Don't feel too sorry for the secondary megafunds. Even if the worst-case scenario – which is that they have too much money – proves to be the case, having too much money is the very definition of a high-class problem.
The term “too much” implies that the capital available outstrips the opportunities. Any private equity secondary market insider will argue, of course, that secondary transfers of securities within this industry remain at a low percentage of the primary market when compared with other corners of the investment world.
Recall, say these boosters, that approximately $500 billion of primary private equity capital has been raised since 1999 worldwide. Assume also that on average ownership of between three and five percent of this capital pool will be transferred every year and you're looking at a $15 billion to $25 billion secondary investment opportunity per annum. In 2003, secondary specialist funds raised just $2.9 billion – a fraction of the overall opportunity, ostensibly.
The optimists also insist that secondary transactions have crossed the institutional perception threshold from unusual, slightly embarrassing bail-out option to accepted portfolio management tool, and as such will remain a permanent feature of the private equity landscape, perhaps even growing in relation to the overall market.
Further encouragement derives from the fact that general partners of primary funds have also become more interested in helping to facilitate transfers of stakes in their funds from one LP to another. Marleen Groen, the founder and chief executive officer of London secondary boutique Greenpark Capital, says: “GPs have become more willing to discuss transfers, provided the proposed buyer is professional and can be relied upon not to cause any trouble later in the fund's life.”
Reinforcing Groen's point is an observation from Timothy Jones, a partner in the London office of Coller Capital: “GPs no longer see the secondary market as a threat but as a tool to be used.” One of Coller's recent transactions, Jones adds, in which the firm replaced 40 percent of a primary fund's original investor base, was in fact initiated by the manager of this fund.
GPs no longer see the secondary market as a threat
These are undoubtedly signs of the secondary market solidifying its position in the asset class. But not every market participant believes that the billion-plus pools of dedicated secondary capital are perfectly suited to the market's future, which will be characterised by smaller, more nuanced transactions and fewer giant multi-partnership interest scoop-outs. Privately, some of these players wonder whether secondary specialists will remain preferred buyers of assets, given the multifarious new entrants to the market.
Any institution considering an initial commitment to a private equity fund can now be told, with a straight face, that a large, vibrant secondary market exists to relieve them of their interests and ongoing commitments, should liquidity be necessary.
The clearest evidence of the emergence of this market has been the rise of the secondary megafunds, of which there have been five so far, managed by Coller Capital, Lexington Capital, CSFB Private Equity and Goldman Sachs Private Equity Group, respectively. These firms continue to control the lion's share of dedicated secondary capital in the market. In 2003, for example, of the $2.9 billion raised by dedicated funds, Lexington alone raised $2 billion. In 2002, $3.4 billion was raised by dedicated funds; Coller Capital spoke for $2.5 billion of it, having raised only $501 million for a previous effort.
Funds of funds also play an important role in secondaries, most notably HarbourVest Partners in Boston, which can invest up to one third of every fund of funds it raises in secondaries.
Some of the specialist firms are now preparing to raise fresh pools of capital, including CSFB and Coller Capital. European practitioners marvel at rumours that the latter firm might in fact attempt spectacularly to raise the bar yet again by setting an unprecedented target of up to $5 billion for Fund V, expected to launch next year. Coller Capital declined to comment on its fundraising plans. Supporters say the rumours are without substance.
Other secondary players are in fundraising mode as well. Goldman is already in the market, raising the third of its Vintage Funds series. Of the medium-sized players, AXA Private Equity and Pomona Capital are preparing new funds. And fund of funds specialists Pantheon Ventures and Partners Group closed dedicated secondary funds this summer, raising $900 million and €€500 million respectively. (For more details on Partners' new vehicle, see p.14.)
MEGAFUNDSThe $5 billion dollar-plus dedicated secondary funds below have been organised to date. Expect more: GS and CSFB are already back in the market, Coller is tipped to return in 2005.
|Manager||Fund name||Size||Vintage year|
|Coller Capital||Coller International||$2,500m||2002|
|Lexington Partners||Lexington Capital Partners V||$2,000m||2003|
|CSFB Private Equity||CSFB Strategic Partners II||$1,600m||2003|
|Goldman Sachs||Goldman Sachs Vintage||$1,100m||2001|
|Lexington Partners||Lexington Capital Partners II||$1,100m||1998|
ISSUES WITH SIZE
There are now more secondary deals than ever, but sceptics doubt the continued pace of large secondary deals. “You're not seeing as many $500 million to $1 billion portfolios for sale,” says Erik Hirsch, chief investment officer of Bala Cynwyd, Pennsylvania-based private equity consulting firm Hamilton Lane.
Ian Charles, a vice president at Dallas, Texas secondary advisor Cogent Partners, says that his firm's volume of transaction- related work has increased markedly, but the size of deals sold to separate buyers has decreased. While Charles expects to see five or six portfolio sales of between $500 million and $1 billion this year, he notes that these will more than likely be broken down into separate asset clusters for a number of buyers. “A seller who transacts on a large, diversified portfolio with just one buyer is leaving a substantial amount of money on the table,” Charles says. “Large portfolios have assets that are less attractive to one buyer.”
Intermediary firms such as Cogent, Probitas Partners, The Camelot Group and Campbell Lutyens have played a major role in bringing greater education and efficiency to the secondary market. Charles estimates that, whereas the average proprietary deal two years ago was $100 million, the deals that escape middle men now hover in the $20 million to $40 million range.
One factor cited for the slowdown in secondary mega-deals is the decline of large banks as motivated sellers. Many of the largest private equity secondary deals – Chase Capital, Abbey National – have been the result of historic shifts in the banking industry. There will not be a similar second wave of bank partnership divestitures. “The big hallmark transactions were from banks and investment banks,” notes Hirsch, whose firm conducts both primary and secondary purchases. “Those were all one-time deals. The banks are not going back to recreate big private equity portfolios.”
One large portfolio of fund investments currently undergoing a transfer is owned by Crédit Agricole, the French bank. At the time of this article going to print, market sources described the pending sale of the €600 million portfolio to ([A-z]+)-based Axa Private Equity as a done deal and merely awaiting completion. Other financial institutions seen as potential sellers of sizeable fund investments include Bank of America, CIBC World Markets, Bank Boston and Caisse de Depot et Placement du Quebec.
With or without a ready supply of large deals, prices are up across the board, buyers note. The rising markets, increasing sophistication of sellers, as well as the increased role of intermediaries have all brought about better pricing for sellers of partnership interests, and this, argue some, will have a dampening effect on secondary fund returns, especially for those with the most capital to put out.
Lawrence Penn, the managing director and head of the private equity and secondary group at The Camelot Group International, headquartered in New York, is not among the mega-sceptics. “We're as close to big portfolio scoopouts as you can imagine,” he says. “There are a couple of billion-dollar deals in play right now, and the big players are the ones that can put $500 million to work. These are huge pools that need to be sold, but it will be done over time in successive tranches. Although a deal can take as long as six months, we tend to execute them in less than six weeks, depending on the mandate.”
But he also agrees that the big players have needed to “be creative in order to put money to work”.
Others question whether new types of investors, especially pensions, can really close the gap that banks are inevitably going to leave once they are done selling. Brian Wright, a London-based partner at independent secondary and fund of funds investment house Pomona Capital, says that pensions have too long an investment horizon to consider wholesale selling of their private equity holdings, “particularly at a time when equity markets are improving and overexposure to private equity ceases to be an issue”.
HarbourVest's Begg makes a similar point: “Pensions won't sell wholesale, because their fund managers are having to be extraordinarily careful not to be perceived as leaving any money on the table. They will use the secondary market to manage down the number of GP relationships, but on a selective basis.”
Where Begg sees a new opportunity for secondary buyers is in the anticipated consolidation of the funds of funds industry: “Secondaries will have to be extremely cautious in terms of pricing such deals, but taking positions in fund of funds managers is going to be an option for some.”
Also looming large on the wild frontier of secondary opportunities is the direct, or synthetic, deal. While the market may see fewer very large bundles of LP interests for sale, a healthy trade in portfolios of direct investments has emerged for secondary investors with an aptitude for bottoms-up analysis.
Like the market for fund investments, the emergence of a market for direct deals benefits GPs of primary funds. That is why these GPs tend to be increasingly supportive. Julian Mash of London-headquartered Vision Capital, one of the pioneers of synthetic secondaries, argues that GPs have become more interested in selling tail ends of their portfolios.
Mash says: “Funds get pretty IRR-indifferent after a few years. There is an impetus to clean up old assets, provided the price is reasonable, because these assets won't move the needle for their current investors who want more focus on newer and more significant assets.”
Large portfolios of direct investments exist in a multitude of different entities – including corporate venture programmes, in banks, in government programmes, in private banks, in family offices. These deals are harder to evaluate, frequently come with more “hair”, and therefore are typically also are much more attractively priced, especially on the venture side, according to Cogent's Charles.
Most dedicated secondary buyers have been active on the direct front lately. Vision Capital, for example, does not have a fund of its own, but counts secondary players GS Vintage Funds, Landmark Partners and Paul Capital among the investors it will work with to finance deals.
In other cases, say market insiders, dedicated secondaries have teamed with operating teams to evaluate and oversee the management of the underlying companies. Often the original portfolio managers are left in place, giving large secondary buyers the advantage of being able to put capital to work in relatively large chunks and at the same time maintaining a continuity of management over what most would consider assets with a higher risk profile.
A number of secondary market insiders say that specialist buyers face another challenge now having less to do with size of fund and everything to do with being a dedicated fund.
Specifically, in a market where GPs are gearing up to compete fiercely for capital commitments, many are less happy about allowing partnership interests to transfer to buyers who will not commit to their next fund.
Says Charles: “There is a growing focus by GPs on requiring buyers to be players in the primary market. They say, “if my LP is selling, they better be replaced with somebody who can commit to my fund.””
Charles says this gives non-traditional secondary buyers such as funds of funds an advantage over secondary buyers, who do not make primary investments.
Hamilton Lane's Hirsch has also seen this trend. “GPs are growing somewhat wary of the traditional secondary money,” he says. “It's basically dead capital. We're seeing some GP groups becoming more restrictive on transfer rights” as a result of this issue.
This is an assertion that dedicated secondary buyers, both large and small, flatly reject. Francisco Borges, the president of veteran secondary firm, Simsbury, Connecticut-based Landmark Capital, says he has heard some discussion of a supposed preference among GPs for transfers to primary-oriented LPs, but has not lost any deals because of it. His firm's longstanding presence in the market, he says, has made Landmark a preferred and trusted secondary buyer among GPs.
Greenpark Capital's Marleen Groen argues that having primary money often, in fact, creates a disadvantage. “When you make primary investments, you say “no” to GPs over 90 percent of the time,” she says. “Guess what? This frequently puts you in a worse position as a secondary buyer.”
Groen says she has “occasionally” heard GPs voice a preference for primary-oriented money, but in every case, “we still get in”.