Private equity secondary market

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In finance, the private equity secondary market (also often called private equity secondaries or secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds.

Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private equity assets.

Driven by strong demand for private equity exposure, a significant amount of capital has been committed to dedicated secondary market funds from investors looking to increase and diversify their private equity exposure.

Contents 1 Secondary market participants 2 Types of secondary transactions 2.1 Sale of limited partnership interests 2.2 Sale of direct interests 3 History 3.1 Early history 3.2 2004 to 2007 3.3 Since 2008 and the credit crisis 3.4 Milestones 4 See also 5 References 5.1 Notes

Secondary market participants

As of 2009, it was estimated that there are dozens of dedicated firms and institutional investors that engage in the purchase of private equity interests in the secondary market with upwards of $30 billion of capital available for such transactions.^[1] The market for secondary interests is still highly fragmented. Leading secondary investment firms with current dedicated secondary capital in excess of circa $3 billion include: AlpInvest Partners, AXA Private Equity, Coller Capital, HarbourVest Partners, Lexington Partners, Pantheon Ventures, Partners Group, Neuberger Berman, and Paul Capital.^[2][3]

Other major independent secondary firms with circa $1–3 billion of current dedicated capital to secondaries include Adams Street Partners, Greenpark Capital, Landmark Partners, LGT Capital Partners, Newbury Partners, Pomona Capital, Saints Capital, and W Capital Partners.^[2][3]

Additionally, major investment banking firms including Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley have active secondary investment programs.^[3] Other institutional investors typically have appetite for secondary interests. More and more primary investors, whether private equity funds-of-funds or other institutional investors, also allocate some of their primary program to secondaries.

Within the secondary arena, certain smaller specialized firms, including Industry Ventures, Lake Street Capital, Nova Capital Management, Saints Capital, Sobera Capital, Verdane Capital, Vision Capital and W Capital, focus on purchasing portfolios of direct investments in operating companies, referred to as secondary directs. Other niches within the secondary market include purchases of interests in fund-of-funds and secondary funds (Montauk Triguard) and purchases of interests in real estate funds (Liquid Realty and Madison Harbor Capital).^[4]

While intermediation in the secondary market is still not as pervasive as in corporate mergers and acquisitions, leading advisors to secondary market sellers include investments banks (e.g., UBS, Credit Suisse, Lazard, Houlihan Lokey), dedicated boutique firms (e.g., Cogent Partners), electronic exchanges (e.g., NYPPEX, SecondMarket), as well as established fund placement agents (e.g., Campbell Lutyens, Park Hill Group, Probitas Partners, Triago). Since 2008, there have been a significant number of new entrants to this space, hoping to capitalize on what is perceived to be a growing market opportunity.

Types of secondary transactions

Secondary transactions can be generally split into two basic categories:

Sale of limited partnership interests

The most common secondary transaction, this category includes the sale of an investor's interest in a private equity fund or portfolio of interests in various funds through the transfer of the investor's limited partnership interest in the fund(s). Nearly all type of private equity funds (e.g., including buyout, growth equity, venture capital, mezzanine, distressed and real estate) can be sold in the secondary market. The transfer of the limited partnership interest typically will allow the investor to receive some liquidity for the funded investments as well as a release from any remaining unfunded obligations to the fund. In addition to traditional cash sales, sales of limited partnership interests are being consummated through a number of structured transactions:^[5]

• Structured joint ventures — Includes a wide variety of negotiated transactions between the buyer and seller that typically is customized to the specific needs of the buyer and seller. Typically, the buyer and seller agree on an economic arrangement that is more complex than a simple transfer of 100% ownership of the limited partnership interest.^[5]

• Securitization — An investor contributes its limited partnership interests into a new vehicle (a collateralized fund obligation vehicle) which in turn issues notes and generates partial liquidity for the seller. Typically, the investor will also sell a portion of the equity in the leveraged vehicle. Also referred to as a collateralized fund obligation vehicle.^[5]

• Stapled transactions — (commonly referred to as "stapled secondaries") Occurs when a private equity firm (the GP) is raising a new fund. A secondary buyer purchases an interest in an existing fund from a current investor and makes a new commitment to the new fund being raised by the GP.^[5] These transactions are often initiated by private equity firms during the fundraising process.^[6] They had become less and less frequent during 2008 and 2009 as the appetite for primary investments shrunk. Since 2009, a limited number of spinout transactions have been completed involving captive teams within financial institutions. ^[7][8][9]

Sale of direct interests

Secondary directs or synthetic secondaries — This category refers to the sale of portfolios of direct investments in operating companies, rather than limited partnership interests in investment funds. These portfolios historically have originated from either corporate development programs or large financial institutions. Typically, this category can be subdivided as follows:

• Secondary direct — The sale of a captive portfolio of direct investments to a secondary buyer that will either manage the investments themselves or arrange for a new manager for the investments.^[5] One of the most notable example of a corporate seller engaging into a direct portfolios sale is the two consecutive sales of direct portfolios from AEA Technology to Coller Capital and Vision Capital in 2005 and 2006 respectively.

• Synthetic secondary / spinout — Under a synthetic secondary transaction, secondary investors acquire an interest in a new limited partnership that is formed specifically to hold a portfolio of direct investments.^[5] Typically the manager of the new fund had historically managed the assets as a captive portfolio. The most notable example of this type of transaction is the spinout of MidOcean Partners from Deutsche Bank in 2003.

• Tail-end — This category typically refers to the sale of the remaining assets in a private equity fund that is approaching, or has exceeded, its anticipated life.^[5] A tail-end transaction allows the manager of the fund to achieve liquidity for the fund's investors.

• Structured secondary — This category typically refers to the structured sale of a portfolio of private equity fund interests whereby the seller keeps some/all of the fund interests on its balance sheet but the buyer agrees to fund all future capital calls of the seller's portfolio in exchange for a preferred return secured against future distributions of the seller's portfolio. These type of secondary transactions have becoming increasingly explored since mid 2008 and throughout 2009 as many sellers did not want to take a loss through a straight sale of their portfolio at a steep discount but instead were ready to abandon some of the future upside in exchange for a bridge of the uncalled capital commitments.

History

History of private equity and venture capital

Early history (Origins of modern private equity) • The 1980s (LBO boom) • The 1990s (LBO bust and the VC bubble) • The 2000s (Dot-com bubble to the credit crunch)

Early history

The Venture Capital Fund of America (today VCFA Group), founded in 1982 by Dayton Carr, was likely the first investment firm ^[10] to begin purchasing private equity interests in existing venture capital, leveraged buyout and mezzanine funds, as well as direct secondary interests in private companies. Early pioneers in the secondary market include Jeremy Coller, the founder of UK-based Coller Capital, Arnaud Isnard, who worked with Carr at VCFA and would later form ARCIS, a secondary firm based in France^[11] as well as Stanley Alfeld, founder of Landmark Partners.^[12]

In the years immediately following the dot-com crash, many investors sought an early exit from their outstanding commitments to the private equity asset class, particularly venture capital.^[13] As a result, the nascent secondary market became an increasingly active sector within private equity in these years.^[14][15] Secondary transaction volume increased from historical levels of 2% or 3% of private equity commitments to 5% of the addressable market.^[16][17][18] Many of the largest financial institutions (e.g., Deutsche Bank, Abbey National, UBS AG) sold portfolios of direct investments and “pay-to-play” funds portfolios that were typically used as a means to gain entry to lucrative leveraged finance and mergers and acquisitions assignments but had created hundreds of millions of dollars of losses.

2004 to 2007

The surge in activity in the secondary market, between 2004 and 2007, prompted new entrants to the market. It was during this time that the market evolved from what had previously been a relatively small niche into a functioning and important area of the private equity industry. Prior to 2004, the market was still characterized by limited liquidity and distressed prices with private equity funds trading at significant discounts to fair value.^[19] Beginning in 2004 and extending through 2007, the secondary market transformed into a more efficient market in which assets for the first time traded at or above their estimated fair values and liquidity increased dramatically. During these years, the secondary market transitioned from a niche sub-category in which the majority of sellers were distressed to an active market with ample supply of assets and numerous market participants.^[20] By 2006, active portfolio management had become far more common in the increasingly developed secondary market, and an increasing number of investors had begun to pursue secondary sales to rebalance their private equity portfolios. The continued evolution of the private equity secondary market reflected the maturation and evolution of the larger private equity industry.

Since 2008 and the credit crisis

The secondary market for private equity interests has entered a new phase in 2008 with the onset and acceleration of the credit crunch. Pricing in the market fell steadily throughout 2008 as the supply of interests began to greatly outstrip demand and the outlook for leveraged buyout and other private equity investments worsened. Financial institutions, including Citigroup and ABN AMRO as well as affiliates of AIG and Macquarie were prominent sellers.

With the crash in global markets from in the fall of 2008, more sellers entered the market including publicly traded private equity vehicles, endowments, foundations and pension funds. Many sellers were facing significant overcommittments to their private equity programs and in certain cases significant unfunded commitments to new private equity funds were prompting liquidity concerns.^[21] With the dramatic increase in the number of distressed sellers entering the market at the same time, the pricing level in the secondary market dropped rapidly. In these transactions, sellers were willing to accept major discounts to current valuations (typically in reference to the previous quarterly net asset value published by the underlying private equity fund manager) as they faced the prospect of further asset write-downs in their existing portfolios or as they had to achieve liquidity under a limited amount of time.

At the same time, the outlook for buyers became more uncertain and a number of prominent secondary players were slow to purchase assets. In certain cases, buyers that had agreed to secondary purchases began to exercise material adverse change (MAC) clauses in their contracts to walk away from deals that they had agreed to only weeks before.^[22]

Private equity fund managers published their December 2008 valuations with substantial write-downs to reflect the falling value of the underlying companies. As a result, the discount to Net Asset Value offered by buyers to sellers of such assets was reduced. However, activity in the secondary market fell dramatically from 2008 levels as market participants continued to struggle to agree on price. Reflecting the gains in the public equity markets since the end of the first quarter, the dynamics in the secondary market continued to evolve. Certain buyers that had been reluctant to invest earlier in the year began to return and non-traditional investors were more active, particularly for unfunded commitments, than they had been in previous years.

Since mid-2010, the secondary market has seen increased levels of activity resulting from improved pricing conditions. Through the middle of 2011, the level of activity has continued to remain at elevated levels as sellers have entered the market with large portfolios. Also, since middle of 2009, secondary investment firms have been one of the key recipient of the improved private equity fundraising market conditions. Several fund managers have raised dedicated secondary funds, sometimes exceeding their fundraising targets.^[23][24]

Milestones

The following is a timeline of some of the most notable secondary transactions and other milestones:

2011

• AXA Private Equity completes a series of large portfolio purchases including $1.7 billion of private equity fund assets from Citigroup^[25] and $740 million of fund assets from Barclays.^[26]
• CalPERS sells an $800 million portfolio of private equity funds to AlpInvest Partners.^[27]

2010

• Lloyd's sells a portfolio comprising 33 funds interests, primarily European mid-market funds, for a value of $730m to Lexington Partners.^[28] In a separate transaction Lloyds sells a £480 million portfolio to Coller Capital through a joint venture.^[29]

• Citigroup sells a $1 billion portfolio of funds interests and co-investments to Lexington Partners. As part of the deal, StepStone Group will take over management of a portfolio of funds-of-funds and buyout co-investments previously run by Citi Private Equity .^[30]
• Bank of America sells a portfolio comprising 60 funds interests for a value of $1.9 billion to AXA Private Equity.^[31]

2009

• 3i sells its European venture capital portfolio comprising interests in 30 companies for $220m to DFJ Esprit, a venture capital fund backed by two global private equity investors - HarbourVest Partners and Coller Capital.^[32]
• APEN (fka AIG Private Equity) refinances its private equity fund portfolio through a $225m structured secondary transaction led by Fortress Investment Group.^[33][34]

2008

• ABN AMRO sells a portfolio of private equity interests in 32 European companies managed by AAC Capital Partners to a consortium comprising Goldman Sachs, AlpInvest Partners, and CPP for $1.5 billion.^[35][36]

• Macquarie Capital Alliance, in June 2008, announced a takeover offer from a consortium of private equity secondary firms including AlpInvest Partners, HarbourVest Partners, Pantheon Ventures, Partners Group, Paul Capital, Portfolio Advisors, and Procific (a subsidiary of the Abu Dhabi Investment Authority) in one of the first public to private transactions of a publicly traded private equity company completed by secondary market investors.^[37][38]

2007

• California Public Employees' Retirement System (CalPERS) agrees to the sale of $2.1 billion portfolio of legacy private equity funds at the end of 2007, after a process that had lasted more than a year.^[39] The buying group included Oak Hill Investment Management, Conversus Capital, Lexington Partners, HarbourVest, Coller Capital, and Pantheon Ventures.^[40][41]
• Coller Capital completes $4.8 billion fundraising and Lexington Partners completes $3.8 billion fundraising for their newest funds, the largest and second largest funds raised to date in the secondary market^[42][43]
• Ohio Bureau of Workers' Compensation sells a $400 million portfolio of private equity fund interests to Pomona Capital ^[44][45]
• MetLife sells a $400 million portfolio of private equity fund interests to CSFB Strategic Partners^[46]
• Bank of America completes the spin-out of BA Venture Partners to form Scale Venture Partners, which was funded by an undisclosed consortium of secondary investors

2006

• Goldman Sachs Vintage Funds purchases a $1.4 billion private equity portfolio (fund and direct interests) from Mellon Financial Corporation, following the announcement of Mellon's merger with Bank of New York^[47]
• American Capital Strategies sells a $1 billion portfolio of investments to a consortium of secondary buyers including HarbourVest Partners, Lexington Partners and Partners Group^[48][49][50]
• Bank of America completes the spin-out of BA Capital Europe to form Argan Capital, which was funded by an undisclosed consortium of secondary investors
• JPMorgan Chase completes the sale of a $900 million interest in JPMP Global Fund to a consortium of secondary investors
• Temasek Holdings completes $810 million securitization of a portfolio of 46 private equity funds^[51]
• The Equitable Life Assurance Society completes the £435 million sale of a portfolio of 10 real estate secondaries to Liquid Realty Partners ^[52]

2005

• Dresdner Bank sells a $1.4 billion private equity funds portfolio to AIG
• Lexington Partners and AlpInvest Partners acquired a portfolio of private equity fund interests from Dayton Power & Light, an Ohio-based electric utility^[53][54][55]
• Merrill Lynch completes the sale of a 20 fund portfolio of private equity funds to Lexington Partners^[56]

2004

• Bank One sells a $1 billion portfolio of private equity fund interests to Landmark Partners
• The State of Connecticut Retirement and Trust completes the sale of a portfolio of private equity funds interests to Coller Capital, representing one of the first secondary market sales by a US pension fund
• Abbey National plc completes the sale of £748m ($1.33 billion) of LP interests in 41 private equity funds and 16 interests private European companies, to Coller Capital ^[57]
• Swiss Life sold more than 40 fund and direct investments to Pantheon Ventures^[58]

2003

• HarbourVest acquires a $1.3 billion of private equity fund interests in over 50 funds from UBS AG through a joint venture transaction ^[59]
• Deutsche Bank sells a $2 billion investment portfolio to a consortium of secondary investors that would become MidOcean Partners

2002

• W Capital, first fund developed to purchase direct company positions on a secondary basis, formed ^[60]

2001

• Coller Capital acquires 27 companies owned by Lucent Technologies, kick-starting the evolution of the market for "secondary direct" or "synthetic secondary" interests.^[61]

2000

• Lexington Partners and Hamilton Lane acquire $500 million portfolio of private equity funds interests from Chase Capital Partners
• Coller Capital and Lexington Partners complete the purchase of over 250 direct equity investments valued at nearly $1 billion from National Westminster Bank^[62]

1999

• The Crossroads Group, which was subsequently acquired by Lehman Brothers, acquired a $340 million portfolio of direct investments in large- to mid-cap companies from Electronic Data Systems (EDS)^[63][64]

1998

• Coller Capital launches the first globally focused secondaries fund

1997

• Secondary volume estimated to exceed $1 billion for first time

1994

• Lexington Partners founded by former Landmark Partners professionals Brent Nicklas and Richard Lichter (currently Newbury Partners)^[65]
• Coller Capital launches Europe's first secondary fund

1992

• Landmark Partners acquires $157 million of LBO fund interests from Westinghouse Credit Corporation

1991

• Paul Capital founded and acquires $85 million venture portfolio from Hillman Ventures

1989

• Coller Capital founded by Jeremy Coller
• Landmark Partners founded by Stanley Alfeld, John A. Griner III and Brent Nicklas

1982

• Venture Capital Fund of America founded by Dayton Carr

See also

• Private equity
• List of private equity firms
• Venture capital
• Firstpex
• History of private equity and venture capital

References

Notes

Topics on private equity and venture capital Basic investment types Buyout • Venture • Mezzanine • Growth • Secondaries • Equity co-investment History History of private equity and venture capital • Early history of private equity • Private equity in the 1980s • Private equity in the 1990s • Private equity in the 2000s Terms and concepts Buyout Financial sponsor • Management buyout • Divisional buyout • Buy–sell agreement Venture Seed money • Startup company • Angel investor • Venture capital financing • Pre-money valuation • Post-money valuation • Venture round • Venture debt • Bootstrap funding Structure Private equity firms and funds • Limited partnership • Limited liability company • Carried interest  • Management fee • Publicly traded private equity (Business Development Company, Venture capital trust) • Private investment in public equity (PIPE) • Pledge fund Investors Corporations • Institutional investors • Pension funds • Insurance companies • Fund of funds • Endowments • Foundations • Investment banks • Merchant banks • Commercial banks • High-net-worth individuals • Family offices • Sovereign wealth funds Related financial terms Undercapitalization • Initial public offering (IPO) • M&A • Leverage • High-yield debt • Capital structure • Capital call • EBITDA • IRR • Envy ratio Private equity and venture capital investors • Private equity firms • Venture capital firms • Angel investors • Portfolio companies