The shoe fits

Talk to a secondaries-focused general partner about recent transactions and you're likely to walk away with an image of them that's part maths genius, part saviour. Talk to the people benefitting from their cash and capabilities, and you'll hear more of the same (albeit with a dash of occasional – envious? – grumbling about secondaries firms securing highly beneficial terms).

This “financial guru” image, of course, is a far cry from the days when secondaries firms were barely acknowledged as more than a fleeting trend, as opposed to a valuable component of the broader private equity universe.

The phrase “elegant solution” has become a mantra among secondary players, and not without reason. Whether it's a firm, a fund or an individual in need of cash, secondary firms are swooping in – complex transaction diagrams in hand – to the rescue.

Far from the mainstream of secondary activity – which tends to be the purchase of either LP fund interests or a portfolio of companies – is the “onesie”, or a single-asset, single company transaction. While secondary stock purchases, particularly in VC-backed start-ups, is nothing new, many say the practice is gaining ground. Different parts of the capital structure are regularly up for grabs and companies have become more accepting of such direct secondary deals.

Onesies are the main focus of groups like Millennium Technology Value Partners, a New York-based spinout from The Blackstone Group, and UK-headquartered Azini Capital, which is backed by more “traditional” secondaries firms Greenpark Capital and Lexington Partners.

The investment thesis revolves around building up a stake in a company via a series of transactions with past or present employees or management looking for liquidity.

Azini, for example, in December bought 500,000 shares in Focus from the financial services software company's founder, John Streets. “Following a series of impressive results and contract wins, including posting our best ever half-year results, it was an opportune time to release a proportion of the equity I have in the company,” Streets said at the time. The deal brought Azini's stake in the UK company up to 29.17 percent, having in May 2008 purchased a 26.9 percent stake from UK venture firm Top Technology Ventures.

Millennium, meanwhile, has recently amassed stakes in companies including social networking site Facebook, online dating service eHarmony and internet shoe retailer Zappos. The latter, already well known in the US, skyrocketed to fame when, in July, agreed to buy it in a roughly $900 million deal.

Its traditional venture backers, including Sequoia Capital and Draper Richards, got much subsequent press, but Zappos noted that it has more than 100 investors. And many of those came in via secondary direct deals.

“Zappos has been around for 10 years and throughout those 10 years there's been a need for liquidity here and there,” explains Alfred Lin, Zappos' chief financial officer and chief operating officer. “When those sorts of situations arise, we try to help our investors so that both parties can be happy – the one who wants liquidity and the one who wants to invest in the company even though we're not raising any capital.”

The company has as a result ended up with all different sorts of shareholders, from employees to investment banks, having only exercised its first rights of refusal “once or twice”, Lin says.

If you show people there's liquidity in their shares, that triggers an enhanced perception of value and can work well for employee retention

In 2006, he recalls, the company did its own secondary transaction by raising money from Sequoia for a share buyback programme. “There were also some secondaries that happened throughout the last two or three years and that's how Lehman Brothers became a shareholder, how Goldman Sachs became a shareholder and how Morgan Stanley became a shareholder.”

Millennium, for its part, did seven separate transactions for Zappos stock last year. The firm declined to provide financial details on the sales or expected returns save to say it was “pleased” and believes the transaction's trends and results will become increasingly common.

“Our involvement with Zappos demonstrates that even in the very best, highest-performing companies, even when reasonably likely exit events are on the horizon, constituents in the capital structure still want, need, or appreciate liquidity with certainty earlier than the ultimate exit of the company,” says Sam Schwerin, Millennium co-founder and managing partner.

Lin adds that secondary transactions are going to become “increasingly more interesting and more important” for any company that isn't just established with a short-term goal. “If you're trying to run a company for the long term, and not just trying to build a company to float,” he says, “different investors will have different timeframes and the longer your timeframe for building a company is, probably the more necessary secondaries are because some investors will have shorter timeframes than you.”

An added benefit, Schwerin says, is that direct secondaries can help a company maintain its human capital. “If you show people there's liquidity in their shares, that triggers an enhanced perception of value and can work well for employee retention,” he notes.

Individual investors aren't the only ones looking for liquidity – investment funds are increasingly running up against the need to give further support to portfolio companies, but often the fund itself has little cash left to do so.

“The biggest issue for private equity, to my mind, going forward will be a lack of reserves in existing funds,” says Tom Anthofer, managing partner of Munich-based direct secondaries firm Cipio Partners. “Now post-Lehman, that's a huge issue for both the older, fully invested funds as well as those that are just halfway through their investment period. These funds no longer face only a J-curve but, in effect, are now up against a Wcurve. By early 2008, many funds had ‘climbed up’ into profit, albeit with most assets unrealised. The crisis basically reset all that, and they will need to start all over again, which means companies may have another five to six years before they will be realised and, on the way there, they will be screaming for more money.”

That goes for venture-backed companies that aren't cash flow positive, as well as buyout-backed companies needing debt refinancing and equity cures, he adds.

Andrew Sealey, managing partner of London-based placement agent and adviser Campbell Lutyens, told PEI last month he expects the firm's fund restructuring practice to rival that of its secondaries advisory arm in the short- to medium-term. “We haven't seen this level of activity since 2002 to 2003,” he said. “In retrospect, too many investments were made at toohigh prices with too much leverage. Many portfolio companies are now under-performing, leading to a requirement for new money and many funds having insufficient reserves.”

Apax France recently dealt with this issue by having secondaries-like firm 17 Capital refinance part of its portfolio. The firm provides mezzaninetype and preferred equity financing that acts like a secondary transaction “in the sense that we provide liquidity,” says 17 Capital co-founder Pierre-Antoine de Selancy. Most firms like his have been focused on the venture space, but “more and more will come into the buyout space – everyone says this is the next big thing”.

“Companies may have another five to six years before they will be realised and, on the way there, they will be screaming for more money”

Another type of restructuring on the rise is the raising of an annex or top-up fund to give GPs a source for follow-on capital. MatlinPatterson, Kohlberg Kravis Roberts, Sun Capital, Kleiner Perkins Caufield & Byers and Graphite Capital are among the firms reported to have recently raised – or are currently raising – annex funds. But today, that often means secondary firms will do some heavy lifting in the background.

“In the past, if a fund needed additional capital for their portfolio companies, the general partner would go to existing investors and say ‘I'd like to set up an annex fund,’ and often those annex funds would be created and the problem was solved,” says Rudy Scarpa, a secondaries-focused partner at funds of funds manager Pantheon Ventures and head of its New York office.

Today, Scarpa continues, existing investors haven't the cash to comply with those requests and banks are less accommodating, leaving secondary firms to offer their expertise.

Pantheon was recently involved in structuring what Scarpa calls a “preferred annex fund” for a private equity firm he declined to name (he notes his team is looking at implementing the same structure for a number of private equity funds at present).

“The solution is basically an annex fund, where instead of the annex fund just investing in the existing portfolio companies, the secondary investors, along with the existing LPs, have the option of investing in the preferred annex fund,” he explains. “Secondary investors together with existing limited partners invest in the annex fund, the annex fund invests in the main fund and that capital goes toward underlying portfolio companies.”

The annex fund receives a preferred return in the form of early distributions, he says, noting it also receives a minimum return.

Scarpa calls the structure a “win-win-win”. Though investors in the original fund are diluted, value in the underlying portfolio companies is maintained or enhanced, thus optimising returns for original LPs. GPs solve their financing troubles, and the secondary firm earns “a fair return, a market return, and on a risk-adjusted basis it's attractive because we get the early distributions”, Scarpa says.

Pantheon is also working with several institutions on applying the same sort of structure to aid limited partners that are over-weighted to private equity and can't make capital calls and/or new investments. “We provide them with capital and they use that capital to fund their capital calls or make new PE investments, and in return we receive a preferred return on that capital so we receive early distributions from their portfolio of private equity fund interests and we also get a minimum return on our money,” Scarpa explains. “So the economics are very similar, it's just the structure is applied in a different context.”

Given that 2009 and 2010 vintages are expected to out-perform, Scarpa reckons LPs will increasingly turn to such arrangements so as not to be left out of the market or lose traction on their relationships with important GPs.

It is, he adds, an “elegant solution”.