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Anatomy of a secondary transaction and benefits of

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Activity in the secondary market for private equity has reached unprecedented levels and the recent growth rates show no signs of slowing. New participants enter the market on a daily basis and fund-raising, as well as deal flow levels, are white-hot. Not only has the secondary market established itself as permanent fixture within the alternative asset segment but participation appears to be virtually a must for all private equity industry participants, due to the clearly favorable returns vis-à-vis primary market investments. Accordingly, the secondary market – especially in the US – is becoming more competitive and efficient, clearly benefiting from the increasing involvement of qualified specialty advisers.

Overview of the secondary market for private equity
Over the past 20 years, private equity has been one of the fastest-growing segments of the financial market. Private equity firms have raised record amounts of capital from individuals and institutions. Recently, many investors have surpassed their allocation targets in light of dramatically reduced valuations and lack of exit opportunities. With little capacity for new commitments, many investors have become far more selective, which has created a tougher fund-raising market for private equity firms. A key part of that expansion is the unprecedented growth of the secondary market in private equity.
Transaction volume in the secondary market increased consistently during the previous five years from approximately $1.5bn in 1998 and will likely exceed $6bn for the first time in 2003. The main factors fuelling this growth included:
o The slowdown in distributions from venture and buyout funds
o The desire on the part of limited partners to manage port- folios more actively, i.e. modify investment allocations and strategies more flexibly
o The desire on the part of the investor to manage GP relationships more actively, i.e. to enter/ exit relationships more flexibly
o Changing legal, tax and regulatory framework in different jurisdictions
o Mergers and acquisitions by institutional and corporate parent companies and fund sponsors
o Changing needs of individual investors
Compared to primary private equity investments, secondary market transactions usually offer strikingly favorable return propositions to prospective buyers and generally yield key strategic advantages such as greater portfolio transparency and maturity. As a result, record amounts of dedicated secondary capital have been raised over the previous four years. Currently, the total amount of dedicated secondary capital exceeds $17bn and new participants continue to enter the market. Key to increased deal flow in the secondary market has recently been the significantly reduced time lag, ie, the average age of partnership interests sold. While the average age of limited partnership interests sold exceeded seven years in 1998, recent transactions included an increasing number of younger funds, averaging three to four years during the first half of 2003. As far as average deal sizes are concerned, transactions recently tend to be smaller due to the considerably increased activity by high net worth individuals, endowments and foundations. Nevertheless, top quartile deal sizes continue to average over $250m, which is not expected to change near term.

The “pension bomb”
Despite the increasing growth of the secondary market and the steady growth in the number of completed transactions across virtually all significant investor groups including Institutions, Corporations, Foundations and General Partners, one investor group has been largely absent from the secondary market to date despite their present precarious conditions: the 123 public pension systems in the US. As of August 2003, public pension systems in the US are underfunded by over $180bn. As a result of the combination of increased allocations to alternative investments, in conjunction with the challenging conditions in the public and private equity markets over the previous three years, losses faced by US pension systems exceed billions of dollars. In the aggregate, US public pension assets shrank 6% in 2002, while liabilities grew by over 10%. As a result, many pension systems significantly exceeded their allocations to alternative assets and private equity segments. In view of rising liquidity needs associated with increasing pension pay-outs, many pension systems currently face a dangerous dilemma, which is the need to actively manage their private equity portfolios despite the inherent characteristics of the asset class, ie, its long maturities and lack of liquidity. In order to return to targeted allocation levels and achieve liquidity quickly, these pension systems have recently evaluated the possibility of a transaction in the secondary market for private equity. Challenges that pension fund managers hereby need to overcome frequently include valuation misconceptions, as well as the lack of awareness of viable structuring options. Since the discontinuation of new investments is generally insufficient to ensure a return to allocation targets, a managed sale of private equity interests in the secondary market under the professional guidance of a qualified secondary advisor is increasingly understood to be the sole viable option for over-allocated public pension systems in the US.

Benefits of including a specialised secondary market adviser
Advisers help overcome major obstacles such as frequently high seller reluctance in view of pricing uncertainties and lack of awareness relative to the optimal transaction structure and management. Established players as well as new entrants know, transfers of limited partnership interests as well as portfolios of direct company interests can be a time consuming process that often requires complex structures given widely-varying legal, tax, and regulatory environments. Not unlike corporate M&A transactions, most secondary sellers are unfamiliar with the process as secondary transactions occur infrequently and the required up-to-date expertise of market conditions and participants is not always available in-house. Potential sellers often cite the lack of resources to allocate to the process, as well as the need for confidentiality and the growing concern of the “embarrassment factor” inherent in a sale below the fair secondary market value.
Qualified advisors facilitate transactions by providing a degree of standardisation and consistency to transaction management. They hereby address the market’s need for a more formal and systematic mechanism for the exchange of limited partnership interests and portfolios of direct company interests. Hereby, consistent methods of portfolio assessment and valuation are as much of interest as are professional and timely transaction execution.

The anatomy of a secondary market transaction
Secondary market advisory specialist firms manage all aspects of the secondary sale process and help accomplish widely varying investor objectives. These include the realisation of fair value for their investments, as well as the timely and professional completion of a transaction in a highly confidential manner. The transaction management is generally divided in three distinct phases, transaction origination, structuring, and execution.
Transaction origination: During this stage, advisors evaluate the specifics of the investor situation and motivation and determine the feasibility of a transaction. Here, it is important to analyse the specific objectives of the investor and to provide up to date information relative to current market conditions and recent realisations in the respective segment of the private equity industry.
Transaction structuring: In the structuring phase, good advisors determine the most efficient transaction structure within the respective legal, tax, and regulatory environment and creates an appropriate divestiture strategy with specific milestones and targets. Subsequently, advisors reach out to a salient group of highly motivated buyers, picked in conjunction with the seller, typically from a database of active purchasers around the world. Advisers usually organise a ‘managed auction’ to ensure best value for the selling client. This phase generally comprises three to four weeks.
Transaction management and execution: Upon completion of the determination of the optimal transaction structure, the completion of the relevant transaction due diligence and completion of a concise offering memorandum, advisers guide the sale process through the creation of the relevant legal agreements, eg, purchase and transfer agreements. Agreements can generally be drafted without outside legal counsel. To ensure efficient and timely execution, top advisors provide detailed guidance on all important required steps to execute the transfer. These include determination of the salient transfer conditions, including co-investor rights and consents and the receipt thereof.
Lawrence E Penn can be contacted on +1 212 332 7166

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