The secondary market in limited partnership interests

The recent meltdown in the valuations experienced by investors in venture-backed firms, and to a lesser extent leveraged buyouts, has created pressure on the private equity fund participants to find ways for disappointed investors to achieve some sort of liquidity.

The problem stems from the structure of private equity funds…and we will talk principally about venture funds because they are the ones most vitally affected.

Ever since I worked on one of the first VC funds in the early '60s, the fundamental structure has remained generally the same. That is, investors commit to provide capital to the fund when called and the fund is scheduled for liquidation ten years after its initial closing.

The idea is that venture capital investing is a long term proposition; and were the LPs to enjoy interim liquidity, the fund would be hard pressed to provide it because the fund invests in illiquid securities issued by private companies and plans to hold those positions for whatever period of time is necessary for each issuer to work through its business plan.

In order to enhance investor returns, the fund keeps only the bare minimum of cash on hand. Its capital calls are built on a 'just-in-time' system, whereby capital is called approximately ten days before it is scheduled to be invested; and cash is promptly distributed as it is received from the proceeds of harvested investments.

The LPs' internal rates of return are enhanced to the extent that the period during which money is in the fund, and out of their pockets, is abbreviated. Accordingly, it is a rare instrument in which the LPs are given the power to withdraw. Collectively, they can get together, but only through a supermajority vote, and compel the fund to liquidate early. However, that is not a remedy many investors cherish; they could wind up with illiquid positions in a bunch of companies they know little about and, accordingly, have to go out and hire someone else to liquidate the inherited portfolios.

Obviously, ten years is a long time in the investment business and circumstances change, even in the best of times. For example, 'Limited Partner A' may wind up merging into someone else, the acquiring company having no interest whatsoever in venture capital investing. In such situations, management at the acquiring company often orders the venture capital interests to be sold fast, often stating 'Get rid of this dreck, which I don't understand, and do it by the end of this week.'

Further, individual LPs are mortal and their estates may have all sorts of good reasons to want to turn assets into cash; indeed, there is a class of LPs known in the trade as the 'formerly wealthy' … entrepreneurs who, on paper, were once worth multi-millions and, accordingly, committed (say) $5m to a venture fund, but are now broke. And, finally (and this is a result of the meltdown), a number of LPs have fallen out of love with the business because of the fund's recent losses. They want to be released from their commitments (which is another subject) and/or they want to exit the fund entirely.

How does one go about selling these interests? Of course, there is no trading market in limited partnership interests, which are illiquid, private equity securities. Moreover, the portfolio is, by its very nature, composed of private positions, some of which are a long way away from reaching a liquidity event. As opposed to hedge funds, where quarterly or semi-annual withdrawals are permitted (because the portfolio itself is invested in public securities), the typical limited partner has little or no redress against the fund itself. Its options are confined, therefore, to seeing if it can dispose of its interest in a private transaction. This is where the 'secondary market' comes in.

I personally came to the 'secondary market' as counsel to its pioneer, Dayton Carr, the President and CEO of Venture Capital Fund of America. Carr, a veteran venture capitalist, saw an opportunity in the early '80s to organize a fund which would specialize in buying limited partnership interests in venture funds on the 'secondary market,' meaning from the existing LPs, and holding the same until maturity. Carr saw several principal advantages: First, by buying in after the fund had been doing business for some period of time, his entity (itself a private equity fund) was, all other things being equal, looking at a shorter period of time before the investments were harvested. Thus, it is currently the case that a private equity fund typically calls its commitments for investments in years 1 through 4, harvests as soon as it can, of course; but, typically, the bulk of the liquidity events occur at least two years or so after the investment is made. That being the case, there is a distinct advantage in buying an interest in a fund from an existing investor in, say, Year 3 or 4. The investment is three or four years closer to the final exit event; and, since the time value of money drives internal rates of return, the shorter period to maturity (again, all other things being equal) enhances the investor's outcome.

Secondly, it is classically true in the venture capital business that the losers are recognized early while the winners take longer to incubate and mature. By buying in at Year 3 or 4, the secondary purchaser tends to avoid a number of the near term disasters in the portfolio; those battles have been fought and lost and the secondary purchaser is not paying for the losers. Finally, since the 'secondary market' is inefficient, shrewd purchasers, with experience built up over the years in venture investing, can make accurate appraisals of portfolio positions and, by so doing, the buy-side enjoys an additional advantage. (It is important to note that an interest in a private equity fund is not ripe for consideration in the 'secondary market' until the holder's commitment has been at least 50 per cent satisfied. If the holder has only put up 5 per cent or 10 per cent of the required commitment, the 'market' is primary, not secondary.)

There are a number of organized purchasers in the 'secondary market,' Venture Capital Fund of America being the oldest now joined by mega-funds, such as Lexington, Landmark, Goldman Sachs and the recently formed NY Private Placement Exchange that purchased the technology platform of the now defunct Offroad Capital. The purchasers perform a valuable service to the industry in general because they are, in effect, the only game in town. Generally, the secondary purchasers buy limited partnership interests; but, they also have the ability and the inclination to buy entire portfolios.

The classic situation is a corporate venturer which, as per Harry Edelson's prediction, made a bunch of private investments in early stage companies (sometimes using the 'spray and play' formula) but, with a change in management philosophy, wants to exit immediately. The intellectual exercise is the same, analyzing the underlying portfolio positions in order to make a rational offer.

The sellers are often disappointed with the offers they receive; the offers are often at very significant discounts from the initial price paid or committed by the selling limited partner and at discounts to the current general partner carrying values. However, the underlying positions are illiquid, sometimes quite difficult to understand, and market conditions are much less favorable than they were a couple of years ago. Moreover, while there are several billions of dollars in dry powder sitting in the arsenals of secondary purchasers, such is a relatively small amount compared to the multi-billions in commitments to U.S. and off-shore venture funds; there is a good deal more potential product than there are experienced buyers for the same.

Finally, there is the psychological impediment which handicaps the fluidity of the market. In the residential real estate market, for example, when prices are rising, deals get made quite promptly and the incidence of seller's remorse is quite low. On the other hand, when the market is dropping, a significant percentage of homeowners who otherwise would be inclined to (and indeed should) sell, nonetheless hold their homes off the market because they cannot psychologically bring themselves to understand that the dream house for which they paid $500,000 is now only worth $350,000. They will hold until the market comes back to $500,000, which may mean they will hold forever. Similarly, as venture funds flounder, many LPs are reluctant to sell their interests, and refuse to sell until the value of their interests rises.