Secondaries Salvation

A recent issue of unquote" recorded $11bn raised for global secondaries, making the sector arguably the fastest-growing part of the private equity industry today. The market is currently worthThere is said to be $100-140bn going up for sale this year, with the annual turnover of primary assets set to more than double from historical averages of 2-3% to 6-8%, according to industry estimates.

Despite these figures, this is not the start of a bubble, as the vast numbers are dwarfed by total private equity monies raised - which in essence is the pool of investable opportunity. In fact, some express concern that there may not be enough money to absorb the dealflow many expect between now and 2011, with capacity to invest believed to be just $20-40bn, according to specialists. "Most observers feel there is more supply than demand, so the more capital being raised to absorb it the better," says Brenlen Jinkens, managing director of specialist secondaries advisers Cogent Partners.

This dealflow will be driven largely by the liquidity issues faced by LPs. University endowment funds in the US are leading the push towards secondaries supply, with Harvard, Columbia and Duke all putting chunks of their allocations on the block. Harvard alone is putting roughly 4% of its $37bn up for grabs. Rather than indicating a u-turn by some of the world's largest private equity investors, selling these stakes could ultimately impact positively on primary investing down the line. But with so many turning towards secondaries, how are the industry titans going to ride the wave they suddenly find themselves upon?

Innovation, of course. "More experienced secondaries buyers typically make it a part of their strategy to do more complex transactions to maintain attractive returns," Marleen Groen, founder and CEO of Greenpark Capital, says. Indeed, some may even purchase interests in funds-of-funds or - if they are not a secondaries fund themselves - even secondary positions in secondaries funds.

Last spring, she explains, Greenpark backed an annex fund for a GP that was looking to buy out the other shareholders of several portfolio companies. This unusual scenario - most annex funds involve cash-starved GPs needing to provide follow-on funds to existing investee companies, something many secondaries players would steer clear of - required a tailor-made solution by an experienced secondaries investor au fait with the industry.

Another option for seasoned secondaries specialists involves transferring more of the risk and reward to the buyer. "One area of deal structuring under discussion involves the secondary buyer funding outstanding unfunded commitments, and then receiving all distributions from a portfolio until a certain hurdle return is met," says Elly Livingstone, global head of secondaries at Pantheon. "Beyond the hurdle return, buyer and seller may agree on a sharing formula, depending on the quality and type of underlying assets. This type of transaction can involve on-going counterparty risk for the buyer, and so deals of this sort are only undertaken by secondary houses with strong structuring skills."

Direct action

One type of deal that has been rare but may pick up in today's climate as spin-outs take hold is the synthetic secondary. An example of this is MidOcean Partners, which came out of Deutsche Bank in 2003. AlpInvest, HarbourVest, Paul Capital and Coller Capital teamed up with a couple of pension funds to back the $1.5bn deal, and went on to fund the next $520m fund as well. MidOcean raised its first truly independent fund in 2007 on $1.25bn, only to announce a year later that it was winding down its UK operations, leaving just two on the ground to manage out the legacy portfolio. The remaining fund is focusing on the US market.

More recently, HarbourVest Partners backed the spin-out of Lehman Brothers Venture Partners from its now defunct parent. HarbourVest acquired Lehman's limited partnership interests and the venture team spun out to form the now independent Tenaya Capital. The team raised a $365m fifth fund in 2007 and now manages a total of $750m across 45 portfolio companies.

Many traditional secondaries specialists are now cautious of synthetic secondaries because of the dynamics of the teams spinning out. This is because many do not have the mindset of independent money managers as they've not been reared as fiduciaries for third party capital, yet suddenly that is what they have become. Whilst taking part of the management company to ensure involvement in its operations as a fiduciary can be attractive from that perspective as well as economically, it can often be problematic for secondaries players. Firstly, and probably most crucially, it takes away some of the carry, which strips away incentive for management. "We'd prefer to back a team that is 100% motivated," Groen confirms. Secondly, it can be a technical hassle since there is no exit for such a stake in a management company, meaning it is ill-suited to be part of a secondaries fund's portfolio.

Despite the recent uptick in direct secondaries fundraising - whether for synthetics or direct - there is unlikely to be any swathe of actual deals in the near term. Groen, whose firm has allocated a small percentage of its funds to direct secondaries portfolios since day one, reckons around 10 have hit her desk so far this year, with less than half well placed for an actual sale. "Many secondaries players have become somewhat wary of directs since they are so much more complicated. The complexity means they should generate significantly higher returns than traditional secondaries, but the reality is that this is not always the case. With traditional secondaries opportunities available in abundance there is less incentive to invest in portfolios of directs."

Andrew Hartley of specialist direct secondaries specialist Chamonix Private Equity concurs, saying returns are not that different now, but adds that this may be set to change. "If we can buy good businesses now, we might generate stellar returns in the future," he says, indicating they'll outstrip those of LP secondaries. "This is because with LP secondaries the interests with underlying GPs may or may not be aligned, whereas with secondaries directs they are."

Buyers' market

The pickings likely to emerge in the direct space will likely be split among the small number of dedicated direct secondaries players: Industry, Vision, Nova, Cipio, Ventizz, Saints, Lake Street - rather than diverted to LP secondaries buyers. "What appears as very attractive is actually something that has very steep barriers to entry," Hartley says. In addition to the complexity of managing such a fund, there is the task of raising it - no small feat in today's market.

That said, some primary GPs with dry powder are looking at direct secondaries. "People bid for different reasons. When dedicated secondaries funds look at direct opportunities, it's a pure profit play. When GPs look at them, they may have technical or strategic reasons," Hartley exlpains. He should know: Chamonix purchased a group of 3i's smaller minority investments at the end of 2006. In fact, venture veteran Amadeus is linked to the 3i venture portfolio currently on the block. 3i itself was once acquisitive: in 2001 it teamed up with Ratos to acquire Swedish private equity firm Atle.

While at first glance it could seem a clever way of achieving synergies with existing portfolio companies, the true reason may be simpler - and less rosy - than that. Some may do it to source a new revenue stream to supplement their own funding drought, while others may see it as an alternative revenue stream for managing the new fund.

Even LP secondaries had barriers to entry at the onset, with the recent wave a new phenomenon. "When we started Greenpark 10 years ago, I expected to have a much more crowded market by now. It has taken longer than I thought to materialise, but new entrants are now coming in as dealflow is increasing significantly. They should be very careful though as the market has many challenges and pitfalls for those that are not highly experienced," Groen says.

The competition will come not only from spinouts, but also existing private equity intermediaries seeking new revenue streams. Some placement agents have long seen secondaries as a natural evolution of their businesses - after all, their bread and butter is connecting LPs and GPs. Triago did its first secondaries deal in 1993, eventually setting up a formal secondaries platform in 2004. Campbell Lutyens has been active for some time, with 3i one of its clients, and Probitas Partners is also in on the game. Other placement agents are pursuing secondaries in less formal ways: at least one is looking to raise a small vehicle to plug gaps in client funds as some LPs struggle to meet capital calls.

Funds-of-funds are also joining the secondaries bandwagon, with more gusto than the placement agents - of the $11bn raised in the last issue of unquote", all were from funds-of-funds instead of traditional secondaries players. Portfolio Advisors has been purchasing direct secondary fund interests since its first close in 2007; Goldman Sachs raised $5.5bn for its fifth such fund; Morgan Stanley will invest in approximately 10% of its $1.14bn fund (by number of investments) into secondaries over the fund's life. HarbourVest, a well established fund-of-funds, raised $2.9bn for its latest vehicle to invest in secondaries, and Wilshire's $615m eighth fund-of-funds will invest in LP interests. Even the relatively new world of cleantech has secondaries interest, with Arcano's EUR250m Earth Fund dedicating 30% to co-investments and secondary positions.

Waiting game

This roster of blue-chip brands wanting a piece of the action indicates secondaries are set to take off. "Deals will pick up in the second half of this year," Hartley says of secondaries, which, despite all the talk, seem conspicuous by their absence. He puts this down to pricing. "There is a clear price disequilibrium, with spreads too high. They are just now getting more realistic and will reach market-clearing prices by the end of the year. But traditional secondaries players believe they have farther to fall." (See graph.)

In fact, the year hasn't been as slow as some suggest, according to Jinkens. "People look at the current environment and say deals aren't being done, but based on what we see and what we're doing, they are. We expect last year's volume of $30bn to be reached if not exceeded in 2009."

While most rhetoric is of blue-chip names selling for a song, some pickings may be anaemic. "Tail-ends are likely to be a significant part of the secondaries market," Groen suggests. "After 10 years, LPs would typically appreciate seeing full liquidity. However, while most funds have a 10-year life-span, they on average get extended to 14 years (for buyouts) and even 16 years (for venture) before full liquidation of all investee companies is reached." Groen cautions though: "While buying in later in a fund's life is a very attractive way to beat the j-curve, buying at the very extended end may only give you holdings with very little exit prospects. After all, if the GP has not been able to exit after 12-14 years, what will be different for the next few years? All the attractive companies are likely to have been sold at that stage. At Greenpark we prefer to invest at the beginning of the harvesting period - on average at four or five years into the life of a fund - not at the very end. Even less so in this economic climate where these rather old vintage funds will have run out of capital to support the investee companies if necessary."

The uptick will be helped by GPs looking to do deals again at the end of this year. "Future transactions could also be stimulated by a return of new investing in the primary market - an increase in the pace of draw-downs could trigger decisions for potential sellers who have been holding back," Livingstone says.

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