Stepping up

The return of the j-curve following the credit crunch, LPs reaching their capacity and funds getting to the end of their lifespan have created good buying opportunities for secondary players. Since 2001, the secondary market has now become an institutional asset class in its own right.

The sale of limited partnership interests in private equity funds and portfolios of direct holdings in private companies have become more common in recent years.

Investors may wish to sell their positions to boost liquidity if the current crunch continues. "We have not yet seen any large effects on the secondary market since the credit troubles started. However, we believe that investors will increasingly use the secondaries market to rebalance their private equity portfolios and recent turmoil in the credit market will likely lead to more investors considering their options in the coming months," says Jonas Agesand, vice president of LGT Capital Partners, a Swiss-based fund-of-funds.

"It is still too soon to tell the long-term effects of the credit troubles, but buyout funds will undoubtedly run into problems selling companies to other buyout investors at attractive multiples if the debt market remains under pressure," says Bjarne Lie, group partner of Verdane Capital Advisors, the Nordic region's most established direct secondaries player.

As a result of the record number of portfolio companies' recapitalisations and secondary buyouts experienced during the past two years, the j-curve has been virtually non-existent for most funds. However, recent market turmoil threatens the return of the j-curve, a well-known phenomenon for long-term private equity investors that has sometimes been forgotten in the euphoria of the record liquidity of the past two years.

"Some LPs are starting to think about creating liquidity in their portfolios of private equity funds to mitigate the effect of the j-curve, opening up the market for secondary funds-of-funds to acquire their positions. The recent credit squeeze and the related downturn in IPO/M&A activity are likely to be a catalyst for a wave of secondary transactions as LPs look for alternative ways to mitigate exposure or realise liquidity out of their private equity investments," explains Christophe Nicolas, investment director of Greenpark Capital, a UK-based private equity secondaries specialist.

Nicolas adds that some of the active LPs have reached their internal capacity limits, like CalPERS. With only three to four fund managers that have hundreds of relationships to manage, the team capacity is stretched to the limit and proactive portfolio management is often required to keep up the performance, notably through the sale of non-core private equity positions to the secondary market.

Positions in venture funds and direct acquisitions of growth companies will gain further popularity if the market turns. Agesand points out that those stakes in venture capital funds may become very sought after by secondary players should the downturn worsen.

Choosing the right opportunity is crucial

"We do not employ a 'tick-the-box' process when deciding which funds to invest in, but remain flexible and recognise that each due diligence process is different," says Agesand. A compelling management team, track record, market opportunity, strategy and terms and conditions are all parameters that need to work well together for GPs that want to attract primary funding from secondary players.

This can pose difficulties for first time funds, but it is not impossible to get established funds-of-funds to invest. "Our investments in first time funds have been some of our most successful. However, they are more time consuming and challenging to evaluate," says Agesand.

He also explains that the investment process is easier when a GP that they already have invested in raises its next fund, but is not less time consuming. "The next time we invest in a fund, we can run a more focused due diligence process, but the process is as thorough as when we invested for the first time," he explains.

For a direct portfolio buyer the investment process can be applied to all sectors. "We do not necessarily do a transaction because it was acquired for a discount. Our willingness to pay for a portfolio of companies is driven by the belief that we can grow the companies in a three- to seven-year perspective," says Bjarne Lie. The reasons for selling also affect the investment focus. Lie points out that typical reasons are strategy shifts, change of personnel and fund expiry. "We have also seen cases where the seller wishes to retain a part of the future upside, but wants to bring in a partner that can help the underlying companies hands-on as they grow," he explains.

Driving factors

As the Nordic industry has matured, the secondary market has followed. "Leading up to 2001 there was many venture groups that established themselves in Germany and the Nordics. Some were successful, some were not, but after the crash there was a vast amount of venture-backed companies for the secondary players to acquire," says Nicolas. He also explains that the natural evolution of the venture and private equity market has been a catalyst for growth in its own right. Many of the funds that were raised 10-12 years ago have reached the end of their lifespan and are ready to be sold. A secondary player can offer an alternative to trade sale or secondary buyouts if the company is not ready to be listed.

"There is still a misconception in the market that secondary positions are sold only when investors need liquidity," says Agesand. Now, the secondary market offers institutions the opportunity of a balanced portfolio of strategic investments. "The secondaries market for portfolios of direct transactions was virtually non-existent six or seven years ago. Vision Capital and Verdane were the first European firms that started to do direct portfolio acquisitions and paved the way for the other players," Nicolas says.

"Corporate venturing also drives the direct secondary market. In sticky capital markets, corporate funds re-shuffle assets and sell companies that do not quite fit the bill for its core operations," he explains. However, it is also important to bear in mind the "softer" factors like alignment of interest with management team and how to best add strategic value to the company. Lie agrees. "For us a portfolio transaction is not about buying low and selling high with a short-term perspective, it is about finding companies with significant long term growth and value appreciation potential." Verdane Capital has this month made a portfolio acquisition of three telecom companies from Inbox Investment AB (page 36).

Cubera Private Equity is a Norwegian direct portfolio buyer which specialises in making tail-end acquisitions from private equity funds that have not been able to sell the companies in their portfolio within the agreed time frame.

Nicolas recognises that Europe has greater venture opportunities than the US because the exit climate has been better here. AIM is the leading outlet for venture listings, and the OMX has also seen many listings of venture-backed companies in recent years. The exit market in the US has been less successful, and the next venture 'star' is likely to be in Europe. This drives a healthy venture market, which also is good news for the secondary players.

But the Nordic secondaries market is still immature. "There are still relatively few funds, relatively small funds, and relatively few managers that are proven across multiple fund generations. These combined factors make the Nordic market less attractive for secondaries," says Lie. However, competition has become stronger recently. Increased competition has emerged both from Nordic and European players. Lie quotes Jack Welch, the CEO and chairman of General Electric, when he describes the current situation in the Nordics: "If you claim you have no competition you have defined your market wrong." Lie explains: "Today, probably the largest competitive threat is the choice for sellers not to sell. There has been a noted attitude shift among portfolio owners over the past two to three years." He concludes by explaining that this attitude might change as a result of the credit squeeze and macroeconomic climate, but the long-term effects remain to be seen.

LGT Capital's Nordic focus

LGT Capital has been one of the large European fund-of-funds that for years treated the Nordic market as one of its most important regions.

The first and the seventh Swedish pension fund has appointed LGT to manage its private equity activities (April 2004, page 5). LGT has also been an active investor in Scandinavian-based funds. The firm has invested in three of Northzone Ventures funds, participated in Verdane Capital VI, closed earlier this year at SEK 1bn (June 2007, page 7), and Finnish Eqvitec has also secured funding from LGT. The three Swedish buyout firms: Accent Equity Partners, EQT and Altor Equity Partners have also received backing from the funds-of-funds manager.

Volume of Nordic LPs investing in private equity

Sweden has the highest number of LPs investing in private equity in the Nordics with 50 in total. Finland follows closely with 44 LPs, while the number of Danish LPs is 38, and the volume of Norwegian LPs is the lowest with 31. Icelandic LPs appear to have a good appetite for private equity. In total, 17 Icelandic LPs are investing in the asset class and in relation to the country's size and number of GPs this is a high number of limited partnership investors. In the Baltic States, only Latvia has LPs that invest in private equity.

Drivers for buyers and sellers

The drivers for sellers of interest in private equity are:

- Changes in the strategies of asset allocations, like reallocation of assets, changes in management staff and financial restructuring.

- Need for liquidity.

- Non-satisfactory performance of some funds.

- Reallocation to a new fund.

The drivers for buyers of secondary positions are:

- Secondary market positions can often be purchased at a discount on net asset value.

- Risk reducing, since secondary acquisitions are more mature than primary transactions as significant amounts have already been invested.

- Can offer acceleration of financial returns and will thus offer more security to investors.

Type of LPs investing in the Nordic regions

This graph illustrates the breakdown of the type of European investors investing in Nordic private equity. The highest number of investors are pension funds which constitute more than 40% of the number of investors. Investment companies and insurance groups are next at 12% and 11%. Local funds-of-funds managers only constitute 2% of the number of investors, indicating an immature secondary market in the region, with international secondary fund managers buying stakes in GPs or acquiring other LP funds.

Fund preference type

This graph illustrates the type of funds in which Nordic and Baltic LPs are investing. The highest proportion of LPs, 45% in total, invests in early-stage funds. The funds-of-funds type is the second most popular destination for LP commitments with 15%. Growth capital is the third most popular fund type to invest in with 13% of LPs preferring this type of fund. Surprisingly, buyout funds are only the fund of choice for 8% of Nordic LPs.

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