Bypassing the partnership

To most private equity market participants, the term “secondary transaction” means the buying and selling of fund interests. But to a growing number of investors, secondaries also include the transfer of ownership of direct investments in companies, with or without their original GPs.

Direct secondary transactions are expected to continue to lag partnership deals on a volume basis, but the growth of this sub-sector has been significant.

The recent spate of secondary direct transactions is largely a direct result of the erstwhile mania for corporate venture capital activity. “We even saw dedicated journals for corporate venturing in 1999, 2000 and 2001,” says J. Christopher Kojima, a managing director at Goldman Sachs' private equity group. “That was a very high-growth period where we saw technology corporate investors building up venture capital portfolios for arguably strategic reasons. Today, I think many of those investors recognise those portfolios may not be as strategic for their business after all.”

“What you're seeing is a focus on core activities and many corporate venture programs are being shed,” Geoffrey Clark, another Goldman Sachs managing director, says. “Those transactions tend to occur at very significant discounts to the original costs of those portfolios.”

Sellers, desperate for liquidity, are willing to unload on the secondaries market because of the lack of alternatives – the IPO market remains flat and there is only a limited amount of activity among strategic buyers.

Vivendi to VC: ‘Non!’
Many of the investment groups that have purchased portfolios of direct investments do not endeavour to be specialists in this type of transaction. Instead, these buyers view the current secondary direct market as an opportunistic windfall.

One particularly representative recent transaction of this type was completed in July, when Global Asset Capital, a firm based in Menlo Park, California, acquired Viventures Partners, the venture capital arm of Vivendi Universal. Global Asset Capital acquired the 30 companies that remained active in Viventures' portfolio, plus all of the more than $400m the firm has under management. The existing Viventures management team will be incorporated into the new operating structure.

Paris-based Viventures was established in 1998 by Vivendi as an early stage global venture capital firm focused on the information technology and telecommunication sectors. Viventures, which opened a US office in San Mateo, California, in 1998, a Singapore office in 1999, and a London office in October 2001, launched a fund targeted at $400m in the second quarter of 2000 and closed it on $600m in January last year. The fund received €200m, or one-third of its capital, from VivendiNet, the Internet arm of Vivendi Universal.

Once this market dynamic shakes out, you're going to see different leaders at different points of the value chain

In a sadly typical story, adverse market conditions forced Viventures to return a fifth of its fund to its limited partners in June 2002. The firm also more than halved its personnel.

Global Asset Capital, however, saw continued life in Vinventures' investment programme. “There's a notion in this business that a firm in transition is a broken firm,” Riaz Valani, Global Asset Capital's founding general partner, says. “I don't think that's the case.”

Valani acknowledges his firm, an experienced investor in technology-related primary deals, was new to the secondary game. “These deals are custom-made, not off the rack,” he says. “There are a lot of people looking for an opportunity to say goodbye and hand over the keys. I think, in terms of managing the existing portfolio, [Viventures is] commensurate with what we do on a daily basis. It's not a huge leap. In terms of presence in the marketplace, it is certainly a significant step forward; it lends itself to the globalisation of our mandate.”

“Once this market dynamic shakes out, you're going to see different leaders at different points of the value ” Valani adds.

Among traditional secondary buyers, Coller Capital has as much of a pedigree in secondary direct buyouts as can be had, given the market's newness. In February, the firm joined forces with New Venture Partners to acquire British Telecom's in-house venture capital unit Brightstar. Coller conducted the acquisition through New Venture Partners, which the firm established in December 2001 through a $100m management buyout of another captive telecom venture capital arm, Lucent's New Ventures Group incubator.

“I think we are the pioneers with the Lucent transaction in developing this strategy, and the concept is now attracting a lot of attention,” Frank Morgan, who heads Coller's New York office, says.

“Our view is that there will be a number of additional opportunities of this type, particularly in the near term,” Morgan says. “This may be a window of opportunity for corporations who developed in-house venture teams to redeploy their assets and to sell off these interests.”

‘Synthetic’ expertise
Coller Capital notwithstanding, most established secondary players do not dabble in directs. “You see very few groups that are operating in the traditional and the ‘synthetic secondary’ market,” Goldman Sachs' Kojima says, using his preferred term for direct deals. “Those require some unusual skill sets to really approach this business in a principal way.” Not surprisingly, Goldman Sachs is behind at least three separate efforts to buy up portfolios of direct investments.

There's a notion in this business that a firm in transition is a broken firm. I don't think that's the case

One of this new breed of acquisition players emerging to take advantage of direct investment opportunities is New York-based ProtoStar, founded by former First Atlantic Partners managing director Joseph Haviv with the financial backing of Goldman Sachs' secondaries group. ProtoStar is searching for portfolios of direct investments in mature companies no longer wanted by the original general partners.

W Capital Partners, which is currently raising a $150m fund, is seeking to acquire direct investment portfolios from corporate venture capital arms. In March, W Capital, alongside Goldman Sachs, bought out the venture investments of Tredegar Corp. Both W Capital and ProtoStar are affiliated with Goldman Sachs.

In Europe, Vision Capital stands out as being one of the few operators dedicated to direct deals. The firm's CEO, Julian Mash, says he is actively reviewing deals from banks, corporate and private equity sellers, but his firm is particularly focused on what might be termed “seasoned deals” – investments that general partners no longer have the resources to adequately pay attention to or can't prioritise highly because they have larger and more recent funds to look after.

Vision Capital, again backed by Goldman Sachs, recently completed its first such transaction – the acquisition of a portfolio of direct investments from Deutsche Bank-owned Morgan Grenfell Private Equity. The seller had moved on to bigger deals in need of more immediate attention. Mash says he expects the desire of GPs to unload whole portfolios of older deals to become a permanent feature of the private equity market.

“We are aware of several private equity firms in Europe where a majority of the portfolio companies by number represent a minority of the value” of the portfolio, Mash says. “As a GP, you have to weight your focus by the money you are managing. Every day that a private equity firm holds on to these middle-tier performers, after the best ones have been sold, is a day that the IRR of the fund goes down. We solve that and deliver much needed liquidity to institutional limited partners.”

Every day that a private equity firm holds on to middle-tier performers is a day that the IRR of the fund goes down

Mash says his firm views as fresh investments what the seller may see as deals that just didn't work out in the original timeframe. Vision Capital may inject new capital and bring operational expertise to the portfolio companies that the companies may otherwise have not received from their original financial sponsors once the funds closed, or who may have moved on to newer and larger funds.

Temporary opportunities
While Mash views direct secondary portfolio transactions as a permanent, structural aspect of the secondaries market, he believes that the sell-offs taking place at banks and corporations represents more of a temporary phenomenon.

As such, the current field for secondary directs is populated with firms that have never done such a deal before, and may never do so again. The biggest “synthetic” secondary deal to date was the recent €1.5bn buyout of Deutsche Bank's direct investment portfolio, DB Capital Partners, by a group of seemingly unlikely investors including NIB Capital, Ontario Teachers' Merchant Bank, CPP Investment Board, HarbourVest Partners, Paul Capital Partners, Bregal, Coller Capital, Northwestern Mutual, The Yucaipa Companies and Presidential Life. What emerged from this landmark secondary direct deal was a new private equity firm called MidOcean Partners.

If transactions like MidOcean Partners prove successful for investors, the broader market will surely be emboldened by the fact that not only can partnership-bypassing secondary transactions be winning moves, but also a broad church of players can participate.

Direct effect
The past two years have seen a number of corporations sell off portfolios of direct investments in private companies. The trend started with venture portfolios but has expanded to include direct investments in mature companies. Here are some highlights:

January 2002:

Coller Capital backs the management buyout of Lucent Technologies' in-house “incubator” technology investment team, Lucent New Ventures Group. The portfolio consists of interests in 27 companies. Lucent retains a 20 per cent stake in the new partnership.

January 2002:

Eastman Kodak spins out its wireless incubation unit, Appairent Technologies, in partnership with New York-based Trillium Group, a venture capital firm.

June 2002:

Atlanta-based Peachtree Equity Partners is formed with a $110m investment from Goldman Sachs Vintage Funds. Peachtree, which specialises in middle-market companies in the Southeastern US, uses the capital in part to acquire the direct investment portfolio of Wachovia Corporation.

August 2002:

CIBC World Markets acquires the venture and investment portfolio of management consultancy Accenture. The consulting firm retains a 5 per cent stake in the portfolio. Accenture's portfolio contains approximately 80 early and mid-stage technology company investments. Accenture had previously announced it was discontinuing venture capital investments and putting its portfolio up for sale.

September 2002:

San Francisco-based Saints Capital buys a portfolio of direct investments in 13 private companies from Massachusetts-based mutual fund company Van Wagoner Capital Management. The transaction includes $130m worth of investments in privately held technology companies.

February 2003:

Coller Capital strikes again alongside New Venture Partners with the buyout of British Telecom's in-house venture capital unit, Brightstar. The transaction, valued at roughly $100m, sees BT retain a 23 per cent stake in the new investment group. Brightstar had been founded in 2000 to devel-

op companies based on the technology developed at BTs research lab, BTexact. At the time of the spin-out, Brightstar had committed roughly $55m to nine companies.

February 2003:

Washington Mutual Bank sells the direct investment arm of Dime Bancorp to two private equity firms, LLR Partners and MidCoast Capital. Washington Mutual had acquired Dime Bancorp in a 2001 transaction. The portfolio of the renamed Prometheus Management Group consists of 30 equity and debt investments.

February 2003:

An investment partnership established by London-based Vision Capital acquires four direct investments from Deutsche Bank-owned Morgan Grenfell Private Equity. Funded by Goldman Sachs Vintage Funds, the deal is described as Europe's synthetic secondary purchase, following the same strategy as Peachtree Equity Partners' June 2002 portfolio acquisition from Wachovia Corporation.

February 2003:

In a landmark $1.6bn deal, an eclectic group of private equity investors backs the acquisition of Deutsche Bank's direct investment arm, DB Capital Partners, to create MidOcean Partners. The deal is led by Dutch pension advisor NIB Capital, Ontario Teachers' Merchant Bank, CPP Investment Board and HarbourVest Partners and includes Paul Capital Partners, Bregal, Coller Capital, Northwestern Mutual, The Yucaipa Companies and Presidential Life. The portfolio consists of 80 investments in large and medium-sized enterprises on both sides of the Atlantic. Deutsche Bank retains a 20 per cent stake.

March 2003:

Goldman Sachs and W Capital Partners pays roughly $75m for the direct investment portfolio of Tredegar, a troubled plastics and aluminum company. The deal gives the two private equity firms interests in life sciences, communications and information technology companies. The original management team of the investment arm is disbanded.

July 2003:

California-based Global Asset Capital, advised by consultant Hamilton Lane, acquires Viventures Partners, the semi-captive venture capital arm of Vivendi Universal. Paris-based Viventures controlled interests in 54 companies and some $400m in commitments. Viventures closed a $600m fund in January 2002. The firm focuses on early stage information technology and telecommunications companies in Europe, North America and Asia.