Table talk

On a sunny Manhattan morning in April, five senior investment professionals representing five major institutional participants in the private equity market gathered around a table at The Yale Club to talk shop. On issues ranging from the secondary market to private equity securitisation to the best opportunities going forward, Chuck Flynn, Michael Granoff, Thad Gray, Sheryl Schwartz and John Wolak agreed to disagree with eloquence, wit and authority.

In a room filled with reporters, tape recorders and cameras, just how candid can a group of limited partners be? As it turns out, quite candid.

The LPs who participated in Private Equity International's debut US roundtable event were eager to share ideas with their peers and learn about the differing ways in which other private equity investors are dealing with the upheaval in the asset class. (The first such event was held in Paris last November and was featured in the December 2002/ January 2003 issue of PEI).

This is not to say that the participants always agreed with each other. Far from it – these LPs came from a range of institutions with differing capital sources and business objectives. Their respective opinions on the private equity market were coloured, they admitted, by the goals and capabilities of their respective organisations, as well as by their own disparate paths to success in the industry.

The main topic of discussion was liquidity alternatives in private equity, a subject with which the participants – as buyers, sellers and/or securitisers of partnership interests – were intimately familiar. Chuck Flynn's Deutsche Bank recently completed the sale of $1.6bn worth of private equity portfolio companies in a secondary transaction to MidOcean Partners. John Wolak's Morgan Stanley is an active buyer of secondary interests alongside its primary fund investment program; his firm recently participated in a landmark securitisation of AIG's private equity portfolio. Sheryl Schwartz's pension is seeking to reduce the number of its GP relationships. And Michael Granoff's Pomona Capital rose to prominence in the market primarily through secondary fund management.

“Advantaged primaries”
The discussion kicked off with this question – where in the current range of liquidity options did the participants feel the most compelling opportunities lay?

From a buy-side perspective, Wolak, Schwartz and Flynn said they were intrigued by what Wolak referred to as “advantaged primaries” – partially funded interests in relatively new funds. They noted that the unprecedented level of supply in the secondary market was most acute for partnerships that have not made very many investments – the manifest consequence of having raised billions of dollars just as before the market started to collapse. They said buying a partially funded interest is, in effect, not dissimilar from making a primary commitment to a blind-pool fund, but with the benefit of extra visibility and several quarters of missed management and startup fees. Wolak said his group was focused on advantaged primaries because, “all other things being equal, you're further along the J-curve and that should have a positive effect on your IRR.”

interests in relatively new funds. They noted that the unprecedented level of supply in the secondary market was most acute for partnerships that have not made very many investments – the manifest consequence of having raised billions of dollars just as before the market started to collapse. They said buying a partially funded interest is, in effect, not dissimilar from making a primary commitment to a blind-pool fund, but with the benefit of extra visibility and several quarters of missed management and startup fees. Wolak said his group was focused on advantaged primaries because, “all other things being equal, you're further along the J-curve and that should have a positive effect on your IRR.” Schwartz said TIAA-CREF was seeking to increase its exposure to favored GP groups through the purchase of partially funded interests. “We can use it as a way to get into funds managed by GPs with which we want to establish or expand a relationship,” she said.

Granoff noted the plethora of under-funded partnership interests currently in the market, and worried that these represent a bubble in their own right. “Many of the people that invested in funds over the past couple of years are now among the formerly high net worth; they can't make the next capital call.”

Granoff also observed that the purchase of an immature fund interest is essentially taking over an obligation, rather than the purchase of a collection of assets. He admitted, though, that many of the mature fund interests currently for sale are not attractive. “We're in a perverse time,” he said. “On average, Pomona buys interests that are 80 per cent funded and are four or five years old. But now, sometimes when we look at assets, we like what we don't know better than what we do know, because what's funded doesn't look all that good.”

“Buying something that is five or ten per cent funded really is a blind-pool investment,” said Wolak. “It is a manager bet, not an asset bet. The bulge that was created in 2000 and 2001 is creating a lot of pressure. The size of the underfunded opportunity, perhaps, is transitory, but I don't know that it goes away completely.”

The waiting game
As potential sellers of secondary interests, the panelists were glum. Schwartz lamented the bargain-basement valuations currently being assigned to traditional secondary transactions. “For sellers, the difference between the bid-ask is too wide,” she said. “I'd rather wait until the market becomes more efficient.”

Not everyone agreed that waiting was the best policy. Wolak asked Schwartz if, like many LPs, her net asset value had been dropping quarter after quarter. “We're hoping that trend won't continue,” she said, drawing laughter.

“The decision to sell involves a fundamental view about the future,” continued Wolak. “For example, at a time when everyone saw their net asset value rising every quarter, people thought, well, I can't sell now. But if you look at the large-scale secondary sales that took place two years ago, the sellers are a lot happier than the buyers. They sold at a 15 per cent discount two years ago, and the net asset value has since declined 35 per cent. And the NAV has declined every quarter. The people who took that early haircut are looking awfully good. In fact, one of the sellers asked me if I thought he could get a bonus based on how much he had saved.”

There is no way to avoid reality

But Flynn, echoing Schwartz, noted that trends are not irreversible. “Just because the Nasdaq is currently off two-thirds does not automatically mean that it will be at 400 three years from now,” he said. “Most people who hold private equity will say that we've had a major one-time dislocation.”

Like Wolak, Granoff was pessimistic on the waitand-see approach to selling secondaries. “Private equity has a much longer digestive process than the public markets,” he said. “It's more likely, in my view, that net asset values over the next three quarters decline than rise, in some ways because of things that have already occurred. The tree has already fallen in the forest. We have people come to Pomona and say, ‘Gee, I don't want to sell at any discount.’ But they're basically taking a discount every quarter. And they've been taking it for the past couple of years. There is no way to avoid reality.”

Why has securitisation not taken off?
The most heated discussion formed around the topic of securitisation, that range of mechanisms for turning illiquid private equity partnerships into fungible fixed-income and other securities. Granoff was skeptical of securitisation's applicability to private equity in the near term. Schwartz, on the other hand, was puzzled as to why this technique was not more popular in the asset class. “I can't figure out why it hasn't taken off,” said Schwartz, herself a former structured-finance specialist. “The only thing I can conclude is that the fees of the underlying managers are exorbitant and, for the blind pool vehicles, you have to count on the fund of funds manager to select properly. But all of those things can be structured around.”

Schwartz noted the lack of enthusiastic buyers for securitised private equity. “One of the problems is that people who understand securitisation are from the fixed-income side, and the people who understand private equity are from private equity. So as far as getting people to buy [securitised private equity], there is a limited number of investors who have both skill sets.”

Gray counted his firm out as a potential buyer of securitised private equity. “It really doesn't work as a buyer unless you are willing to buy a whole portfolio,” he said. “We're cherry pickers. We've never bought a whole portfolio and we probably never will, for the simple reason that more than half of what is in a whole portfolio consists of things that we've looked at before and passed on.”

Wolak noted the unpredictable nature of distributions as one potential stumbling block in securitising an asset. “Part of the problem is that, unlike other securitisations, where you have contractual cash flow and well defined payment and amortisation schedules, you don't have that in private equity,” said Wolak. “The lack of distributions over the past couple of years has raised the question, ‘How does this thing really work?’”

Granoff took Wolak's comments a step further – securitisation does not work, he said, because securitisations to date have been structured and rated based on historical return data that painted a rosier picture than turned out to be the case. He described recent such deals as “not real securitisations” because the equity pieces – the riskiest, so-called “first loss” strips – were not sold.

“Today, the reason why securitisation hasn't worked is because the cash flows don't work,” Granoff said. “My own view is that the situation is going to get worse going forward, not better. If you asked me three years ago, based on our distribution flow, how much leverage our portfolio could support, I would say that it could support a lot of leverage. If you asked me that today based on recent distribution patterns, I would say a lot less leverage. That's true of everybody.”

Granoff warned that if distributions continued to dry up, the holders of securitised private equity may come to feel that the whole endeavour is a bit of a “shell game.”

Gray brought up another potential monkey wrench in the securitisation mechanism: “When you get a distribution in private equity, you don't always get to keep it. That's a complexity with private equity that doesn't exist with credit cards or houses, where there are no look-backs. I personally think private equity is a very dubious asset class to securitise.”

But Gray and Granoff met stiff resistance from Flynn and Schwartz, who described securitisation as a range of tools to help investors accomplish liquidity and capital-relief goals. Countered Schwartz: “The timing of the cash flows can be solved by having back-up credit facilities. That's not a credit risk; it's a timing risk which banks, for a price, will be willing to cover.”

Flynn sought to dispel the notion that securitisation always meant a top-tobottom repackaging of assets. “It's not a binary situation where you either choose to receive 70 cents on the dollar in the secondary market or leverage up the entire capital structure through a securitisation deal,” said Flynn. “There's a continuum. When I analyse the AIG transaction, I believe it proved to be a fantastic deal for their specific purposes. Securitisation does not mean that you have to drill all the way down. If the market at certain times bears a 70 per cent debt load, that might be the case. If the market at another time only bears 30 per cent, a good strategy would be to layer up the top 30 per cent with debt and keep the residual at the bottom as equity. So the degree of equity, just like with an LBO, can be totally dialed.”

Wolak noted that securitisations are not only designed to maximise returns. “You could argue on a purely economic basis that you still are holding the same risk, albeit more levered, after a securitisation,” he said. “But certain investors are able to characterise those as different securities within their portfolio, which frees up capital.”

Added Flynn: “There is a tremendous demand for capital relief. At Pomona, you're paid to be IRR investors. But particularly in the US, banks and major insurance companies, while not going against IRR, have larger corporate purposes around regulatory capital relief.”

All agreed that securitisation would likely become a standard feature in private equity if for no other reason than the large fees associated with these transactions. “People are very creative and can think of ways to solve the equation,” Granoff conceded. “Over the next several years, I wouldn't bet against human creativity to make money.”

Schwartz said the many concerns raised about securitisation were certainly surmountable. “I guess I'm much more optimistic about prospects for securitisation than you guys are,” she said. “I've seen other asset classes get securitised that have the same uncertain cash flows as private equity. There are enough fees involved to prompt people to find a way to make it happen.” Granoff: “That's why I think it happens in the long term.” Schwartz: “I don't think it will be so long.”

I love inefficiency
Participants remained agnostic as to whether they believed the current level of activity in the secondary and securitisation markets would translate into those liquidity options becoming more pervasive features of the private equity landscape. Wolak said securitisation could potentially grow into a tool for fundraising as well as active portfolio management. “I've had some conversations with bigname buyout firms that are interested in thinking about those kinds of ways of raising capital,” he said.

Wolak also said he has “mixed feelings” about the prospects of secondaries and securitisations become widely used tools. “From a buyer's perspective, I'm against anything that creates greater efficiency in this market,” he said. “One of the hallmarks of the private equity business is that it is an inefficient asset class. There should be a large bid-ask spread; there should be information dislocation. That's what makes it interesting and potentially very attractive from an investment perspective. On the other hand, as a fund of funds manager, it certainly would be nice to have a more active role in managing the portfolio on behalf of our clients.”

Gray said his firm would remain mostly uninterested in buying or selling secondary interests. “We concentrate much more on doing our due diligence up front so we don't get to that point,” he said. “If we do, frankly, we have to ask ourselves why we've failed. Either someone has lied to us about their intentions, or they've drifted fundamentally from what they did before.”

Flynn predicted and welcomed the growth of liquidity options. “It always surprises me that secondary money flow has not approached 10 per cent or 15 per cent of total traffic in private equity,” he said. “Listed equity managers – even legendary people who pen books on the subject – make the wrong decisions about 25 per cent to 30 per cent of the time. Even if you have the best managers in the private equity market, what is wrong with making bets that aren't so great, and having a mechanism to make those bets liquid? I believe that secondary money flows will double over the next few years from where they are now.”

Granoff said the continued growth of the secondary market would not come simply from the proliferation of “lousy funds,” but from the rise of motivated sellers. “We have bought interests from people who are selling for their own reasons, not because of what is going on in the funds,” he said, adding that there will never be any real demand for lousy funds, no matter what the discount offered. “In the end, our business is not based on realising your discount. It's not like buying distressed bonds where if it comes back to par you've made your money.”

Everyone agreed that liquidity options would always be better for larger than for smaller investors. Nevertheless high-net-worth investors would continue to find few buyers for their partnership interests The same economy of scale applies to securitisation, said Flynn: “There's the risk of the portfolio, then there's the ability to gauge and measure that risk. The flipside of private equity's inefficiency is that the fundamental information that you use to gauge the risk is significantly less than what you get in other asset classes. Those solutions push you further into larger transactions, where there is greater diversification. That seems to be the magic bullet on securitisation.”

The road ahead
Stated plainly, the secondary and securitisation markets partially answer the question, “What should I do with my existing investments?” At the end of the discussion, we asked our panelists to briefly summarise their strategies going forward: what did they intend to do with their fresh capital, and where did they see the best opportunities?

In five years people will write articles about the good deals that were done

Most agreed that today is a far better time to begin investing in private equity than two or three years ago. Valuations are down and the best GPs are much more focused deal fundamentals. Granoff hailed the lack of competing sources of growth capital in the market as an indication that now is a good time to have dry powder. “In four or five years, people will write articles about the good deals that were done,” he said.

This view was tempered by three points. Gray warned that if the lack of corporate acquisitions and nonexistence of the IPO market continued, it would mean that good deals would have few exit options. Gray also noted the ongoing lack of visibility for earnings. And Granoff predicted that while good deals would get done by good managers, a great deal of mediocre managers would experience “severe pain.”

Wolak, Granoff and Flynn expressed enthusiasm for the secondary market as an investment opportunity. “For the next three to five years, you cannot beat the secondary market,” said Flynn. “That to me, without a question, is the area with the most opportunity.”

Flynn had concern over the prospects for venture capital firms, while Gray said new technologies continued to hold forth the promise of a rebirth of that sector.

Where Gray differed from most of the participants was in expressing reservations over activity in Europe. “During the bubble, venture capital firms used to do five or six investments per quarter. Now we see that in Europe, even conservative buyout groups have gone from two to three investments per year to one per month. One has to ask whether Europe is getting a little on the frothy side.”

Some participants expressed cautious interest in Asia and Japan. But Granoff said the world beyond the US and “certain parts of Europe” was not worth the risk involved. “If you look back at all the experience of private equity and look at what works, private equity is not a global asset class if you want to make money. There's not really that much benefit to being global at the current time.”

All five stressed, however, that their focus was on managers first. Sectors and strategies are meaningless without the right group of GPs to execute on those strategies. Our roundtable LPs all said they looked primarily for a history of success. First-time fund managers, they said, should mostly look elsewhere for capital. “Unlike in the public markets, in this market, success breeds future success,” said Gray. “It is a cumulative process because of the contacts and reputation that accrues from success. The key is to pick groups that are successful but haven't peaked yet.”

As ever, the process of evaluating a management team in an attempt to pick the best group remains more of an art than a science. “At the end of the day, you never really know what's going on inside these firms, which is why you need to be diversified,” said Wolak. “You can do all the work, but then your GPs go out and do silly things. You are going to make mistakes.”

Do securitisations solve problems or defer them?
Flynn: There are always instances where investors say they are going to wait until the spreads narrow; that they are going to wait it out. But if an efficient method can be created to package your non-core funds that doesn't involve rapacious or exorbitant fees, that is something at least to consider.

Granoff: I must say I think it ends up in the same place.

Flynn: But you have a point of view because you're a secondary player, and every secondary player is paid to trash securitisations.

Granoff: Well, no. We have been approached by everybody to be a buyer of it. People are dying for us to be a buyer of the equity or the sub piece. But the answer is that there's no free lunch. If you take the strip off at the top and it's double-A rated, well, the equity is less valuable. So in the end, you can't say that you don't have to drill all the way down, because somebody has to own the bottom part of the pyramid.

How important are discounts on secondary purchases?
Schwartz: If it's a name we want to get into, we're willing to pay up. In one case, we paid par, because we didn't want anyone else to get it. The way we viewed it was that we saved on the management fee for a couple of years. The seller didn't show it to anyone but us, and we liked that.

Gray: I find it very difficult to pay X knowing the market is at fifty per cent of X.

Schwartz: I don't. Not for the top quality funds that we could not get the allocation we wanted during their fundraising. But I am not willing to pay up for just anyone. It's a very short list that we want a larger exposure to.

Wolak: I suspect Michael [Granoff] has a slightly higher cost of capital.

Granoff: [Laughs] I may have a slightly higher cost of capital. We always have a push and pull in my firm where the people responsible for sourcing deals never want me to say that we buy at discounts. They would like to say what Sheryl says: “We'll pay whatever it takes”

Are GPs cooperative on secondary transactions?
Granoff: I've seen the attitudes of general partners change pretty dramatically and now I must say that we get incredible cooperation from general partners. When I started doing this, a lot of general partners looked at it in somewhat of an egocentric way and said, “Well, someone may sell a position in your fund, but they'd never sell an interest in my fund.” GPs now also realise that it might even be a good thing. Maybe a liquidity mechanism brings in additional capital from people that would not have participated without it.

Flynn: They all want to know whether they're the loaf or the leaven. Are they just part of the mass of unwanted funds that you want to get rid of, or are they the more interesting fund that needs to be thrown in to make the whole basket interesting?

Wolak: I think GPs know it comes with the territory and their concern now is whether the buyer is going to actually make the capital calls.