In the private equity game, it’s not often that players get the chance to be proven instantly wrong or instantly right. Such a real-time scoreboard is for traders of liquid securities, not buyers of 10-year illiquid partnerships. And while secondaries investors tend to have shorter investment horizons, because they buy into up-and-running funds, these professionals don’t expect their underwriting skills to be assessed until years later.
But every now and then, a party to a private equity secondary transaction has the rare privilege of doing a deal and shortly thereafter being made to feel exceptionally smart or dumb, depending on which direction the asset in question takes.
The quest for what one secondaries veteran calls valuation “exactitude” is a difficult one that involves inexact art as well as science. Before a fund interest or bundle of fund interests can change hands, buyer and seller must come to an agreement on price – and the price is based on a number of factors, starting with the fair value of the underlying portfolio companies. As is the case in any transaction, primary or secondary, companies to which low growth expectations are assigned tend to trade at low valuations, and high-growth companies at high valuations.
Fred Maynard, HarbourVest
But sometimes a valuation step-change happens that catches just about all parties off-guard, with the effect of making someone in the secondaries-market cast of characters – the buyer, the seller, the would-be buyer or the would-be seller – feel sheepish. Let’s say a private equity fund with a big position in Company X trades at a price that includes the assignment of a $100 million valuation to Company X, and an expectation that an exit event for the company may be three years away. If, two months after the trade, Company X is acquired for $200million, the buyer of the partnership feels like a hero and the seller feels like a chump; while the would-be buyer who let himself get outbid feels like a chump, and the would-be seller who refused to part with the asset feels like a hero.
This hero/chump bifurcation was likely at play in the recent stunning news of Silver Lake’s sale of Skype Technologies to Microsoft. According to secondaries market sources, a number of buyers bidding for interests in Silver Lake Partners III, which held the private equity firm’s position in the internet telephony company, refused to budge from discounts of as much as 80 percent of par. These buyers based their weak price appetite for Silver Lake III primarily on their bearish view of Skype, according to a source. By contrast there were sellers of Silver Lake that passed on pricing because they felt there was “more upside in Skype, says a separate secondaries source.
In this case, the non-sellers were very right. Following a hold period of just 18 months, Silver Lake and its co-investment partners in May agreed to sell Skype to Microsoft for $8.5 billion in cash, generating a return of more than three-times investment. Overnight, the view of Skype’s status as a wonky corporate orphan changed to one of a company at the epicenter of global communication. This of course also dashed the view of anyone in the secondaries market that felt Silver Lake III couldn’t possibly be worth anything above par. Now, as a result of the Skype sale, the new par is much higher, and anyone who rode the fund from point A to point B feels pretty heroic about it.
To varying degrees, private equity fund valuations get “Skyped” on a regular basis. One source points to another surprise exit that caught the secondaries market off-guard – Elevation Partners’ sale of Palm to HP in 2010, an exit that scored the private equity firm a modest profit. “At one point you couldn’t sell [the] Elevation [fund],” says a secondaries market source. “No one was going to take a look at it. But that turned out to be a decent deal – people were basically thinking that it was not going to work out.”
HARD TO PREDICT
Skype is a fairly notable example of something that is endemic to investing generally – the risk of mispricing an asset. What makes this risk especially unique in the secondaries business is that the buyers are one step removed from the underlying assets, and often have to assign independent valuations to hundreds of portfolio companies during a short bidding period.
“That’s just the nature of the business,” says Fred Maynard, a managing director at HarbourVest who focuses on secondary investing. “In almost every secondary transaction that we have ever done, we’ve never gotten the analysis exactly right. The actual performance [of individual portfolio companies] is either higher or lower than we projected. Sometimes they have wildly outperformed, and sometimes they have dramatically underperformed.”
Maynard confirms that he prefers the “wildly outperform” scenarios because “it’s always preferable to feel smart than stupid.”
Secondaries investors make their money by buying into private equity partnerships at a discount to actual performance. This necessarily means that bids need to be short of the rosiest projections. Paying a full price for a great fund scores a fat zero in the secondaries game. And in a highly uncertain economy, it is rare to see a secondaries investor bid bullishly. “Secondary buyers in this kind of environment have to be pretty cautious,” says Jean-Marc Cuvilly of placement and secondaries agent Triago. “Even when you have public equities at reasonable valuations, if you’re a secondary buyer you really have no choice but to take that with a grain of salt. Secondary buyers usually take a more skeptical view, and for sure sometimes their view is overly pessimistic – that’s why there’s still a big spread in the secondary market.”
Jason Gull, a partner and head of secondary investing at Adams Street Partners, identifies two aspects of potential exit value that secondary investors try to get right: timing and amount. In other words, secondary buyers need to take a view on when a portfolio company is likely to be liquidated and what the probable range of exit values might be. Of the two, timing is often the most difficult. “We’ve actually done a lot of data churning internally to try to improve what we do,” says Gull. “When we are wrong we want to know why we are wrong, and what types of types of things we tend to be more wrong about.”
Gull adds: “If there’s one place where GPs are off most often, it’s timing. Timing is very difficult, and relatively small changes in timing can have a big effect on IRR. We’re all concerned with present values and discount rates.”
Maynard says that even a pleasant surprise can be “equally concerning” for an ambitious secondary investment firm “because there’s something that we didn’t get. We should have known. If you miss a fundamental value driver, that’s cause for concern because when you miss something on the upside, it means you might do the same on the downside.”
SURPRISES ARE BAD
While an unexpectedly quick exit can be a happy surprise for a buyer, the reverse surprise can be a slow and excruciating disappointment – a company or set of companies that are held much longer than expected can dash the hopes of secondary buyers who were banking on a certain baseline IRR.
Predicting the current value of a private company is, of course, a difficult task faced by all private equity investors. But the more mature the portfolio company, the more likely there are to be stable cash flows and comparable corporate assets upon which to base an accurate valuation. By contrast, early stage or technology-based portfolio companies, i.e. those most often held by venture capital firms, are more likely to have binary-outcome surprises – and as such are not as popular among secondary investors.
Triago’s Cuvilly says that the unpredictable exit schedule and valuation of venture-backed companies often “makes it difficult for sellers to sell their venture assets” in the secondary market. They realise that valuations could “go any which way” and “don’t want to leave any money on the table” by selling a fund interest that soon afterwards benefits from a strong exit, he says.
Gull points out that today’s emerging markets also contain “venture-like euphoria” in their expectations for high growth rates and consolidation; this can hamper secondary trading because the actual exit outcomes are hard to predict.
While euphoria and keen attention to valuations can present secondary investment challenges, the opposite condition – lack of attention – can spell opportunity. Bryon Sheets, a partner at Paul Capital in charge of secondary investing, says his firm takes special care to focus on the often-orphaned, long-time holds that exist in private equity portfolios. “We at Paul Capital think it’s important to focus on the bottom 20 percent” of the value in a portfolio, often resident in the orphans. “These usually get less attention from the GPs, and getting them right can mean the difference between an average outcome and a superior outcome.”
Sheets explains that having a deeper understanding of the drivers of value at the smaller, older end of the portfolio helps his firm prepare a well-informed bid – so it’s more likely to discover an undervalued gem, and less likely to be disappointed by an IRR-killing slowpoke.
Still, being wrong on key assets is just part of the secondaries business. And it’s rare that individual companies can throw an entire partnership investment off-kilter. As Sheets puts it: “Investors aren’t paying us to take concentrated bets.”
It’s also important to note that big, sudden portfolio hits do not necessarily spell doom for a secondary investment. Maynard describes a portfolio of assets that his firm bought in 2001 “before the tech bubble burst. All of a sudden our modest discount became not a very attractive price.” He says he told his entire team: “I want you to know that we did this deal together.”
Over the subsequent years the portfolio “went from bad to 1.5 times money. It turned itself around.”
It is hard to say which is more crushing – buyer’s remorse or seller’s remorse. A seller of an individual fund interest that proves to be worth far more in a short period of time can look especially short-sighted in front of his colleagues and board overseers. Sheets points out a technique that sellers sometimes use when there is valuation uncertainty in a portfolio, whereby an earn-out mechanism allows the seller to keep a certain amount of upside if there is a valuation boost post-sale. Sheets says this mechanism is casually referred to as “anti-embarrassment insurance”.
But these seller hedging techniques are not especially popular with secondaries buyers. After all, lack of seller embarrassment tends to mean that the buyer hasn’t realised the full benefit of the upside. And that can be embarrassing too.