What is a secondary direct portfolio transaction?
On 21 February 2003, Vision Capital announced the acquisition of a portfolio of direct company investments from funds managed by Morgan Grenfell Private Equity for a reported sum of around €100m. The transaction was one of Europe’s first secondary direct portfolio transactions (also known as ‘synthetic secondaries’), in which the whole or part of a seasoned fund is acquired, providing limited partners and the fund manager with liquidity for an entire portfolio of companies still in the fund via a single transaction.
A secondary direct portfolio transaction represents a useful new exit mechanism for investors in, and managers of, private equity funds, in a manner that aligns both parties’ interests. It begins with the creation of a new investment vehicle to hold the investments acquired. This new fund will have a new manager, in this case Vision Capital. It is important to note that in a secondary portfolio transaction, the underlying companies themselves are not sold, but instead the existing fund is or its interests in the companies are.
In the case of Morgan Grenfell, it was decided to acquire the assets rather than the fund itself. The portfolio of companies included in the transaction comprised substantially all the investments held by Morgan Grenfell Equity Partners I-V, originally a 1995 fund where the latest investment had been made in 1999, except for those excluded at the request of Morgan Grenfell. The investments in question were majority stakes in Deloro Stellite Group Limited (UK), Abrasive Technologies Holding AG (Switzerland), AB Cerbo Group (Sweden) and a minority interest in Shearings Group Limited (UK).
These transactions contrast with both conventional secondaries transactions where an individual limited partner sells its fractional stake in one or more funds, and with a secondary buyout where an individual company is sold to a new private equity firm.
Market dynamics: increasing size and liquidity problems.
Many private equity firms, including Morgan Grenfell, have raised increasingly larger funds in recent years, leading them to focus on making larger new investments to serve their investors in these newer funds. Meanwhile, the exit rate from smaller transactions in older funds has been depressed by the relative lack of activity in the M&A market and the focus of many private equity firms on executing new deals. According to the Centre for Management Buyout Research, there are currently (Q3 2003) around 3,600 private equity held companies in the UK alone that have yet to find an exit.
These trends have in many cases led to a build-up of smaller, older investments which by number often constitute a significant proportion of a fund’s or private equity firm’s portfolio, whilst accounting only for a small proportion by value. To illustrate: in Morgan Grenfell’s case, their single largest investment (made by a subsequent fund) represented a greater commitment than the whole of the portfolio sold to Vision Capital.
Many private equity firms have also changed strategy and focus in the last few years, further distancing their more mature portfolios from their current investment activity. Morgan Grenfell was no exception, particularly in the wake of its parent Deutsche Bank’s change of strategy in relation to private equity.
From the point of view of the limited partners in these seasoned funds, the outcome of these developments is a fundamental lack of liquidity, which can have serious consequences for their portfolio allocation. There are two main drivers at work. First, the recent weaker performance of other asset classes, whereby the percentage of total assets allocated to private equity (which doesn’t mark to market) is held constant, can cause the absolute amount of capital committed to private equity to be reduced. Second, the lack of liquidity in existing fund investments, with little or no distributions returning cash to institutions, means that the amount of capital within a private equity programme that is available for new fund investment can be squeezed.
The resulting pressure on the investor is often most intense at precisely the time that the best new investment opportunities in new funds are available. Once the best investments in any fund have been sold (usually within five years of a fund’s final closing), IRR can only decline as less good performers in the portfolio (operating under the constraints outlined below) cannot keep up with the superior investments that have already been sold, providing an ever weaker rationale to hold on to these older investments.
Moreover, in common with private equity firms and their investors, the underlying portfolio companies also face constraints when they are held in older funds. The starkest issue is access to new equity capital for strategic growth opportunities. This is usually difficult to secure (and hence very rare, although technically not impossible) once a fund is closed to new investment. Also, the private equity firm personnel who held the relationships with a company’s management may have moved on, or there may have been management changes at the company level that render the allocation of management equity inappropriate to the current situation. At the same time, many companies face the difficult task of recovering from aborted sale processes without sufficient time or resources to chart a new strategy. This “transaction fatigue” also has a detrimental effect on the companies’ bank relationships and financing alternatives.
Benefits of secondary portfolio acquisitions.
Benefits for private equity firms
The principal benefits for private equity firms are:
- The realisation of non-core portfolios at a fair price.
- Achieving this in a single transaction, which is more efficient than a series of smaller piecemeal disposals that, if they are achievable at all, take much longer.
- The freedom to focus on the investments which are core, and where the majority of their clients’ capital is committed.
Benefits for limited partners in seasoned funds
The principal benefits for limited partners in seasoned funds are:
- The realisation of liquidity where alternatives are slower or impractical, and at a fair price.
- The increased flexibility that the liquidity provides to make new fund commitments.
- Locking in the certainty of cash amounts and the timing of returns.
Benefits for portfolio companies
For portfolio companies in seasoned portfolios, the principal benefits of secondary portfolio acquisitions are:
- The certainty of being “off the market”.
- The benefit of a new, medium-term investment horizon with access to follow-on capital for development and/or acquisitions.
- The ability to refinance the company and re-incentivise management.
As the incoming investor in the Morgan Grenfell acquisition, Vision Capital’s view was that fair value could be delivered to the selling private equity firm and their investors whilst offering the underlying companies the opportunity to create further value and thereby providing a return for Vision Capital’s investors over a new time horizon.
The transaction process.
The execution of secondary portfolio transactions has much in common with single company investments and conventional secondaries transactions. The portfolio acquired from Morgan Grenfell comprised four companies in three jurisdictions, with different securities held in each one, and each with individual and tailored investment agreements.
The key stages for the transaction closely followed the usual sequence for a single company transaction, with each step customised to the requirements of the seller. The sequence was as follows:
- Indicative offer: at this opening stage there was discussion of price, together with the assembly of key terms and objectives, at an outline level of detail, on the fund, the companies and the investments in them.
- Refined offer: following further information being made available on the companies and the funds, and formalisation of financing for the transaction, a more detailed offer could be submitted.
- Due diligence: this stage required the simultaneous review of the companies in multiple jurisdictions, focusing on commercial aspects with confirmatory legal and financial due diligence being significantly more limited than for a single company investment as it was based on a portfolio level of materiality. This involved the management teams of the portfolio companies and Vision Capital was advised by LEK, KPMG and SJ Berwin during this process.
- Documentation: the documentation for the transaction fell into two categories. Firstly, Vision Capital formed a series of investment partnerships (much like funds in legal form) to hold the investments; and secondly, the acquisition documentation was created to accommodate the needs of Morgan Grenfell and the individual companies. Various interim arrangements were put in place to ensure the smooth transition for the companies to the new structure.
- Completion and beyond: following execution of the acquisition agreements with Morgan Grenfell, Vision Capital, the management teams at the companies and their banks began the process of positioning the businesses for future growth and the implementation of new medium term strategies. Every Vision Capital controlled company in the portfolio has completed a refinancing since February 2003 and is working on an acquisition.
Now that the process of a secondary portfolio transaction has been proven it now offers an innovative and new complement to existing exit strategies and has the potential to be employed throughout the private equity industry.
Secondary portfolio transactions offer both investors in, and managers of, seasoned private equity funds the significant benefits of liquidity at a fair price structured so as to give both parties a meaningful exit. The alternative is a return-reducing delay to liquidity. Putting a full stop to their investment in the mature fund also allows both the GP and LPs to focus on key priorities for the future. And by offering the portfolio companies and their management access to further capital and a new, medium-term horizon, the buyer of the portfolio or fund can energetically address new strategies for creating value for its own investors. It is therefore possible to formulate a win-win for all parties.
Vision Capital provides bespoke liquidity solutions for entire secondary direct portfolios and funds, benefiting both limited and general partners looking for an exit from seasoned private equity investments and complementing traditional secondary solutions for individual LPs invested in multiple funds.
The preceding article was extracted from Routes to Liquidity, a 224-page Research Guide recently published by Private Equity International. To order your complete copy click here or call the order hotline on +44 (0)20 7906 1181.