Secondhand deals - how attractive?
A fund of funds approach is often advocated as the best way to dip a toe into private equity. This can, however, just lead to very average returns as investment is diversified across a wide range of managers, with the added cost of the extra layer of management added in.
There is another alternative that aims at the same objective of diversification, but with a number of advantages, including arguably a better return profile. This is investing in a secondary private equity fund, which purchases interests in existing private equity funds from investors seeking liquidity. Secondaries can be attractive investments in their own right, as well as an integral part of a private equity portfolio.
Growth of secondary market
Whilst secondary transactions have been occurring for at least a decade, their recent rapid rise in number results from the massive expansion of the overall private equity industry over the last decade. Many initial investors have changed their strategies and, as a result, are seeking to divest themselves of their private equity portfolios. The growth of secondaries looks to be a permanent feature of the market, as it acts as a lubricant for both buyers and sellers of private equity, adding to the attractiveness and liquidity of the primary market by providing an alternative way of divesting private equity assets when flotations and trade sales are difficult or not the exit of choice.
Interest in the sector has increased tremendously, with London-based Coller Capital, a specialist secondaries investment manager, raising $2.6bn (E2.1bn) at the end of 2002 from institutional investors, shattering its $1bn target. Beside the specialist secondary investment managers, a number of mainstream private equity houses have also targeted the area – HarbourVest, Goldman Sachs, and CSFB for example – and this trend will certainly continue.
The returns in a secondary portfolio are clearly dependent on the prices at which assets are bought. Some commentators have characterised the growth of the market as being fuelled by motivated sellers willing to sell assets at large discounts to achieve liquidity – their concern being that the amount of money currently being targeted at secondary transactions is making the market increasingly competitive and driving prices up.
The argument against this is that price is still only one factor. The more successful secondaries players are able to offer sellers valuable benefits in terms of their ability to purchase complete portfolios swiftly and with a high confidence of closure. The market should therefore expand as more holders of private equity portfolios recognise this as an option. Clearly, as the market becomes more competitive, there will be more of a premium attached to players with a strong track record and this may cause a shake-out of some of the more recent entrants.
The risk profile of a secondary fund is generally more attractive for many investors. In a traditional private equity investment, either in a fund or a fund of funds, the lifetime is typically set at 10 years, with limited one year extensions, and positive returns are usually only seen after five to six years. The highest risks are in the early years when some investments may be written off, giving a ‘J’ curve profile. A secondary fund would typically invest in funds three to five years into their life when the bulk of the capital commitments have already been invested, avoiding the trough of the ‘J’ curve to obtain a reduced risk and if, as often the case, the assets are purchased at a discount, good returns. Typically, the secondary fund would be fully invested in three years and cashed out in five to six years, which would be beyond the stated 10-year lifetime of the original funds. Such a strategy, secondary managers claim, should give more consistent returns than can be expected in the primary private equity markets. Indeed, Stephan Breban from consultants Watson Wyatt thinks that secondaries offer a far greater opportunity for better returns, although he argues that there are also risks – you need to ensure pricing is disciplined and current market conditions are not conducive to such discipline at the moment.
From an institutional investor’s viewpoint, a key distinction between investment in a fund of private equity funds and investment in a secondary fund is that in the former the investor is taking a risk on the selection of managers, whilst in the latter, the risk is on the selection of assets. However, as Breban argues, secondaries are designed to be opportunistic in their search for exceptional returns; they are not designed to give a balanced exposure to the opportunity set and can be skewed in one direction or another, unlike a fund of funds with 10-20 individual funds. Whilst secondaries have a very important part to play in a portfolio, Breban favours combining them with other investments. However, a client could use, say, three different secondary funds as an alternative to a traditional fund of funds eg, a venture capital, a US and a European specialist rather than one secondary on a stand-alone basis.
For the secondary manager, the critical ability is that of being able to price whole portfolios of illiquid assets in a market characterised by a fundamental lack of transparency. Long-established players large enough to have seen many transactions have built up detailed databases of private equity funds and the prices at which assets within them have been sold.
Secondary investment deal flow is driven by a number of factors and, interestingly enough, many assets are not put up directly for auction. General partners are often reluctant to reveal confidential company information on their portfolios to the marketplace. The recent acquisition of Abbey National’s portfolio of private equity by Coller Capital was a case in point. The assets were largely European buy-outs that Abbey National had been selling off in dribs and drabs over the last year or two, following its decision to quit the private equity business. Coller were able to use their own database of fund valuations to offer Abbey a ‘clean break’ solution, acquiring the rump of the portfolio at one go. Clearly, the terms were attractive enough for Abbey National to agree to the transaction.
The bulk of activity by a secondary fund is buying positions in other funds from original investors. The other class of business is buying total portfolios of corporate investments in private equity, typically because the company has decided for strategic reasons to divest itself of private equity investments. The acquisition of Lucent’s portfolio of technology investments in 2001, again by Coller Capital, was the first significant example of this. As in a fund of funds structure, the relationship between the general partners and the management of the companies in which they invest would be unchanged in a secondary fund. The secondary manager is usually replacing an existing institutional investor’s holdings in a variety of individual funds, rather than investing directly. A secondary player, like a fund of funds player, typically waits till at least 75% of its fund had been invested before raising more capital.
Why would someone wish to sell a private equity portfolio? There is a variety of reasons that motivate sellers. Some institutional investors make strategic decisions to shift out of private equity, as the Shell pension fund in the US did in the early 1990s. Banking institutions are currently a major source of deal flow, as many built up their private equity capabilities, only to reconsider as the economic environment changed or following M & A activity. Royal Bank of Scotland, when they acquired NatWest, found themselves in possession of a private equity portfolio in addition to their own large private equity business. The former was sold off as a secondary – its captive manager becoming Bridgepoint.
Most banks would view private equity as a non-core business, with perhaps only a couple of the banking groups in the UK, for example, able to claim that they have integrated private equity with corporate lending. As a result, they can find it hard to justify the management resources spent in administering an illiquid portfolio of assets. For insurance companies, by contrast, there is a stronger rationale for having private equity portfolios alongside investments in listed equities although often, illiquid investments have accumulated over long periods and again may not justify the management time devoted to them.
The secondaries market can become an active portfolio management tool for existing private equity investors and for new investors to develop a portfolio of investments with a more acceptable cashflow profile than the ‘J’ curve obtained from a new private equity fund or fund of funds.
New investors, as well as existing owners of private equity portfolios, need to be aware of the secondary market as an integral part of their investment, risk management and divestment strategies. As well as players in the primary market who have begun to target the secondary market, there are some well established specialist secondary managers and new entrants appearing on a regular basis. As the market becomes more competitive and efficient, the winners are still likely to be those managers with a good track record and a good database!
Alan Briefel is managing director and Joseph Mariathasan is a consultant with StratCom in London