.

Penn adds that while every smart buyer sets a limit on price, he has seen newer market participants be more aggressive on what they were willing to pay.

The presence of non-traditional buyers can sometimes have the effect of breaking up a portfolio – the kind of situation a large firm likes. For example, a lone pension determined to buy a particular partnership interest out of a broader portfolio may be able to pay more for two reasons. First, the pension is eager to establish a relationship with the GP and willing to take on blind pool risk. Second, the pension, free of management fees and carry inherent in a secondary fund, has a lower cost of capital.

If enough motivated non-specialists circle a portfolio, the seller may be tempted to consider a ?mosaic? auction. ?Oftentimes, we'll compare the bids for entire portfolios against bids where you break up the portfolio and sell it to different groups,? says McGrady. ?Many times we've seen instances where the mosaic comes in at a substantially higher price.?

McGrady adds that mosaic bids carry with them much greater transaction risk: any single buyer backing out can imperil the deal. ?There will always be a role for dedicated secondary buyers,? he says. ?In those situations where discretion and speed of execution are important, negotiating with a traditional buyer may be appropriate, given the assets are fairly valued.?

Big secondary shops, specialising as they do in diversified collections of fund interests, are also better able to provide creative, complex paths to liquidity for motivated sellers. ?The financial institutions, pension funds, endowments, foundations are far more sophisticated today than they were when we were in this business five or seven years ago,? Goldman Sachs' Clark says. ?What they're looking for today are highly structured transactions, profit shares and other ways to slice the pie. That is driven by the fact many of these assets are not worth as much as the net asset value, or the book value, suggests. So structuring has to be brought in to mitigate the loss implication for liquidating a portfolio today.?

?The right of first refusal and finding solutions for this and related issues in transferring portfolios of direct investments is particularly challenging, and that's an area where the sellers we've worked with have been particularly sophisticated,? Kojima says.

Part-time job?
While deal flow is especially strong at the more chaotic, smaller end of the secondary market, limited partners should make sure that their fund of funds managers are enthused about secondaries for the right reasons. One consultant warns investors to be wary of funds of funds that have an allocation to both primary and secondary investments but get paid better for secondary investing. This can lead to a situation where a great deal of energy is focused on what is supposed to be a small component of a fund of funds' strategy. Some funds of funds, for example, will charge no carry on primary fund investments, but will charge carry on secondary and co-investments.

?In theory, [secondaries are] supposed to be their part-time job,? the consultant says. ?I would be worried if I were an investor in a fund of funds that started doing too many secondaries. If you were a GP at a fund of funds that got 15 per cent carry on secondaries, what would you go after??

Some of the established rules in the secondaries market have yet to be broken. Secondaries investors at the partnership level are still generalists; no player has yet emerged with a specific sector or geographic focus.

But the classic distinction between primary and secondary fund investment specialists, although the two types rely on difference skill sets, is certainly much less meaningful today than it was in the past. Funds of funds are nursing their secondaries capabilities, while a number of dedicated secondary houses such as Paul Capital and Pomona are building primary franchises, and others may follow suit. Marleen Groen, founder and CEO of Greenpark Capital in London, notes: ?There is a lot of movement in the market. Entities with a primary investment strategy are looking at secondary plays, and vice versa.? As a result, the boundaries between the two categories are becoming increasingly blurred.

However, this is a gradual process, and it is too early to tell exactly how it will play itself out. For now, it seems, participants in the secondary market are ready for almost anything, and all agree that this untamed market is exactly the way they like it.