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Busier than ever

Dedicated secondary buyers are flat out, with billion dollar portfolio disposals being arranged by leading LPs such as CalPERS. At the same time, buyers are beginning to seriously contemplate what an end to the private equity boom might mean for them. Philip Borel reports.

HIGHS AND LOWSCogent Partners, which advises owners of private equity assets in disposal situations, tracks pricing in the global secondary market.

Number of Number of Average % of NAV
Funds Bids High Low Average Median High High
-Low -Median
All 119 490 109.5% 77.3% 93.1% 93.1% 32.3% 16.4%
Buyout 70 287 111.8% 81.4% 95.9% 95.6% 30.4% 16.2%
Venture 43 173 107.2% 68.6% 88.4% 88.9% 38.6%
Other 6 30 99.6% 82.4% 91.0% 90.4% 17.2% 9.2%

CALPERS ARRIVES
The most significant piece of evidence for an acceleration of limited partners' portfolio management activities currently on display is a large portfolio of limited partnership interests being marketed by CalPERS, the giant Californian pension fund. At 31 December 2006, CalPERS had $31.2 billion allocated to private equity investments. At the time of writing, according to market sources, it was preparing to sell between $2 billion and $3 billion of fund commitments in a move that professionals are taking as confirmation that in terms of scale and credibility, there is now little for the secondary market left to prove.

The Sacramento-based pension scheme has been expected to enter the secondaries arena for years. Given the enormous size of its asset base, limited resources available to the CalPERS investment team have long provided a rationale for a reduction of the number of individual funds in the portfolio – it currently contains about 160 GPs.

In 2005, CalPERS said it had reviewed its position in private equity and resolved to manage its holdings through a smaller number of core groups going forward. Ever since, prospective buyers have been eagerly anticipating the implementation of the plan, and the market has been awash with speculation for months.

Now the moment appears to have come. In late July, prospective buyers said CalPERS had sent out confidentiality agreements as a first formal step of the disposal process. At press time, several observers said the circulation of a list of the funds included in the sale was imminent.

Leon Shahinian, who runs the alternative investment programme for CalPERS, explains the strategic rationale: “We have a number of objectives for this transaction, none of which include liquidity. We want to reduce the number of relationships in the programme, ease the administrative burden, make larger allocations to fewer funds and build a more concentrated portfolio. We also intend to maximise our return on investment, which is why in terms of structuring the transaction, we are pursuing a number of options.”

Shahinian did not comment on any specifics of the deal. “Assuming it gets done, CalPERS will deliver a very clear message.

Other large transactions are certain to follow,” says Andrew Sealey of Campbell Lutyens, a London-based corporate finance and secondary advisory house. “This is house-keeping on a mega-scale. It will move the market on, sending a signal to other large institutions that it is smart to buy but also to sell,” concurs Groen.

Sources say the transaction is likely to be carried out in chunks of several hundred million dollars each, as opposed to one large block.

The general partners included on the list may have mixed feelings about the deal. Given the pension's standing as a leading LP, “sold by CalPERS” is a label that might do little for a manager's standing in the market place, especially at a time when the concentration of capital in the hands of leading GPs is steadily increasing.

On the other hand, ownership transfers within a manager's investor base have long been commonplace and do not necessarily need to cause embarrassment. Says Kojima at Goldman Sachs: “GPs might in some cases be surprised at an LP's need for liquidity, but they accept this as a reality. They realise LPs need to make adjustments from time to time, and secondary transactions have occurred across most funds in the marketplace today. A proactive GP will be actively involved and help guide its LPs through the process.”

“Everyone can come in and buy secondary assets – the trick is to achieve a return from the deal.”

WILL SECONDARIES STILL MAKE MONEY?
For buyers, the CalPERS portfolio is likely to provide rich pickings, and market participants are predicting long queues now that the disposal process has started.

However, the long queues also reflect the big challenge facing managers of secondary capital in any deal: pricing. Because of the steep valuations doing the rounds, buying well is difficult. “Everyone can come in and buy secondary assets – the trick is to achieve a return from the deal,” cautions Charles Soulignac of Fondinvest Capital in Paris, whose secondary team specialises in medium-sized European investments.

Buying at big premiums can still be viable depending on the acquirer's cost of capital and strategic objectives. For example: “If you are an LP new to the asset class and looking to build up assets under management, as well as developing relationships with GPs, highly priced deals can make strategic sense,” says Groen.

However, whether such fully priced purchases will make money is another matter. Sealey at Campbell Lutyens argues that portfolios of partnership interests in buyout funds, pre-leverage, are currently priced at IRRs in the low teens.

If the interests are mature, i.e. relatively fully funded already, the prospective returns may be even lower: according to a note published at the beginning of the year by Partners Group, the Switzerland-based alternative asset all-rounder with a significant presence in secondaries, mature secondaries are among the least favourable private equity investment strategies anywhere in the world.

“When valuations come down, people won't go from expecting premiums to accepting discounts in a straight line. For a period, there won't be many deals unless sellers are genuinely liquidity-constrained.”

Luckily for the specialists, however, there are plenty of other, more lucrative things to do instead. Any review of the most popular strategies must include:

Partially funded, or “manager” secondaries: the less mature the assets being sold, the more difficult the valuation – and the more potential upside for the buyer. Jones at Coller Capital reports that the recent increase in trades of partnership interests less than 50 percent funded has been noticeable. “It's another sign that LPs are becoming more active, selling funds early when they're still in the J-curve.” There can be several reasons for investors to dispose of unfunded assets – regrets over a previous investment decision; a strategy adjustment following a personnel change; or regulatory pressures altering the commercial logic underpinning existing allocations.

Direct secondaries: deals involving the sale of bundles of portfolio companies to a secondary buyer are universally described as more complex and less competitive than the trading of LP interests – and hence more appealing to the buyer. Specialist buyers have established themselves doing nothing but directs, such as Vision Capital and Nova Capital Management in London, W Capital Partners in New York or Cipio Partners in Munich. More broadly positioned secondary funds have also had ample opportunity to hone their direct investment skills and acquire collections of private equity- and venture capital-backed companies (see p. 74). As a result, direct secondaries are now a well established part of the market.

Synthetic deals and “staples”: blends of manager secondary and direct investment techniques, often initiated at the behest of a GP. If existing investments are rolled into a new investment vehicle run by a new manager, secondary pros speak of synthetic secondaries. If in order to acquire a portfolio with the incumbent manager a new investor provides a mix of primary and secondary capital, the transaction will often be classified as a “stapled secondary”.

Staples are increasingly common among captive teams seeking independence from financial institutions. Prominent examples include the Goldman Sachs-sponsored spinout of CCMP Capital from JPMorgan in 2005, and the $1 billion creation of Shell Technology Ventures Fund I earlier this year, a deal aimed at moving venture capital investments off the oil giant's balance sheet, with Coller Capital taking a 45 percent stake. In both situations, the equity sponsors agreed to provide significant amounts of primary capital for new investments going forward.

Staples only work if the general partner has a compelling investment case to present to the participating investor. Market participants say general partners trying to make the provision of primary capital a condition in a secondary deal are taking a risk. Says Dawn: “In requiring a staple as a condition of approving a transfer, the GP needs to consider carefully his fiduciary responsibility to his current LP who is selling, in addition to being cognisant of how the market may view such a tactic.” Kojima at Goldman Sachs also thinks managers ought to approach staples with caution: “GPs should be thoughtful about the balance between their objectives and those of their LPs.”

“The market does not appear to distinguish between good and poor assets, pricing questionable assets at an unreasonably high level. It's a great selling opportunity.”

Structured transactions: this article can't do justice to the many different alternatives to straight sales that vendors can now choose from. Suffice it to say that depending on the seller's objectives, an upside retention mechanism is often built into the deal. Joint ventures between buyers and sellers such as Coller's Shell transaction are the most basic approach to a structured solution; private equity securitisations such as Temasek's Astrea deal in 2006 (in which Temasek chose to keep a large piece of equity in its books, according to a source) or public market vehicles such as Bank of America's Conversus IPO in June (see p. 81), both of which have the additional attraction of creating fee income for the issuer, are more complex options.

Emerging markets: should none of the above appeal, a move into emerging private equity markets is yet another option presenting itself to secondary funds. Observers believe that roughly 10 percent of global secondary investment nowadays involves assets and/or vendors outside North America and Europe. These markets are far from developed, but secondary buyers with sufficient manpower are doing deals in these parts as well.

DISTRESS ON THE HORIZON
What all of these types of secondary have in common is that they depend upon bullishness among buyers and sellers. However, whatever a secondary operator's preferred investment strategy, the big question increasingly on everyone's mind is this: what will happen when the market finally turns?

With the debt markets experiencing a period of severe indigestion already, the possibility of a downturn now appears more realistic than it has done in years. Limited partners under pressure to liquidate private equity positions at heavy discount were last seen in the market in the aftermath of the 2001 venture capital crisis. But when the downturn kicks in and distributions slow, everything else being equal, “highly motivated” selling will once again be a feature in secondaries, with portfolio management as a generator of deal flow likely to experience a severe drop at the same time.

To investors in dedicated secondary funds, this scenario has obvious appeal. “There could be opportunities for secondaries to take advantage when changing valuations push LPs up against their allocation limits so that they have to sell,” notes Shahinian at CalPERS, which to date has invested some $2 billion in secondary strategies, including a $500 million commitment to Conversus.

However, any change is unlikely to happen overnight. Says one expert: “When valuations come down, people won't go from expecting premiums to accepting discounts in a straight line. For a period, there won't be many deals unless sellers are genuinely liquidity-constrained.”

Already the woes in leveraged finance are making it prudent for secondaries to be even more cautious when pricing new investments. “When looking at prices being paid for assets today in the secondary market, investors need to incorporate views on operational performance and exit scenarios, mindful of the volatility and uncertainty in the credit markets,” indicates Kojima. “The only way to do this is to have a company-specific approach with informed insights on the capital markets.”

But even though valuing assets in the current environment is tricky, there are funds to be invested and deals to be done. Whatever the market sentiment, the show must go on. Says Aubert at LGT: “You've got to study underlying companies very carefully, look at their leverage, understand the timing of liquidity events and the risk profile. Doing nothing is not an option.”

And so the race for value continues at pace. What remains moot is that question about holidays. If you didn't spot any secondary guys on the beach, don't rely on catching them on the ski slopes this winter either.