Secondary private equity transactions are like no other transactions. The logistics of transferring a large fund portfolio, or indeed a direct equity portfolio of minority interests, are challenging and unique in the private equity community. And yet the volume of such deals continues to grow, from about $2bn in 2000 to over $3bn in 2002 and rising above $6bn in 2003. Industry observers expect secondary volume to set new records over the next few years. This is impressive growth when one considers that private equity assets are fundamentally not meant to be traded.
Paul Capital is one of the firms that helped pioneer this market in 1991 when it completed one of the first ever acquisitions of a substantial private equity fund portfolio from the Hillman Company. During that time, it has become clear that how one goes about the process of structuring an efficient and successful secondary sale process is important, and that one of the keys to implementing a successful sale is understanding the motivations behind each stakeholder in any transaction.
OVERVIEW OF A SUCCESSFUL TRANSACTION
There are at least three key players in a typical secondary transaction: a seller, a buyer and a general partner. Sometimes there are as many as six participants, including portfolio company management and “shareholders” within a fund or portfolio company. In addition, there may be an intermediary involved in brokering the deal, which adds an additional set of motivations and objectives. Each of these players participates to varying degrees depending on the nature of the transaction (e.g. whether it is a fund or direct purchase), and understanding the motivations and objectives of each is key to designing a proper transaction structure. It is also a key to reconciling the inevitable conflicts that arise and that can keep such sales from closing smoothly – or at all.
A seller's primary objectives are typically (1) to achieve fair market value for its assets, and (2) to be certain of closure. How one obtains fair market value reflects the age-old tension between auctions and negotiated sales. Some sellers believe that fair market value can only be achieved in the context of an auction. However, as counter-intuitive as it may sound, auctions can actually work against a seller's desire to maximize value. In our experience, broad public auctions often lead general partners to “clam up”, since few general partners want to entertain questions and inquiries from multiple potential buyers poring over their financial statements. This lack of current portfolio information tends to increase buyer uncertainty and hence decrease the price such a buyer is willing to pay. In addition, it can be the case that buyers are less than 100 percent forthright during auctions. This is likely to be exacerbated by the lack of a longstanding relationship with the seller. As a result, broad auctions carry substantially greater transaction risks than negotiated sales or limited auctions with two or three participants. As a result many sellers, including most of those who have pursued multiple secondary sales, have concluded that the incremental value (if any) from pursuing a large auction is not enough to justify the risks.
Certainty of closure is generally a function of a buyer's experience, credibility (including capital availability), and information access as noted above. Sellers want to work with parties that have successfully completed similar transactions before. If there are specific accounting objectives or timelines to be met, that will favour those with demonstrable experience in accelerated closing logistics or crafting custom solutions. Other seller motivations may include reducing unfunded future commitments, retaining financial sponsor relationships, maintaining discretion, and minimising market disclosure. It is important to note that a different constituency within an organisation may represent each of these different goals. Consider a financial institution with its multiple objectives: the CFO must balance the firm's P&L impact quarter-to-quarter with its balance sheet exposure to private equity, the investment bankers risk losing future business with fund sponsors, and the group currently managing the assets may desire job security above all else. Understanding and addressing each of these needs is important to a successful outcome.
A buyer's objectives are relatively straightforward. Typically, buyers want (1) a motivated seller, and (2) a reasonable probability of achieving their target return. A motivated seller translates into a high certainty of closure, and that allows for an efficient use of resources, since due diligence can be very time consuming. Buyers also want an opportunity to earn an appropriate, risk-adjusted return on their acquisitions. This is made possible by ensuring that the buyer has enough information on the portfolio to make an informed decision. In that regard, secondary buyers typically favour portfolios that are more funded (50 percent or more of commitments called) than unfunded, which helps to drive the early cash flow characteristic of the secondary asset class. Having said that, some buyers, including Paul Capital Partners, will purchase less funded interests if high quality GP groups manage them.
GENERAL PARTNER OBJECTIVES
Finally, there are the general partner's needs. At a minimum, general partners want to see (1) a credible buyer with the capital to finance the ongoing capital obligations of the departing investor, and (2) a confidential, discreet process managed by professionals with experience in secondary transfers. This is particularly true if there are transfer restrictions that include Rights of First Refusal and co-sale rights to other investors in the fund. They want a minimum of distraction to their fund management while ensuring that all of the necessary transfer requirements have been complied with. In this context, the general partner is a relatively benign mediator and a somewhat disinterested party to the transaction. However, some general partners have begun taking a more strategic role in intermediating secondary transfers. One recent trend is for GPs to direct transfers toward value-added investors who might support future funds. Another trend is to ensure that transferees will not subject the general partner's fund to disclosure risk under the Freedom of Information Act laws (i.e. a “FOIA-safe” transferee).
WHY SO MUCH FOCUS ON DISCOUNTS?
Often the first question a seller asks of the secondary buyer is “how large will the discount be?” This is a difficult question to answer, as the appropriate response to such a question should be “discount to what”? Often there are several reported values for the same private equity assets in a seller's portfolio, depending on the context in which they are used. For example, there is the value reported to the seller by each underlying fund manager. The valuation policy applied by each fund manager can also differ significantly, to the point where even the same securities in the same portfolio companies may be valued differently by two or more funds that share the same investment.
Some general partners will write up or down their investments using the valuations of the latest financing rounds. Still others will value at the lower of cost or market, never writing an investment up but writing it down if its performance or a third-party financing round dictates it. Others use public market multiples of revenue or cash flow to “mark-to-market” their portfolio based on current financial performance. There is also the book value of the assets as reported on the seller's balance sheet, which may reflect the fund manager's reported value plus any capitalised fees or expenses related to the fund, or may simply reflect original cost (notwithstanding a higher reported value by the general partner).
In other cases, there could be “goodwill” or other noncash items allocated to the seller's book value that have no relation to the assets' underlying performance. Finally, there is the issue of economic, or intrinsic value, in relation to a seller's carrying value. If a seller holds a public stock through a fund that trades today at $2 but which the general partner valued last quarter at $10, how meaningful is the discount? Clearly, it depends on the context. If the seller is willing to recognise the diminution of value in that stock, the discount will likely not be that important. However, if that same seller will incur an earnings loss because of a write down from book value, the discount could be very meaningful.
REASONS FOR DISCOUNTS
A variety of factors drive discounts on secondary purchases. However, the primary driver is the quality of the underlying assets. A secondary investor looks at the intrinsic value of underlying assets to determine the purchase price. Therefore, in a sense the reported net asset value and implied discount are irrelevant to the purchaser. This intrinsic valuation is driven from both a bottom-up and top-down view. From a top-down view, secondary buyers will evaluate a portfolio across industry sectors, vintage year exposure, and fund managers to get a sense of where the reported value is concentrated.
How large will the discount be?‘ is difficult to answer, as the appropriate response to such a question should be ‘discount to what
From a bottom-up perspective, each portfolio company will be evaluated in the context of its business model, financial performance to date against plan, strength of management team, and path to eventual liquidity. The fund's expense structure (carried interest and management fee levels) will also be an important consideration. Other important factors include the co-investor syndicate behind each company, the outlook for capital markets liquidity, and more subtle risk factors such as each company's financing risk and the level of investor fatigue in each deal. A secondary buyer tries to incorporate all of these variables (and, often, more) into an analysis that forecasts the expected cash flows from a fund and calculates their present value. This forms the basis for a price indication.
It is hard to be specific about discounts to reported net asset value. Having said that, one can generalise regarding the range of discounts that are typical for certain types of assets. Over the past three years, secondary buyers have generally priced venture capital assets with larger and wider discounts than buyout assets, often in excess of a 50 percent discount to reported value. Buyout assets during this time have typically traded in a tighter range and generally for discounts ranging from 20 per cent to 50 percent.
VALUATIONS AND PRICING IN AN UNCERTAIN WORLD
In an environment where economists are hesitant to predict any improvement in many leading economies, and where secondary transactions can be as large as $500 million+ or more, just how does a secondary buyer go about valuing 100+ companies in 10 days?
The answer to this lies in the underlying philosophy that each secondary firm adopts towards its due diligence. Some buyers employ more of a “technical analysis” that takes a high-level view of a fund manager's track record and vintage year and attempts to reach a price based on a top-level perspective. Others use a “fundamentals” approach that assesses the underlying performance of each asset to forecast a realisation amount and its timing.
It should be noted that the more concentrated the portfolio, the deeper the due diligence must go since the impact of the unknown is greater. This is especially true when one considers the unique diligence that must be done to understand valuations fully in the current environment. For example, across many corporate venture portfolios today, sellers who commonly did not participate in the latest financing rounds now have liquidation preferences and other “senior securities” above them. Understanding how these various preferences work through the capital structure of a company, under various exit scenarios, is important to arrive at the correct valuation.
Similarly, in the buyout space, understanding how each company is performing relative to its loan covenants can be critically important to deriving equity value. Qualitatively, it is also important to understand the degree of support for a deal within the investor syndicate, particularly if it is likely that the company will need to seek near-term financing. Understanding any litigation around failed deals, and the potential for such liabilities to be passed on to a new purchaser, is also important to making the right purchase at the right price.
Finally, it is important to consider the issue of pricing unfunded commitments in a private equity fund. Most secondary buyers prefer acquiring largely funded partnership interests. This is what provides the secondary buyer with a favorable risk/return profile, since it affords the opportunity to assess the value of a portfolio that is largely complete.
In today's uncertain environment, just how does a secondary buyer go about valuing 100+ companies in 10 days?
Uncalled commitments typically cannot be acquired at a discount per se, meaning the secondary buyer must pay dollar-for-dollar for these future liabilities. This is often dilutive to a secondary buyer's returns. Offsetting this dilution is the benefit that comes from purchasing the existing assets at favorable pricing and not having to incur the first few years of management fees and operating expenses. Thus, those secondary buyers who will purchase “early secondaries” as they are commonly called will often do so only if the fund managers are expected to generate top quartile returns. It is a particularly challenging issue with venture portfolios because the secondary buyer must differentiate between the amount of uncalled capital that will be invested in follow-on rounds in the current portfolio and the amount that will actually be allocated to new investments.
AFTER A DEAL IS STRUCK … ON TO THE CLOSING
There are several logistical steps involved in the transfer of private equity fund and direct interests. First, the buyer must research and follow the necessary procedures regarding any preemption rights such as Rights of First Refusal, co-sale rights, tag-along rights and others. The complexity of these preemption rights varies significantly and requires consideration by the buyer and seller as early in the process as possible, particularly if a large number of interests are involved.
Next, the general partners must give and document their consent. This is rarely an issue for experienced, credible buyers. However, as indicated earlier, general partners are looking for more than just a substitute limited partner. They are looking for the value-add that comes from a more strategic relationship, such as the ability of a new limited partner to be helpful in future generation funds (either as an investor, or as a contact for introductions or in providing industry expertise).
In terms of legal documentation, there are certain key agreements that must be negotiated and signed by both buyer and seller. These include a Purchase & Sale agreement, and an assignment and assumption agreement for each interest. The assignment and assumption agreement is the actual transfer document, and typically includes the general partner consent. Other ancillary documentation may include opinions of counsel on various matters, and closing certificates certifying the validity of each party's representations and warranties at the closing.
Nearly every Purchase & Sale agreement includes a set of standard and customary representations and warranties that confirm such items as validity of title, authority to sell and completeness of information. Other key provisions include the conditions to closing and indemnifications for breaches of contract. Another provision that is getting more focus in the current environment is confidentiality, particularly in assignment and assumption agreements where general partners are starting to insist on protection given the public disclosure issues surrounding the Freedom of Information Act in the US.
The actual closings and fundings for a secondary transaction can take place on a single day or in a series of closings spaced apart as general partner consents and transfer agreements are received. Multiple closings are more common for larger transactions that may encompass several dozen different partnership interests.
As institutional investors continue to make primary commitments to private equity funds, the need for secondary buyers to provide a valuable source of liquidity will continue to grow. However, these transactions require careful planning and a clear understanding of each party's motivations to reach a successful conclusion. Understanding how a secondary buyer values and prices illiquid assets in today's more uncertain environment will only increase the odds of a satisfactory outcome.