It’s easy to miss the entrance to the Manhattan office of Lexington Partners. Nestled in between the entrance to two shops (one of which is the famous department store Barneys), a security guard stands behind the unassuming glass door of what looks like a half-finished building. But venture inside, and at the back of the threadbare lobby – all bare plaster and exposed wiring – is an elevator that transports you up to the opulent, oak-panelled 23rd floor offices of the firm that currently manages the world’s biggest dedicated secondaries fund.
The contrast seems appropriate, somehow. Lexington is one of the biggest and most significant players in two important parts of the private equity universe: as well as that $7 billion secondaries fund, which it closed earlier this year (along with a $650 million mid-market vehicle), it has also previously raised $2.4 billion in dedicated capital for co-investment. It has a blue-chip investor base that stretches from Beijing to Berlin to Boston. Yet the firm – like its founder and managing partner Brent Nicklas – has always maintained a relatively low public profile. So much so, in fact, that Private Equity International was frankly a bit surprised to be granted an audience with Nicklas in New York in September.
After some profuse apologies for the state of the lobby, which is apparently being renovated by the building’s new Brazilian owners (there’s talk of a rainforest theme, Nicklas tells us – we’re guessing this wouldn’t have been his first choice of decor), we begin by discussing the Lexington boss’s route into private equity more than 20 years ago. A New York native, Nicklas began his financial career with Citibank and New England Life Insurance Company in Boston, before returning to the Big Apple to take an investment banking job with Merrill Lynch. Here, he arranged private placements of debt and equity – a role that brought him into contact with some of the original US private equity groups.
It’s notable that even now, some 30 years on, Nicklas won’t say who these groups were. Given the size of the industry back then, it’s not exactly difficult to guess; and it’s hard to imagine they would particularly care, all this time later. But Nicklas is clearly a man who takes confidentiality very, very seriously, at least when there are journalists in the room.
In part, this is because he dislikes the way the industry is covered by the mainstream press – its obsession with big deals and big personalities. But it also reflects a broader dissatisfaction with the way the industry has evolved in recent years.
“I really think we need to put the ‘private’ back into ‘private equity’,” he says. “Going public may have served a purpose and some people may have benefited. But you’re taking a little of the mystique away. On the one hand you’re telling people that taking companies private has huge advantages, and then on the other you’re taking your own business public. That’s a little bit contradictory.”
Is this why Lexington has kept its head largely below the parapet, we ask? “We struggle with it, because there are some advantages to being well known and being bigger – particularly if you go global. Showing up in a new place, being Lexington helps; people know who we are. But should you be on the horn every day?” Not in his view.
Nicklas argues that raising the industry’s public profile will ultimately be bad for performance. “It’s called private equity for a reason. You can do things as a private company that you can’t do as a public company – move more quickly, incentivise people differently, restructure more easily – all this stuff that made private equity great. But as you get more dependent on public markets and more exposed to public supervision, you start to eat away at those advantages. When we talk to investors, that’s the number one thing they’re worried about – not only that it’s difficult to pick winners, but also that the performance of private equity is becoming more correlated to public markets.”
Nicklas talks a lot about these conversations with investors. The Lexington philosophy, he suggests, is all about putting LPs’ interests first – in a way, perhaps, that the rest of the industry often fails to do.
Indeed it was this philosophy, he says, that brought him into the industry in the first place, with Connecticut-based Landmark Partners. Back then, private equity was little more than a cottage industry – “appreciated but under-served”, as Nicklas puts it. Having spent his recent career on the buyside, Nicklas saw a market opportunity. “I felt there was too much focus on what GPs wanted, as opposed to what LPs wanted. So we tried to develop products that better served the needs of the investor rather than the sponsor.”
That said, Landmark was, at least in its original incarnation, just a plain old venture capital firm. And as Nicklas freely admits, the move into secondaries investing came about “really by accident”. In 1990, the firm had gone to visit Cigna, a locally-based US insurance company, to try and persuade it to invest in Landmark’s new growth fund – only to discover that Cigna wanted out of venture capital altogether. So Landmark asked if they’d consider selling their existing fund interests. Eventually, the deal was done, with Landmark acquiring more than 60 venture fund stakes with a book value of more than $150 million.
“That was really the beginning of the wholesale secondary market,” says Nicklas. “There had been individual trades before that, but it was mostly one LP selling their interest to someone else who was already in the fund. This was unique in its scale.” Landmark went on to buy a large portfolio from the Harvard endowment fund, which was looking to reduce its manager relationships, and then in 1993, it acquired some $350 million-worth of buyout fund interests from Westinghouse’s recently liquidated finance subsidiary. This, says Nicklas, was the deal that “really put secondaries on the map” – and, by extension, the man himself, since he led the firm’s buyout secondaries business out of its New York office.
However, Nicklas and the rest of Landmark’s senior partners clearly had different ideas about what this map looked like – because in 1994, Nicklas sold his stake in Landmark and left to start his own firm, Lexington Partners, along with his colleague Richard Lichter. Both Nicklas and Landmark declined to comment about this split on the record, but according to Lichter (who has since left Lexington to start his own firm, Newbury Partners), it was – at least in part – about strategic differences. “Brent and I were buyout guys; and so we were interested in doing buyout secondaries. Landmark was more interested in venture and real estate secondaries, and less interested in buyouts. Maybe they didn’t quite realise its potential, or maybe they were just more comfortable in a different part of the market.” However, it was a painful separation. “These things are never 100 percent smooth,” admits Lichter. “It’s like a divorce… There were some personality issues, so it was a difficult process.” Eventually, though, the two sides “got together and reached an agreement” – after which Nicklas and Lichter were free to carry on focusing on buyouts, in practice changing very little but the name on the door.
As a concept, secondaries proved an instant hit with investors, who realised it gave them the ability to manage their portfolio, generate liquidity, jump the J-curve and get into funds that wouldn’t otherwise be available. But it proved a much harder sell to managers, who didn’t like this sudden intrusion into what had always been a closed club. “Their reaction was: ‘Who are these Lexington guys coming in and buying interests in our fund?’” admits Nicklas. “So there was some missionary work required in terms of getting transfers approved.”
Even as GPs started to realise that it didn’t make commercial sense to tie in a reluctant investor – since they’d probably never get any money from that investor ever again – many tried to gain more control of the process, by building in the right to buy the interest themselves or offer it to their other LPs. But Nicklas and co ploughed on, convinced that GPs would come round to the idea eventually. “The buyout guys needed so much money as deal sizes got bigger, so they’d have to do whatever it took to get investors to come into the fund – including [giving them] the right to sell down their interests.” There was a further upside, GPs soon realised: by selling down their stake, capital-constrained investors could free up some cash to invest in the manager’s new fund.
The subsequent growth of the secondaries market suggests Nicklas’ instincts were right. Last year, Lexington’s own estimates suggest there was about $21 billion of activity in the secondary market; it’s expecting the total to hit $25 billion this year. And there may be more to come: Nicklas says that about 5 percent of fund interests now change hands this way, but he expects this to end up being closer to 10 percent.
He wasn’t finished there, though. “I began to see another opportunity as we talked to investors about user-friendly products – something beyond fund investment but short of being a full blown sponsor.” That middle ground, of course, was co-investment. “It’s still a full J-curve business, because they go in at the same time as the sponsor. But it dramatically reduces fees and carry because they’re acting as a minority investor. So they get more exposure to the companies they’ve decided to invest in, and it brings the average cost of management down.”
Although Nicklas evidently prides himself on understanding investors’ needs better than most, this time round it was LPs that took some convincing. “People questioned whether we’d get invited into deals. It was the buffet theory: you’re going to eat at the buffet table last, so all the lobster and caviar will be gone by time you get there.” But again, the Lexington boss was convinced the long-term trends were in their favour. “Our theory was that deals were going to get so big that sponsors wouldn’t be able to do them all by themselves, and yet might be reluctant to share them with direct competitors. [Whereas] we’re very friendly passive capital.” Again, the bet came off: co-investment has become a big part of Lexington’s business, accounting for around 15 percent of the capital it has raised to date.
These days, any big LP at least understands the benefits of having an active secondaries and co-investment strategy. “What you see now is that many large investors want to do all three – primary, secondary and co-investment” (Lexington itself does a small amount of primary investing, usually for relationship-building purposes). And Nicklas believes his firm should take a lot of credit for that. “Lexington has been at the forefront of that model. We take tremendous pride in the fact that [we’ve] developed two businesses that have become integral parts of private equity investing around the globe.”
SLOW AND STEADY
It’s likely that some of the other trail-blazers in this space – the likes of Adams Street, Pantheon, HarbourVest and Coller Capital, for example – may bristle at this assessment of Lexington’s preeminence. Nonetheless, investors certainly seem to buy into the Nicklas/Lexington story, judging by its recent fundraising success.
The process got off to an inauspicious start: the firm started pre-marketing in the second half of 2008, just before the collapse of Lehman Brothers. Investors were so spooked that the first close, which had initially been pencilled in for late 2008, didn’t happen until the second quarter of 2009. However, this may have been a blessing in disguise. “I get excited when things get difficult and volatile because we are somewhat counter-cyclical; we benefit from volatility and illiquidity,” says Nicklas. “When distributions from a primary fund decline, the only way you can get liquidity out of a portfolio is via a secondary sale. So it puts us in a stronger negotiating position.” Sure enough, the deals the firm did in 2009 (some from the end of the previous fund, and some from the start of the new one) were apparently done at discounts of up to 50 percent of net asset value – which then tracked upwards for eight consecutive quarters.
“The one thing that really helped them was that they did some good deals at the start of the fund, and they were able to effectively use this as a marketing tool to get other people in,” says one competitor. About a year into the fundraise, Lexington had asked investors’ permission to raise the hard cap from $6 billion to $7 billion – partly because it had decided to accept two large separate accounts (reportedly from Chinese sovereign wealth fund China Investment Corporation and a US pension fund, although Nicklas inevitably didn’t specify), which were worth about $1 billion in total. The early portfolio uplift, therefore, not only allowed late-coming investors to buy in at last year’s prices, but also provided the fund’s original LPs with a strong incentive to increase their commitment. According to Nicklas, many of them did just that – with little or no encouragement from the firm (of course, it’s also true that if they hadn’t done this, they would have seen their upside diluted). The end result was that Lexington was over-subscribed, even for its revised $7 billion target.
So why was it so successful? Good returns are a prerequisite: Funds IV and V both recorded internal rates of return around the 20 percent mark (see p. 33), while Fund VI, despite a lower IRR, was still a first quartile performer (Fund VII is, so far, doing even better). Then there are the terms, which Nicklas argues have always been generous to its LPs. As well as lower fees for the expanded section of the fund, Lexington also introduced a preferred return on top of its 100 percent cash hurdle, and upped its GP commitment from 1 percent to 1.5 percent (equivalent to more than $100 million – a sizeable sum for a firm with fewer than 50 investment professionals). Nicklas also believes the firm’s status as an independent, discretionary manager, with none of the potential conflicts or worries about change of control that afflict captives and advisory firms, made the sell an easier one. And he argues that the firm has done a better job than most of getting out early to tap international investors: about half of its commitments to ‘Lex 7’ came from outside the US, compared to its previous average of about one-third.
Either way, it clearly worked. In fact, one of its biggest investors, the Florida State Board of Administration, liked it so much that it did a Victor Kiam and bought (some of) the company: in July 2010, it said it had paid $41.25 million for an undisclosed stake in Lexington, which sources say was in fact just under 10 percent – thus valuing the management company at about $400 million (Nicklas was for some time the sole owner, but the business was reorganised in 2009 to give some equity to all his partners).
Of course, the size of the new fund provides Lexington with serious firepower: it allows it to pursue big deals like last year’s acquisition of $1.1 billion-worth of private equity interests from Citigroup (where it brought in StepStone Group to manage some of the assets), and its £470 million deal for a portfolio of private equity fund interests from the UK’s Lloyds Banking Group.
However, not everyone is convinced that bigger is necessarily better, at least as far as secondaries are concerned. “There’s no pricing advantage to being big,” says one rival. “It’s the same argument that the mega-funds used to justify their fund sizes, but the difference there is that you can’t split those deals into six pieces like you can with secondaries.” Dealing with a single buyer is clearly a lot easier – but sellers are unlikely to compromise much on price to save a small amount of extra inconvenience, he argues. “If you work at a pension fund, you’re going to get fired for doing that.”
It also means that you’re increasingly reliant on auction deals. “Back [when we started Lexington], there were no intermediaries,” says Lichter. “You had to source all your deals through your network. But as the market evolved, you started to see more and more large auctions. At that point, sourcing and negotiation for these deals didn’t matter; if you paid more than the next guy, you won.” Lichter felt that non-auction deals yielded juicier returns, and put more of a premium on sourcing and negotiation skills. With Lexington heading in the other direction, he left to start his own firm, Newbury Partners. “Lexington was becoming the dominant player in those big auctions – but my average deal size was $15 million to $20 million, so I felt that if I stayed at Lexington I’d be marginalised”.
Nicklas claims that the majority of Lexington’s deals are still non-auction, but some market sources are sceptical of this – if only because so many of the big deals that Lexington needs to do to spend that kind of money are intermediated these days. And relying on auctions presents difficulties. “In the secondaries business, you’re a passive LP; there’s no value-add post-transaction,” Lichter points out. “So you have to buy it right. The more you pay, the lower your returns. It’s different with buyouts, because one group might have a better way of harvesting value from an investment than the next group. With secondaries, you can just pay too much.”
Nicklas maintains that Lexington will be careful and patient; in fact, the firm has been outbid on purchases this year, he says, because it “just didn’t see” the rationale behind prices that some of its competitors were willing to pay. He’s particularly suspicious of anyone who uses leverage to squeeze out a higher price, since in his view this negates one of the key advantages of secondaries – early cashflow (which instead must be used to service debt). “We find that if we can keep returns in a stable band, with very low volatility, and if we get quick and consistent cashflow, we don’t have to swing for the fences.”
But as one advisor put it: “If you have that much dry powder to put to work in the next few years, how many auctions can you afford to sit out?”
ONWARDS AND UPWARDS
Another potential problem for Lexington is succession. Nicklas is 63 years old, so it’s no wonder investors are starting to think about what happens next. “The big question mark with Lexington for many LPs is: what happens when Brent goes? How will the culture change?” asks one investor. “Some of the big buyout houses have done a great job of grooming the next generation of leaders before going public, but you don’t get the sense that Lexington has done that. There are lots of good soldiers – but the worry is that there’s not another Brent there.”
Nicklas insists that Lexington has no shortage of up-and-coming talent. “One of the things we’ve been pretty good at over the last 20 years is developing talent internally. We have lots of professionals here in their late 30s or early 40s who have worked their whole career at Lexington. So we have a really deep bench.” Because the firm is still relatively small, it can offer new recruits a lot of high-level exposure at an early stage, he says – unlike many other financial businesses.
What’s more, Nicklas himself shows no signs of slowing down; he “hasn’t gotten bored yet”, he says. So what keeps him motivated? “It’s always fun to get in on the ground floor of a business and be an innovator and a founder,” he says, after a pause. “If you have one really good idea that you can turn into a great opportunity in life, you’re very fortunate. And if you have a couple – secondaries and co-investment, which have now become integral parts of private equity around the world – that’s immensely satisfying.” Is it less fun in a world where there’s less new ground to break? “I hope we continue to break ground,” he retorts. “It’s a pretty competitive world out there, so if you’re not gaining, you’re probably losing.”
Some would argue that Nicklas is precisely the kind of person who should now be utilising his status and influence to make the public case for private equity; after all, he’s clever, polished, well-connected, and knows the industry inside out. But we can’t see it, somehow. “Some people think the answer is to form trade groups and try to educate people – the press, the public, the government – that we’re not bad guys, that private equity really does good things. But you’re never going to convince everyone. At an industry level, it’s just really hard to do.”
Instead, he says, “all you can do is just focus on your business at an individual level.” In other words, spend less time ‘on the horn’, and more time looking after the most important people in the industry – which, for the avoidance of doubt, does not mean journalists.
1994: Brent Nicklas splits from Landmark and starts Lexington Partners
1996: Lexington closes first fund – a $242 million vehicle dedicated to mezzanine secondaries
1998: Opens first European office, in London. Raises CIP I, its first co-investment vehicle, in partnership with the Florida State Board of Administration
2000: Closes first international secondaries fund, Lexington Capital Partners IV, with $600 million of commitments. Together with Coller Capital, leads the purchase of a portfolio of over 250 private equity interests from UK bank NatWest – the first $1 billion secondaries deal in Europe. Also completes the first $1 billion US deal, buying a portfolio from Chase Capital Partners alongside Hamilton Lane
2004: Raises Lexington Middle Market Investors I, its first vehicle dedicated to buying stakes in younger mid-market funds
2006: Part of a consortium that buys a $1 billion portfolio from American Capital Strategies
2007: Raises its first vehicle dedicated to co-investments in Europe and Asia
2008: Part of a consortium that buys a $1.5 billion portfolio of 52 legacy private equity interests from CalPERS, the largest public pension fund in the US
2010: Buys $1.2 billion portfolio of 128 private equity interests from US bank Citi – including co-investment funds, fund-of-funds and mezzanine funds – with StepStone Group providing ongoing management services. In Europe, also buys a £470 million portfolio from Lloyds Banking Group. The Florida State Board of Administration acquires a stake of just under 10% in Lexington for $41.25m
2011: Opens Hong Kong office. Holds final close on LCP VII, with $7 billion of commitments, plus the $650 million Lexington Middle Market Investors II