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News April 18, 2011 Issue

The Inside Scoop On The Private Equity Secondary Market

Just when you werenít thinking about that sleepy little lockup that still has five years to go, it turns out your illiquid investment might have a few lives left in it yet.

Whether youíre managing your own private equity fund or are an investor in others, the private equity secondary market is thriving, and it could be for you.

A ten year commitment in a private equity fund Ė and possibly up to twelve years if the fund exercises extension options Ė can turn out to be a long time for investors, especially when fortunes change as quickly as the markets. In response to this dilemma, an active and growing market for existing investor commitments in private equity funds had developed. The private equity secondary market, where transactions are referred to simply as "secondaries," is a viable option for buyers seeking private equity exposure and sellers seeking to reduce risk and reallocate portfolios.

A variety of independent players are active in the private equity secondary market. Well-known names such as Adams Street Partners, Pomona Capital, AXA Private Equity, HarbourVest Partners, AlpInvest Partners, Greenpark Capital, and Landmark Partners are among firms dominating the secondaries scene. According to Private Equity Intelligence, heavy hitters such as Goldman Sachs, Credit Suisse, JP Morgan Chase, Deutsche Bank, and Morgan Stanley have active secondary programs.

The transactions are not straightforward buying and selling propositions like stock market transactions. Private equity secondaries involve extensive due diligence, as well as negotiations between the buyer and seller and approval from the fundís general partner (GP).

Hirschler Fleischer partner Brian Farmer spoke about the history of the private equity secondaries market and offered some tips for buyers, sellers, and fund managers alike.

In the past seven years or so, a strong secondary market has developed for private equity fund interests, said Farmer. Cogent Partners, one of the leading investment banks serving the secondary market, reported $20 billion in secondary transactions last year. This year, the market is expected to be the same or larger.

Secondary interests are typically priced based on a percentage of their net asset value (NAV), commonly the value of the interest under GAAP or similar standards as reported by the fundís GP. Many secondary interests currently trade in a range of 85-95 percent of NAV. During the financial crisis, however, interests were trading at 60 percent of NAV and even lower.

In 2007 and 2008 the market also saw the rise of "stapled" transactions. In a stapled transaction, the fundís GP would permit the transfer of interests provided the buyer committed to the GPís next fund. These types of conditions were not well received by secondary sellers, who were looking for easy, clean routes to liquidity. Secondary buyers reacted similarly, viewing the stapled transactions as a bit of a "stick up." For these and other reasons, stapled transactions have been on the decline recently.

During the financial crisis, the market imbalances made pricing on secondary sales of private equity interests very attractive. As a result, fund-raising by secondary funds Ė the main buyers of secondaries Ė reached an all-time high in 2009. Twenty-one secondary funds raised $22.8 billion in commitments that year, according to [alt-investment research firm] Preqin. When liquidity returned to the markets beginning in late 2009, pricing of secondary interests rebounded. Consequently, last year saw a decrease in secondary commitments raised, down to $10.8 billion raised by sixteen funds.

Secondaries rarely happen early in a private equity fundís life. Besides the ordinary two-year holding requirement under the securities laws, too much uncertainty exists about the fundís ultimate success and the risks are too great.

The earlier an investor attempts to sell fund interests in the secondary market, the greater the discount. More capital remains to be drawn, and more doubt remains about what the fundís ultimate investments will be. Unmet capital calls are a contingent liability that prevents the buyer from possibly selecting other investment opportunities. The market will factor that uncertainty into the value of the fund interest as a discount to NAV.

It is more common that in the mid-to-later life of a fund, when 40-80 percent of the capital commitments have been called and deployed, that a secondary market in fund interests will be most active.

Not every private equity fund can attract interest in the secondary market, either. Only the "blue chip" fund managers offering their third, fourth, fifth or later funds, with a proven track record, are prime secondary market candidates.

Other types of secondaries exist as well, said Farmer. For example, near the end of a fundís life, the GP might seek to sell the remainder of its portfolio in a transaction called a secondary direct. Pension plans as well as secondary funds have been buyers of secondary directs.

Reasons to take the secondaries plunge:

Rebalancing.

Like any portfolioís investment allocation, market activity can skew relative values in asset classes, requiring the portfolio to be rebalanced. Oftentimes, an institutional investorís exposure to private equity investments may be determined to be too high, or remaining capital commitments need to be reduced. Such investors may announce the availability of certain of their private equity interests. Buyers willing to assume those obligations can find value in taking the commitments off an investorís hands.

Meeting successful managers.

The secondary market is also a way for investors to be introduced to particular fund managers. Access to the best fund managers is often difficult due to competition among investors; secondaries offer a possible entry point. Regulation D restrictions may also limit access to top quality managers. Buyers can be introduced to such managers and given access to those managersí future offerings by purchasing secondary interests.

Where can a prospective secondary investor get into trouble?

Timing can be your enemy.

There are big timing issues in secondary investments, said Farmer. Typically the GP provides a NAV every quarter, and secondary interests are priced from that, adjusted for distributions and capital contributions since that date.

The closing of a secondary transaction most often happens at the end of the following quarter. The farther an investor gets from a pricing date, the more uncertain is the information underlying the purchase decision. As a result, thereís an optimal window for such transactions each quarter.

Secondaries can be Ďsign-and-closeí transactions or Ďsign-and-close-laterí transactions. The purchase and sale agreement between the buyer and seller will typically contain a material adverse change (MAC) clause in the delayed transactions. A seller will want to be careful not to lock up an asset it believes to be committed, only for the buyer ultimately to walk away from the deal based on a MAC clause. Therefore, sellers must be careful not to allow negotiations to turn the buyerís commitment into an option rather than an obligation.

The structure of the investment may need to be changed.

Tax-exempt or offshore investors often hold fund interests through special purpose investment vehicles separate from the main fund. These vehicles may not be suitable for other investors, however. The structure of the investment may need to change for the buyer and the time necessary to do so should be factored into the transaction.

Buyer and seller considerations.

The seller should be comfortable that the buyer can meet any remaining capital commitments on the interest. This may require review of the buyerís financial statements or other due diligence on the buyer.

Negotiation of the representations and warranties that buyers and sellers must make can be complicated.

The buyerís objective is to obtain maximum assurance that there are no problems with a fund in which it is about to invest. A seller would be foolish to give a blanket representation that no problems exist, since the seller is a passive investor. The sellerís goal is to represent that the seller has given the buyer accurate and complete copies of all information on the fund received from the fundís GP, but to avoid significantly broader representations.

Tax obligations are also subject to negotiation. Depending on the timing of a transaction, a seller can be allocated taxable income even though the buyer received the distribution associated with that taxable income. Certain tax-exempt investors, such as pension funds and endowments, may be indifferent to those issues. Where a party is not in tax-exempt status, however, it must be addressed.

Fund claw-back rights.

Some negotiations may involve responsibilities related to fund claw-backs. For example, when a fund sells a portfolio company, the profit is then distributed to investors. If a future event results in a fund liability to the purchaser of the portfolio company, the fund may "claw back" some of the investorís distributions. The fundís governing documents typically allow this. The buyer must ensure that the seller remains responsible for any claw-back based on a distribution received by the seller.

Things to watch out for when negotiating a secondary with a GP.

The fundís GP typically has the right to veto a transfer of interests, said Farmer. A chief concern is the creditworthiness of the buyer, who must be able to make the remaining capital commitments.

The GP generally requires both the buyer and seller to remain jointly and severally liable for funding remaining capital commitments, as well as anything "bad" that might happen related to the transfer. The GP will seek to require full indemnity from both buyer and seller on these risks. With some exceptions, the GP usually gets that, said Farmer.

The buyer and seller negotiate a separate purchase document to allocate risks and various responsibilities among them. The sellerís goal is to convert its investment into a liquid asset with the least remaining liability. The buyer seeks to ensure it avoids any "overhanging" seller liabilities.

A basic purchase and sale agreement was developed several years ago by a law firm active with secondary market transactions. It is not a "model" document, but has become something of a standard starting point. While the fundís GP has no involvement in the separate negotiations between the buyer and seller, the purchase and sale agreement is often referenced in the GPís approval of the transfer, and the GP knows itís there, he said.

With regard to the GPís form of approval, each GP tends to create its own approval letters and that document is less standard. The GP letter is also far less negotiable. Tax indemnifications and seller back-up liability to the fund for buyer defaults are two areas where GPs typically will not be flexible. Most negotiation occurs between the buyer and seller.

What is the CCOís role in these transactions?

Some of the CCOís responsibilities include the following:

  • Secondary transactions require extensive due diligence. Buyers must learn about the fund and the manager. Sellers must ensure the buyer can meet remaining commitments.
  • The legal risks of the transaction must be evaluated.
  • A prospective buyerís obligations to its own investors or clients must be considered. For example, if an adviser buys a secondary interest for clients, the adviser must ensure the fund can provide timely financial statements to investors, as a buyer it must ensure it receives financial statements so that the adviser can comply with client custody rules.
  • The same is true for valuation responsibilities. A commitment by the adviser to provide quarterly valuations to clients means the fund that was the subject of the secondary must also be capable of providing quarterly valuations.
  • The adviser must also make sure the fund can meet any deadlines the adviserís clients have for completing their tax reporting.
  • Advisers must be careful that a private equity fundís confidentiality restrictions donít prevent the adviser from providing essential information on the fundís performance and investments to the adviserís clients.