PE1      Private Equity Secondary Market  PE2 Valuation Analysis                                                          ...
© 2010 by Arnaud van Tichelen. All rights reserved. This work is registered with the UK Copyright Service:Registration No:...
                                                                                                        ‐ 2 ‐ CONTRIBUTORS...
W e a r e pro ud to h av e as s is t ed w i th th is s tud y . W e b e li e ve i t pro v i des an e xc elle n t pr imer to...
     We leverage our network and expertise to help limited     partners achieve their private equity allocation     object...
-3-ABSTRACT       During the current liquidity crisis, the Private Equity industry has been reshaped andexperienced a sign...
-4-CONTENTS    CONTRIBUTORS OF THE STUDY.....................................................................................
-5-            1.5.1 The beginning of the market (1982-2002).......................... 41            1.5.2 The growth of t...
-6-               3.2.1 The contingent conditions ......................................................... 60            ...
-7-            1.1.4 The valuation depends on the vintage year of the fund . 80     1.2.   Listed Private Equity funds ......
-8-                         3.3.4 The lag of the NAV ........................................................................
-9-TABLE OF FIGURESFigure 1: Structure of the study .........................................................................
- 10 -Figure 26: Total return swaps for a portfolio of limited partnership interests ....................... 53Figure 27: ...
- 11 -LIST OF TABLESTable 1: Financial advisers in the secondary market .....................................................
- 12 -ABBREVIATIONS AND SYMBOLSASCRI    Asociación Española de entidades de Capital Riesgo (SPAIN)AVCJ     Asian Venture C...
NEED LIQUIDITY?                                     the marketplace for alternative assets                                ...
“You may like our performance, you may not like our performance, but you’re my                                            ...
PART I:INTRODUCTION
I.     Introduction                                                                 - 15 -I. INTRODUCTION         During t...
I.      Introduction                                                                 - 16 -processes (II.2) as well as tax...
PART II:CHARACTERISTICS OF THE PRIVATE    EQUITY SECONDARY MARKET
II. Characteristics of the Private Equity secondary market                                     - 18 -II. CHARACTERISTICS O...
II. Characteristics of the Private Equity secondary market                               - 19 -the LPs and GPs. It describ...
II. Characteristics of the Private Equity secondary market                                         - 20 -Figure 3: Raised ...
II. Characteristics of the Private Equity secondary market                                         - 21 -                 ...
II. Characteristics of the Private Equity secondary market                 cs                                             ...
II. Characteristics of the Private Equity secondary market                                          - 23 -Figure 6: Volume...
II. Characteristics of the Private Equity secondary market                                        - 24 -        money than...
II. Characteristics of the Private Equity secondary marketFigure 7: Reasons that motivate the sellers in the market (2007/...
II. Characteristics of the Private Equity secondary market                                        - 26 -Figure 8: Reasons ...
II. Characteristics of the Private Equity secondary market                                        - 27 -Figure 9: Secondar...
II. Characteristics of the Private Equity secondary market                          - 28 -At the beginning of the investme...
II. Characteristics of the Private Equity secondary market                 cs                                             ...
II. Characteristics of the Private Equity secondary market                                        - 30 -Preqin, 47% of cur...
II. Characteristics of the Private Equity secondary market                                      - 31 -gathered for this an...
II. Characteristics of the Private Equity secondary market                                          - 32 -He also advises ...
II. Characteristics of the Private Equity secondary market                                   - 33 -                       ...
II. Characteristics of the Private Equity secondary market                                 - 34 -     •   Banks36: These e...
II. Characteristics of the Private Equity secondary market                                      - 35 -         from reduct...
II. Characteristics of the Private Equity secondary market                 cs                                             ...
II. Characteristics of the Private Equity secondary market                                - 37 -        Table 3: The ten l...
II. Characteristics of the Private Equity secondary market                                   - 38 -Figure 14: Non-traditio...
II. Characteristics of the Private Equity secondary market                                     - 39 -Partnerships that uti...
II. Characteristics of the Private Equity secondary market                                    - 40 -                 1.5. ...
II. Characteristics of the Private Equity secondary market                                     - 41 -                     ...
II. Characteristics of the Private Equity secondary market                                       - 42 -Figure 16: The begi...
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  1. 1. PE1 Private Equity Secondary Market PE2 Valuation Analysis Arnaud van TichelenC ARACALLA SCALNAR S P A R T E R ICADE, Faculty Advisor: Rocío Sáenz-Díez London, September 2010 TM the marketplace for alternative investments
  2. 2. © 2010 by Arnaud van Tichelen. All rights reserved. This work is registered with the UK Copyright Service:Registration No: 96521. Short sections of text not to exceed two paragraphs, may be quoted without explicitpermission provided that full credit including notice is given to the source.
  3. 3.     ‐ 2 ‐ CONTRIBUTORS OF THE STUDY1                                                        ABOUT THE AUTHOR Arnaud van Tichelen recently graduated with distinction from ICADE’s international business administration  program  (E‐4).  During  ICADE,  Arnaud  worked  6  months  at  UBS  within  the M&A team and 6 months at Comgest (asset management) as an equity analyst. He currently works in the Investment Banking Division (Consumer products and retail) of UBS in London. He can be contacted at a.vantichelen@gmail.com  1  Three other investment funds shared their views but requested to remain anonymous. The author is grateful to Professor Rocío Sáenz‐Díez, to Trevor Giles from Caracalla Capital and to Nick Hatch from Scalar Partners for their support in this work but also to the investment professionals who contributed to this study for their precious time and valuable insight.  
  4. 4. W e a r e pro ud to h av e as s is t ed w i th th is s tud y . W e b e li e ve i t pro v i des an e xc elle n t pr imer to the p riva te e qu i ty s eco nda r y mark et along with impor ta n t m ar k e t h is to r y a nd v alu a ti on t ec hn iq ues . W e h op e in ves tors w il l le arn an d pr ofi t from th is work. Trevor S. Giles CMA CFA Managing Director C ARACALLA capital sourcing corporate finance gp / lp secondary for the canadian marketto c ontac t us va ncou ver , br itish c olu mb ia , c ana da 1 .8 77 .3 54 .4 422o n the w eb w w w .ca r aca l la .ca
  5. 5.   We leverage our network and expertise to help limited  partners achieve their private equity allocation  objectives including: venture and private equity fund I  sourcing, screening, due diligence, monitoring and I  reporting, fund accounting, and secondary advisory    Feel free to contact us:    San Francisco Office        Salt Lake City Office  th 580 California Street, 5  Floor      10813 S. River Front Parkway, Suite 300  San Francisco, California 94109      Salt Lake City, Utah 84095  +1 (415) 283‐3280          +1 (877) 872‐3643    secondaries@scalarpartners.com  www.scalarpartners.com/secondaries 
  6. 6. -3-ABSTRACT During the current liquidity crisis, the Private Equity industry has been reshaped andexperienced a significant increase in the level of interest and activity in the secondarymarket. However, despite its growth, the market is still inherently inefficient and pricingtends to vary widely among bidders. Investors need to be aware of the challenges anddynamics of this fast evolving market and to carefully analyze each potential sourcedopportunity. This research paper attempts to analyze the characteristics of the Private Equitysecondary market. Furthermore it analyses the valuation in the market and provides anactual valuation of a real secondary investment opportunity supported by the developmentof a secondary valuation model. This analysis is based on more than 25 interviews conductedwith expert participants in secondaries. Currently, transaction volume for secondaries is near an all-time high whichgenerates further liquidity and benefits the asset class as a whole. Near-term and long-termfactors are driving a fast growing market which many expect will grow about 16% annually(CAGR) in the next five years. However opportunities on the market are mirrored bysignificant challenges. Although the top-down method is helpful in determining the value ofa potential secondary, empirical data clearly shows that a bottom-up valuation is cruciallyimportant in determining the value of an asset in the secondary market.Keywords: Private Equity, secondary market, secondaries, liquidity, valuation, sellinglimited partnership capital commitments, secondary fund, LP, GP, fundraising, unfunded,carried interest, waterfall.
  7. 7. -4-CONTENTS CONTRIBUTORS OF THE STUDY................................................................................................. II ABSTRACT ................................................................................................................................... III CONTENTS ................................................................................................................................... IV TABLE OF FIGURES ......................................................................................................................... IX LIST OF TABLES ............................................................................................................................... XI ABBREVIATIONS AND SYMBOLS..............................................................................................XII I. INTRODUCTION....................................................................................... 15 II. CHARACTERISTICS OF THE PRIVATE EQUITY SECONDARY MARKET ...................................................................................................... 18 1. DESCRIPTION OF THE MARKET ........................................................................ 18 1.1. Theoretical framework ................................................................................... 18 1.1.1 Private Equity basics .................................................................... 18 1.1.2 An illiquid investment ................................................................. 19 1.2. Volumes of investment in Private Equity................................................. 19 1.2.1 The size of the primary market ................................................ 19 1.2.2 The size of the secondary market ........................................... 21 1.3. Different reasons to resort to the market ................................................ 23 1.3.1 Reasons that motivate the sellers ........................................... 23 1.3.2 Reasons that motivate the buyers........................................... 26 1.4. The secondary market participants ........................................................... 29 1.4.1 The advisers .................................................................................... 29 1.4.2 The sellers ........................................................................................ 33 1.4.3 The buyers........................................................................................ 35 1.4.4 Other emerging participants: the private marketplaces 38 1.5. History ................................................................................................................... 40
  8. 8. -5- 1.5.1 The beginning of the market (1982-2002).......................... 41 1.5.2 The growth of the market (2003-2007) ............................... 42 1.5.3 The credit crunch (July 2007-2009) ...................................... 432. THE TRANSACTIONS ON THE MARKET: DESCRIPTION OF THE DIFFERENT STRUCTURES AND SALE PROCESSES .................................................................. 46 2.1. Different types of transactions ..................................................................... 46 2.1.1 Sale of limited partnership interests ..................................... 46 2.1.2 Direct sale ......................................................................................... 46 2.2. Different sale structures ................................................................................. 47 2.2.1 Straight sale ..................................................................................... 49 2.2.2 Strip Sale ........................................................................................... 50 2.2.3 Stapled Secondary ......................................................................... 50 2.2.4 Structured secondary sale ......................................................... 51 2.2.5 Total return Swaps ....................................................................... 53 2.2.6 Securitisation: CFOs...................................................................... 54 2.2.7 Securitisation of the unfunded ................................................. 54 2.2.8 Spin-out ............................................................................................. 55 2.2.9 Tail-end ............................................................................................. 55 2.3. The different sale processes .......................................................................... 56 2.3.1 GP option: arrange a sale through the manager ................ 56 2.3.2 Exclusive sale with a secondary buyer ................................. 56 2.3.3 Open auction ................................................................................... 57 2.3.4 Targeted auction ............................................................................ 57 2.4. The execution of the transaction ................................................................. 573. LEGAL AND TAX CONSIDERATIONS .................................................................. 58 3.1. Legal considerations in the revision of the LPA .................................... 58 3.1.1 The Consent of the GP .................................................................. 58 3.1.2 Pre-emption rights: Right of First Refusal (ROFR)........... 59 3.1.3 Legal reporting requirements .................................................. 59 3.1.4 Sale notification requirements ................................................. 59 3.1.5 Payment of costs incurred by the transaction ................... 59 3.2. Legal considerations in the negotiation of the Purchase and Sale Agreement ............................................................................................................. 59
  9. 9. -6- 3.2.1 The contingent conditions ......................................................... 60 3.2.2 Material Adverse Change clauses ............................................ 60 3.2.3 Clawback provisions .................................................................... 60 3.2.4 Threshold funds ............................................................................. 60 3.2.5 Indemnifications ............................................................................ 61 3.2.6 Joint liability: French legal framework ................................. 61 3.2.7 Stapled transaction clauses ....................................................... 61 3.3. Tax considerations ............................................................................................ 61 3.3.1 Taxation of Private Equity funds ............................................. 61 3.3.2 The United States: the 2% law ................................................. 62 4. THE FUTURE OF THE MARKET .......................................................................... 62 4.1. Empirical demonstration: The primary market drives the secondary .................................................................................................................................. 62 4.1.1 Secondary market projections model ................................... 63 4.1.2 Historical relationship between the secondary base and the volume in the secondary market ........................................................... 64 4.1.3 Secondary market transaction volume: 2010-2014E ..... 64 4.2. Future growth catalysts .................................................................................. 66 4.2.1 The “denominator effect” ........................................................... 66 4.2.2 The new requirements of the financial institutions......... 68 4.2.3 An increasing pressure on the investors: fall in the distributions combined with an increase in the capital calls ..... 69 4.2.4 The improving economic outlook ........................................... 71 4.2.5 The bid offer spread is reduced ............................................... 72 4.2.6 A market that is becoming a more important asset class for investors ......................................................................................................... 73 4.3. Ever more structured operations................................................................ 74III. VALUATION IN THE PRIVATE EQUITY SECONDARY MARKET 76 1. HISTORICAL MARKET VALUATIONS ................................................................. 76 1.1. Transactions: historical valuation .............................................................. 76 1.1.1 General trend .................................................................................. 76 1.1.2 The valuation depends on the type of asset ........................ 78 1.1.3 The valuation depends on the funding ratio ....................... 79
  10. 10. -7- 1.1.4 The valuation depends on the vintage year of the fund . 80 1.2. Listed Private Equity funds ........................................................................... 81 1.2.1 Concept .............................................................................................. 81 1.2.2 Historical trading: a proxy towards the valuation in the secondary market ........................................................................................ 82 1.2.3 Limits of comparison with the Private Equity secondary market .............................................................................................................. 832. HOW TO THEORETICALLY VALUE THIS ASSET................................................. 85 2.1. Top-down method............................................................................................. 85 2.1.1 The transaction or trading value/NAV ratio ....................... 85 2.1.2 Comparable transactions method ........................................... 86 2.1.3 The valuation method by the trading multiples ................ 86 2.2. Bottom-up method: the valuation model ................................................. 86 2.2.1 Structure of the bottom-up valuation method of a fund’s interest............................................................................................................. 87 2.2.2 Valuing the underlying asset..................................................... 87 2.2.3 Project the unfunded.................................................................... 89 2.2.4 Determine a timing of capital calls/distributions............. 90 2.2.5 Aggregate the cash flows in the fund’s waterfall............... 90 2.2.6 Discount the cash flows by the cost of capital .................... 93 2.2.7 Sensitivity valuation analysis ................................................... 943. REAL WORLD VALUATION: EMPIRICAL CONTRAST OF THE TWO METHODS . 95 3.1. Top-down method: market valuation ....................................................... 95 3.2. Bottom-up method: valuation using the model ..................................... 96 3.2.1 Introduce the fund’s financial data and growth estimates96 3.2.2 The analysis and the valuation of the portfolio companies99 3.2.3 Adding of the cash flows in the waterfall of the fund .... 102 3.2.4 Determination and sensitisation of the price of the limited partnership interest according to different scenarios ................ 106 3.3. Comparison of the results: explanation of the difference................108 3.3.1 Comparison of the results ........................................................ 108 3.3.2 The concept of NAV is subjective .......................................... 108 3.3.3 Each asset is different ................................................................ 108
  11. 11. -8- 3.3.4 The lag of the NAV ....................................................................... 109 3.3.5 A buyers’ market.......................................................................... 110 3.3.6 Key valuation method: bottom-up ........................................ 112IV. CONCLUSIONS ........................................................................................114 1. CONCLUSIONS .................................................................................................. 114 1.1. Analysis of the secondary market: an opportunity for the Private Equity industry..................................................................................................114 1.2. The future: growth and sophistication ...................................................114 1.3. Valuation in the secondary market: trend and method ...................116 2. FUTURE RESEARCH ......................................................................................... 117GLOSSARY ................................................................................................................................118REFERENCES ................................................................................................................................123 1. BOOKS .............................................................................................................. 123 2. REPORTS .......................................................................................................... 123 3. ARTICLES ......................................................................................................... 127 4. DATABASES ...................................................................................................... 129APPENDIX ................................................................................................................................131
  12. 12. -9-TABLE OF FIGURESFigure 1: Structure of the study ............................................................................................... 16Figure 2: Different Private Equity styles................................................................................... 18Figure 3: Raised capital in the primary market ($ billions) ...................................................... 20Figure 4: Transaction volume in the secondary market ($ billions)......................................... 21Figure 5: Geographical distribution of the transactions .......................................................... 22Figure 6: Volume raised by secondary Private Equity funds ($ billions) .................................. 23Figure 7: Reasons that motivate the sellers in the market (2007/2008/2009) ....................... 25Figure 8: Reasons for resorting to the secondary market in the next two years (2010-2011) 26Figure 9: Secondary funds - Top, median and bottom IRR quartiles (by vintage year) ........... 27Figure 10: The “J-Curve”........................................................................................................... 28Figure 11: Importance of the secondary market to investors’ Private Equity strategies ........ 29Figure 12: Breakdown by seller type in the secondary market (2008 vs. 2009)...................... 33Figure 13: Buyer types (by transaction volume - H1 09).......................................................... 36Figure 14: Non-traditional buyer types (H1 09) ....................................................................... 38Figure 15: History of the Private Equity secondary market ..................................................... 40Figure 16: The beginning of the market (1982-2002) .............................................................. 42Figure 17: Changes to LPs’ exposure to secondary funds over the years 2008-2009 ............. 44Figure 18: Proportion of investors who ruled out transactions in 2008 because of pricing concerns ........................................................................................................................... 45Figure 19: Two types of secondary transactions: sale of limited partnership interest and direct sale ......................................................................................................................... 46Figure 20: Transaction volume breakdown – (Limited partnership interest and Direct sale) (2007 to 2009) .................................................................................................................. 47Figure 21: Different sale structures in the secondary market ................................................. 48Figure 22: Comparison of the characteristics of the different sale structures ........................ 49Figure 23: Traditional sale structure: straight sale of a limited partnership interest .............. 50Figure 24: Structure of a stapled secondary sale of a portfolio of limited partnership interests .......................................................................................................................................... 51Figure 25: Structured joint-venture sale of a portfolio of limited partnership interests ........ 52
  13. 13. - 10 -Figure 26: Total return swaps for a portfolio of limited partnership interests ....................... 53Figure 27: Securitisation by means of CFOs ............................................................................. 54Figure 28: Securitisation of the unfunded ............................................................................... 54Figure 29: Comparison of the characteristics of the different sale processes ........................ 56Figure 30: Secondary base (in bn$) .......................................................................................... 64Figure 31: Estimates of the secondary market transaction volume according to the historical relationship ($ billions) ..................................................................................................... 65Figure 32: LPs’ anticipated level of Private Equity commitments at the end of 2010............. 67Figure 33: Plans to address the over allocation issue .............................................................. 67Figure 34: Distributions as a % of NAV ..................................................................................... 70Figure 35: Anticipated changes in capital calls in the next 12 months .................................... 71Figure 36: Timing of the tightening of the bid/offer spread .................................................... 73Figure 37: Anticipated changes to LP’s exposure to secondary funds over 2010-2011 .......... 74Figure 38: Secondary bids over time (as a % of last fund’s NAV) ............................................ 77Figure 39: Value of the best bid in comparison with the total exposure to the asset (NAV + unfunded) ......................................................................................................................... 78Figure 40: Historical valuation of the best bids received for each fund type (% of the NAV) . 79Figure 41: Valuation according to the vintage year of the fund (H1 2009) in % of its NAV .... 81Figure 42: Historical trading of the listed Private Equity funds – Premium / (discount) with its NAV ................................................................................................................................... 82Figure 43: Comparison between trading of listed Private Equity funds and bids received in the secondary market ...................................................................................................... 83Figure 44: Two valuation methods of the secondary assets.................................................... 85Figure 45: Structure of the bottom-up valuation method ....................................................... 87Figure 46: Dry powder in the secondary market in 2010 ($ billions)..................................... 110Figure 47: Estimate of the dry powder in the secondary market in 2011 ($ billions) ........... 111
  14. 14. - 11 -LIST OF TABLESTable 1: Financial advisers in the secondary market ............................................................... 31Table 2: Legal advisers on the secondary market .................................................................... 32Table 3: The ten largest dedicated fund managers at the end of 2009................................... 37Table 4: Distribution of the transaction probabilities during the life of a fund....................... 63Table 5: Tier 1 capital and 3% cap of five major US banks....................................................... 69Table 6: Effect of the funding ratio on the valuation (H1 2009) .............................................. 80Table 7: Projection multiples of the unfunded according to the quality of the management team ................................................................................................................................. 90Table 8: Cash flows of the fund and distributions - Waterfall ................................................. 93Table 9: Top-down valuation of a limited partnership interest ............................................... 95Table 10: Main characteristics of the fund .............................................................................. 97Table 11: Financial data and growth hypotheses of a portfolio company .............................. 98Table 12: Analysis and projection of the operating data of a portfolio company (base case) ........................................................................................................................................ 100Table 13: Projection of the debt repayment and valuation of the investment ..................... 101Table 14: Cash flows from the fund’s investments ................................................................ 103Table 15: Calculation of the costs of the fund ....................................................................... 103Table 16: Waterfall of the fund .............................................................................................. 104Table 17: Net cash flows available for LPs ............................................................................. 104Table 18: Determination of the returns of the secondary investor according to the acquisition price ............................................................................................................. 105Table 19: Determination of the price to be paid according to scenarios and returns .......... 106Table 20: Sensitivity of the returns to the different key variables ........................................ 107Table 21: Contrast of the valuation according to the different methods.............................. 108Table 22: Discrepancy in the valuation of the assets (H1 2009) ............................................ 109
  15. 15. - 12 -ABBREVIATIONS AND SYMBOLSASCRI Asociación Española de entidades de Capital Riesgo (SPAIN)AVCJ Asian Venture Capital JournalBVCA British Private Equity & Venture Capital Association (UK)CAPEX Capital Expenditures: Investment in fixed assetsCFO Collateralized Fund Obligation: debt security of Private Equity fund or hedge fund assetsDCF Discounted Cash Flow: valuation method consisting in valuing the asset by discounting its future cash flowsEBIT Earnings Before Interest and TaxesEBITDA Earnings Before Interest, Taxes, Depreciation and AmortizationEV Enterprise value (equity+ debt)EVCA European Venture Capital AssociationFCF Free Cash FlowGP General Partner: fund managerIRR Internal Rate of ReturnIRS Internal Revenue Services: tax authority in the USAKYC Know Your Customer: due diligence requirement that financial institutions must perform to identify their client and ascertain relevant information to doing financial business with themLBO Leveraged Buy OutLP Limited Partner: Co-owner of a limited partnershipLPA Limited Partnership Agreement: constitution agreement of a Private Equity fundMAC Material Adverse Change: legal provision that allows the acquirer to withdraw from the transaction if the target suffers a substantial changeMBO Management Buy OutNAV Net Asset ValueNOPAT Net Operating Profit After TaxesNPV Net Present ValueNVCA National Venture Capital Association (USA)PEF Private Equity FundPSA Purchase and Sale AgreementQMS Qualified Matching Service: approved management services for secondary transactions by the tax authoritiesROFR Right Of First RefusalSPA Share Purchase AgreementSPV Special Purpose VehicleVC Venture Capital: Private Equity investment style in the early stages of the development of the companies
  16. 16. NEED LIQUIDITY? the marketplace for alternative assets SIGN UP TODAY at SecondMarket.com for FREE access LARGEST secondary market for buying and selling alternative assets NINE MARKETS including Private Company Stock, Limited Partnership Interests and Bankruptcy Claims ROBUST MARKETPLACE with over 20,000 participants and more than $20 billion in assets available for sale FREE TO LIST ASSETS for sale, receive market insights and place bids Get connected at: www.SecondMarket.com @SecondMarket SecondMarketliquidity@SecondMarket.com | +1 212.668.5920 | Member FINRA | MSRB | SIPC | © 2010 SecondMarket Holdings, Inc.
  17. 17. “You may like our performance, you may not like our performance, but you’re my partner for the next twelve years.” David Bonderman (TPG founder)
  18. 18. PART I:INTRODUCTION
  19. 19. I. Introduction - 15 -I. INTRODUCTION During the current liquidity crisis, it may be valuable for a limited partner to dispose of an interest in a Private Equity fund, but how? The secondary market can provide this desired liquidity which is critically important to limited partners. Many key issues are taken into account when disposing of an interest, but as Cicero said: “belli nervus pecunia”, money is the sinews of war, the value of the asset sold, is the key consideration in a transaction in the secondary market. But how are these assets valued? Why are there such large disparities between the different bids received for the same assets? The secondary market is growing constantly and is now a major participant in the Private Equity industry. From a very private confidential market to a broad liquidity provider for the investment community, the market has changed dramatically. In 2009, funds raised for the purchase of Private Equity fund interests accounted for roughly 20% of all Private Equity funds closed during the year. Over the last decade, the market has become more and more complex and become the reflection of new opportunities. However, although the market is being established it remains inefficient. Motivations for entering the secondary market are increasingly different and complex. What volumes are traded in the market? Who are the participants? Transactions are becoming more complex. What are the different sales structures and their characteristics? Beyond structuring of transactions, why can there be so much price disparity between the bids on the same asset? Is there a way to accurately value these assets? How could we measure the fair value of an interest in a fund? Secondary market literature is limited and due to this lack of information, many investors and agents still do not understand all of its characteristics, nuances and complexities. No study giving a comprehensive and thorough overview of the market and its main issues has been published prior to this paper. This study attempts to answer a lack of information and to be a guide through the characteristics and valuation of the Private Equity secondary market. Structure of the study The content of this study is organized around the following structure: The first part (section II) explains the main features of the market. Its basic characteristics, size, participants, motivations to enter the market and historical development are detailed (II.1). Also analyzed are the different sales structures and
  20. 20. I. Introduction - 16 -processes (II.2) as well as tax and legal considerations in such transactions (II.3) in order tobetter analyze and project future trends of the market (II.4). The second part (section III) focuses on the valuation of the assets on the secondarymarket. After analyzing the existing market valuations (III.1), the different valuation methodsare explained based on theoretical knowledge and direct experience of secondary marketparticipants (III.2). Once the theoretical approach of valuing these assets is understood, areal world valuation is demonstrated. An interest in a Private Equity fund is valued followingtwo valuation methods: bottom-up and top-down (through the valuation model developedin partnership with several market participants) in order to demonstrate the optimalvaluation method of assets in the secondary market (III.3). The last part (section IV) lists the main conclusions of the study and its investigations.Main considerations on the market, its future and the valuation of these assets arehighlighted in order to summarize the key contributions of the study.To support the present study, appendices are attached containing databases of marketparticipants, marketing documents of the present study, summaries of meetings and callswith sponsors of this study, analysis of historical data in the market and a projection modelof secondary transaction volume.Figure 1: Structure of the studySource: Author’s own
  21. 21. PART II:CHARACTERISTICS OF THE PRIVATE EQUITY SECONDARY MARKET
  22. 22. II. Characteristics of the Private Equity secondary market - 18 -II. CHARACTERISTICS OF THE PRIVATE EQUITY SECONDARY MARKET 1. Description of the market 1.1. Theoretical framework 1.1.1 Private Equity basics2 Private Equity funds are limited partnerships, the purpose of which consists of taking short-term interests in unlisted companies. The objective sought is that with the help of the capital investment and fund management team, the investee company increases in value and the fund exits obtaining a profit. Private Equity funds (PEF) can be invested in a many different ways according to their investment strategy (investment style, the type of assets in which it invests or targets). Figure 2: Different Private Equity styles Source: adapted from JP Morgan Asset Management; «Secondary Private Equity Discussions»; 2009. A Private Equity Fund (PEF) is a collective investment scheme through which assets are administered by an investment firm (the Private Equity firm). The assets are divided into interests conferring to their holders, the Limited Partners or LPs, a property right thereon3. The LPs’ commitments are managed by the Private Equity firm acting as the General Partner or GP which also invest in their own funds, typically providing 1% to 5% of the overall capital. In making an investment in a PEF, LPs sign a Limited Partnership Agreement or LPA with the GP. This document, drawn up by the GP and its advisers, governs the relationship between 2 Gómez-Acebo & Pombo abogados y ASCRI; «Capital riesgo (Private Equity) aspectos regulatorios, mercantiles, financieros, fiscales y laborales»; 2006 3 CNMV, «Reglamento de los fondos de capital riesgo», www.cnmv.is/legislacion/capital_risk/REGLAFON.DOC (Last accessed: 6 November 2009)
  23. 23. II. Characteristics of the Private Equity secondary market - 19 -the LPs and GPs. It describes the rights and obligations of the parties and sets forth thefund’s operating mandate and limitations.The amount that LPs invest is called committed capital. The LP commits in writing to providecapital funding within the agreed time limit (in general ten days4) upon notification of themanager’s capital call. In general, the investor will provide capital over a period of time andthe portion committed by the investor but not yet paid is called the unfunded commitment.The LPA sets forth details on how the fund is to be managed including the management fee5which is measured as a percentage of the committed capital or the assets undermanagement depending whether the fund is in the investment period or liquidation period(it is generally applied to the committed capital during the investment period and to theassets under management during the liquidation phase). The management fees are usually2% but they can differ slightly (between 1% and 3%) according to the manager’s reputationand fund size.The LPA also defines the fund’s distribution structure (also called waterfall). The carriedinterest is defined in this part. Carried interest represents the fund manager’s share incapital gains resulting from operations carried out by the fund once the investment of theLPs has been returned and a minimum return to the investors called the hurdle rate (about8%) has been provided for. In Private Equity Funds, the carried interest is usually about20%6. 1.1.2 An illiquid investment An investment in a PEF is fundamentally illiquid given that LPs commit to fulfillingtheir obligation to invest the agreed amount decided in the LPA over a period which isusually ranges from 10-12 years.The secondary market is developed in response to this lack of liquidity in this asset class. Inthis market existing investments are traded as well as the unfunded part of the commitmentin combination (the most usual) or separately. 1.2. Volumes of investment in Private Equity 1.2.1 The size of the primary market Primary markets are those in which assets or financial instruments between investorsand companies or banks are issued for the first time.4 Akin Gump Strauss Hauer & Feld; «Role of the secondaries market and LP trends»; 20095 See section III. 2.2.4- ii. The fund management costs6 See section III, 2.2.4- iii. The waterfall
  24. 24. II. Characteristics of the Private Equity secondary market - 20 -Figure 3: Raised capital in the primary market ($ billions) 500 455 450 400 370 375 350 300 250 255 246 250 200 133 140 150 117 120 100 81 70 80 50 50 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 7Source: Author’s own using data from: Private Equity Analyst (1996-1999); Thomson Reuters, AVCJ, EVCA, AsiaPrivate Equity, NVCA (2000-2008); Preqin (2009).As the graph above demonstrates, investments in Private Equity increased annually until thetechnology bubble burst in 2000. After a short period of decline in new capital raised (mainlydue to Venture Capital funds) the market rebounded from 2002 to 2007 following a periodof macroeconomic expansion. In 2007, after reaching historic highs, the trend reversed dueto the financial crisis and the volume of new capital raised fell dramatically.In 2009, investments in Private Equity continued to fall and due to a difficult economicrecovery it is forecast that annual volume in the next two years will remain constant8.According to Preqin, the first quarter of 2010 shows a constant trend with $50 billion raised,representing an increase of 5% in comparison with capital raised in the first quarter of 20099.From 2005 to 2008 the Private Equity asset class raised nearly $1.5 trillion. Driven byattractive returns and the enthusiasm of investors, the Private Equity industry has grownsignificantly in recent years from approximately $950 billion in 2003 to $2.5 trillion in 200810.7 The data used are from a historical analysis of the information published by different market participants. Seeappendix 8.3. The selected data are the most accurate and are from recognised and trustworthy sources8 Bain & Company, Inc; «Global Private Equity Report 2010»; 20109 Preqin; «Q1 2010 Private equity Fundraising Update»; 2010 (via Twitter 1 April 2010)10 Including the NAV of the portfolio and the unfunded. Preqin; «Private Equity secondary market: Short-TermBoom, Long-Term Growth»; 2009
  25. 25. II. Characteristics of the Private Equity secondary market - 21 - 1.2.2 The size of the secondary market i. Transaction volume in the secondary marketFigure 4: Transaction volume in the secondary market ($ billions) 18 16.1 16 CAGR 2002-08 13.4 14 12 41% 10.3 10 9.1 8.4 8 7.5 6.9 6 4 3.1 2.4 2.3 2.1 2 1.5 0.6 0.7 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 11Source: Author’s own using data from: Dow Jones; «Guide to secondary Market Buyers»; 2009 (Sale price +Unfunded; transactions of traditional participants: funds of funds and secondary funds); UBS Private FundsGroup; «Adams Street Secondary Networking Event»; 2010 (2009). The data of this market are estimates given that since it is not an organised marketthere is no system capable of capturing the exact volume of transactions in the market.Furthermore, the data that are published represent large-scale transactions in whichsecondary dedicated funds or fund of funds were involved. The smaller more numeroustransactions of LPs’ interests are not usually published and therefore their impact is verydifficult to measure.For a long period of time, the secondary market was nearly invisible given its low volume.Since 2003 it has become a major market, as can be inferred from the recent media interest(press, conferences, etc.).11 The data used are from a historical analysis of the information published by different participants. Seeappendix 8.1. The selected data are the most accurate and are from recognized and trustworthy sources
  26. 26. II. Characteristics of the Private Equity secondary market cs - 22 -In 2008, transaction volume in the secondary market was over $16 billion. Despite themagnitude of this amount, this large volume represents less than 1% of the total size of the volumePrivate Equity industry12. Compared with other asset classes, this is a very low proportion ofsecondary transactions. This implies that many investors keep their interests until maturitywith little opportunity to change their strategy and sell their investment during this period.In 2009, according to the present survey shown in appendix (8.1), secondary participants(advisers and buyers) estimated the secondary transaction volume at an average of $7.5billion, which represents a 50% decrease over 2008 volume.Figure 5: Geographical distribution of the transactions : 2007 2008 Europe 1% Europe 1% 21% 2% Asia 43% Asia 50% 76% USA USA 6% Other OtherSource: Author’s own using data from UBS Private Funds Group; «Private Equity Secondary Market review»;2009.The majority of transactions are carried out in the United States and Europe where the mainparticipants are present and transactions more significant.One of the secondary market’s growth drivers is the volume raised in the primary market.Historically, a positive direct relationship between the primary and secondary markets sitiveseems to have existed. ii. Volume raised by dedicated secondary funds The volume raised by dedicated secondary funds has also grown significantly in thelast five years. Since 2003, funds dedicated to the Private Equity secondary market have dedicatedraised commitments totalling $75 billion.12 Secondary transactions in 2008 (Dow Jon Guide)/Assets managed by Private Equity in 2008 (Preqin)= $16 Jones te $161billion/ $25 trillion = 0.64%
  27. 27. II. Characteristics of the Private Equity secondary market - 23 -Figure 6: Volume raised by secondary Private Equity funds ($ billions) 20 18.5 18 16 14 13.0 12.3 12 10 8.9 7.8 7.2 8 6.4 7.4 6 4.0 4 2.7 2.4 2.0 2 1.1 0.7 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 13Source: Author’s own based on data from : Dow Jones; «Guide to secondary market buyers»; 2009 (1996-2008); Preqin; «Private Equity Spotlight January 2010»; 2010 (2009).In 2009 it was the only segment of Private Equity that grew in comparison with 2008 andrepresents 7.5% of the total funds raised14.According to Campbell Lutyens15 and Probitas Partners16, it is forecast that in 2010secondary funds will raise some $27 billion if they manage to achieve their fundraisingtargets. 1.3. Different reasons to resort to the market What characterises the market today is the multiplicity of reasons that differentparticipants have for entering the market17. 1.3.1 Reasons that motivate the sellers Inability to finance unfunded commitments: This reason is often cited when an over-commitment strategy is employed. In good times the investors commit more13 The data used are from a historical analysis of the information published by different participants. Seeappendix 8.2. The selected data are the most accurate and are from recognised and trustworthy sources14 Secondary funds / total funds raised = 246/18.5= 7.5%15 See appendix 7.13, which includes a summary of the call to Campbell Lutyens (10 March 2010)16 Probitas Partners; «Adams Street Secondary Networking Event»; 201017 Kelly DePonte, Probitas Partners; «Routes to liquidity»; 2009
  28. 28. II. Characteristics of the Private Equity secondary market - 24 - money than they have to invest in this asset class and then finance capital calls with distributions from mature funds. But during downturns when the distributions are reduced they are unable to fund capital calls. They need to sell their interests that entail large unfunded commitments (i.e. most recent funds). Urgent need for liquidity (distressed sellers). To comply with the new regulatory accountancy risk management and capital requirements (Basel II). Change in the overall strategy: sale of non-core assets. Corporate transaction: mergers and acquisitions, restructuring, change in the management team. Denominator effect18: due to the fall in publicly traded security valuations the weighting of other assets increases in the portfolio. This imposes a re-balancing of the different assets classes in order to comply with the allocation threshold of assets in the portfolio policy. Change in the investment strategy: geographical area, sector, vintage year, change in the management team, asset class… Reorganisation of the portfolio and exit from problematic funds. To lock-in performance. To focus on relationship with some GPs: having interests in few funds allows to follow a limited number of GPs and therefore to reduce the management and administrative costs. To avoid distributing remaining assets of a fund to the LPs: a manager prefers to sell assets in the secondary market to return cash to his LPs rather than distribute the fund’s remaining assets19.18 For more details on the denominator effect, see 4.2.1. The denominator effect.19 Charles Soulignac, CEO Fondinvest Capital; «Secondary Market in private equity - an asset class inexpansion»; 12 March 2002. www.AltAssets.com (last accessed: 3 February 2010)
  29. 29. II. Characteristics of the Private Equity secondary marketFigure 7: Reasons that motivate the sellers in the market (2007/2008/2009) 2007 13% 14% 17% 56%Source: Author’s own using data fromIn the figure above two major reasons why sellers resort to the secondary market stand out:active portfolio management and the need for liquidity. Since 2009, due to the credit crunch,the main reason for selling has become the need to find liquidity.
  30. 30. II. Characteristics of the Private Equity secondary market - 26 -Figure 8: Reasons for resorting to the secondary market in the next two years (2010-2011) "Lock in" returns Re-direct resources to other asset classes or uses Re-focus resources on the best- performing GPs Re-balance portfolio within the PE asset class Increase liquidity 0% 20% 40% 60% 80% 100% Winter 2009-10 Summer 2007Source: Author’s own using data from Coller Capital; «Global Private Equity Barometer Winter 2009-10»; 2009.According to a survey by Coller Capital carried out in the winter of 2009, the main reasonswhy sellers are going to use the secondary market in 2010-2011 will be lack of liquidity andportfolio management (to rebalance their allocation to Private Equity or refocus resources). 1.3.2 Reasons that motivate the buyers To generate large returns by exploiting market inefficiencies20:The secondary market is characterised by price and information inefficiencies. Moreover, theimbalance between the supply and demand for assets may create a buyers’ market.These returns are reflected in the average IRR of the secondary funds created between 2000and 2005 which are between 20% and 30% higher than the average of the primary funds21.20 Goldman Sachs PEG ; «Private Equity liquidity : a perspective on the secondary market »; May 200821 Preqin; «Private Equity Secondary Market: Short-Term Boom, Long-Term Growth»; 2009
  31. 31. II. Characteristics of the Private Equity secondary market - 27 -Figure 9: Secondary funds - Top, median and bottom IRR quartiles (by vintage year)Source: Preqin; «2009 secondary review»; 2009.According to a survey by Probitas Partners published in November 2009, more than 50% ofinvestors believe returns of the best secondary fund managers (those of the top quartile) invintage year 2010 will reach an IRR of 20% or more during the life of the fund22. To optimise the risk-return trade-off of a portfolio:In some cases the transaction allows investment with preferred conditions in the funds,providing greater seniority in the capital structure and therefore less risk alongside preferredreturns. To invest in an identifiable portfolio of assets:In the primary market, the investor invests in a blind pool and trusts the judgement of theGP to buy high-performing assets. When buying in the secondary market, the investor knowsthe assets in which the fund is invested and can estimate its growth and future value. To gain access to future funds of a certain GP:The acquisition of a fund’s interest seeks to develop a relationship with a GP in order toobtain access to future funds that will be raised. To diversify the portfolio:It allows diversifying the portfolio, adding a different vintage year or buying funds from anoutstanding vintage year. To minimise the impact of the J-curve on the portfolio:22 Probitas Partners ; «Private Equity Market Review and Institutional Investor Survey»; 2009
  32. 32. II. Characteristics of the Private Equity secondary market - 28 -At the beginning of the investment, a PEF requires capital to invest (“investment period”)and in this phase the fund typically shows negative returns. The fund’s return rate reaches aturning point from the moment in which the fund distributions appear. The effect of thisimpact on portfolio returns is called the “J-curve effect”23.Figure 10: The “J-Curve”Source: JP Morgan Asset Management; «Secondary Private Equity Discussions»; 2009.Upon adding more mature assets to a portfolio the J-curve effect is reduced. Some GPstherefore resort to the secondary market to buy interests in mature funds in order to reducethis impact.According to Capital Dynamics, a Private Equity fund takes 5 years to achieve a NAV of 80%of the committed capital. Buying an interest in a mature fund allows for acceleration ofinitial returns and improves liquidity of the portfolio since secondary funds usually generateearlier distributions24. However, the main motives that drive the market are those of the sellers. Indeed, inquantitative terms, the majority of transactions were led by large financial institutions(banks, insurance companies) that decided Private Equity is not their core business and soldtheir interests in the secondary market in order to reemploy this capital to other activities.That trend is called “active portfolio management”.For all these reasons, the secondary market increasingly forms part of investors’ strategy.23 Private Equity Magasine ; «J Curve: la vraie bonne raison d’acheter»; 200924 Capital Dynamics; «Perspectives»; 2009
  33. 33. II. Characteristics of the Private Equity secondary market cs - 29 -Figure 11: Importance of the secondary market to investors’ Private Equity strategies : 22% Not a core part of the strategy 10% Core part of strategy 68% Of growing importance to strategySource: Author’s own based on data from Preqin; «Private Equity Secondary Market: Short Short-term boom, long-term growth»; 2009.According to a survey by Fidequity, more than 80% of investors in the Private Equitysecondary market seek to increase their exposure to this asset class25.Furthermore, the GPs’ attitude toward secondary transactions carried out in their funds isgenerally positive. A study carrie out by Preqin26 showed that whereas nearly 63% of GPs . carriedhave experienced a secondary transaction in their funds, only 25% of them have expressedconcerns regarding these sales. 1.4. The secondary market participantsThe three main participants active in the secondary market are advisers, sellers and buyers. ndary 1.4.1 The advisers In a secondary market transaction, the seller must employ the services of legal andfinancial experts in order to maximise the transaction value and correctly understand theinherent risks. Furthermore, the buyer must employ the services of a legal adviser to analyse rmore,the existing LPA of the fund in which it invests and to draft the Purchase and Sale Agreement(PSA). i. The financial advisers27 In July 2010, according to current analysis of existing financial advisers (see list in ancialappendix 1.1), there were nearly 50 financial advisers serving the market. According to25 Fidequity; «Global Private Equity Limited Partner Survey Global Survey-Q3 2009»; Q3 200926 Preqin; «Private Equity Secondary Market: Short Private Short-term boom, long-term growth»; 2009 ;27 See appendix 7.13, which includes a summary of the call to Campbell Lutyens (10 March 2010)
  34. 34. II. Characteristics of the Private Equity secondary market - 30 -Preqin, 47% of currently active financial advisers have entered the market since 200328. Thisis a growing sector and it is forecast that new advisers will enter the market in coming yearsto exploit new market opportunities, but also to compensate for declines in the mainfundraising activity of many placement agents. However, one must distinguish specialistadvisory firms in the secondary market from brokerage firms which have no advisorycapabilities in structuring and valuation of complex transactions. The three largest advisoryfirms in the secondary market that advise on the largest transactions are UBS PFG, CogentPartners and Campbell Lutyens. The advisers mainly act on behalf of the seller and theyadvise them in numerous ways29.• Knowledge of the market: the adviser knows the current state of the market and the preferences of large buyers.• To structure transactions: the adviser knows the different options for structuring transaction and their advantages and drawbacks. He can advise on the most appropriate and then structure it.• Price orientation: evaluating a price range for the asset, evaluating the fund’s underlying assets and detailing the valuation method. The adviser knows the current valuations of the market and has a team capable of modelling the asset price.• Detailed knowledge of the buyers in the secondary market: adds value in the marketing strategy, knows the potential buyers and can contact them.• To manage the process: advises in the selection of the most suitable sale process (auction, private sale…), provides suitable information, manages the queries, coordinates legal advisers, receives bids, reviews them and assesses which is the best.• To close the process: manages the transfer of funds and closes the transaction.Seeking the service of an adviser is highly advisable when carrying out a secondary markettransaction because it typically achieves the best returns (in the acquisition or sale) andprovides for the efficient management of many complex issues (portfolio analysis, valuation,legal, terms, etc.)30.Advisers usually charge a commission that depends on the characteristics of eachtransaction (size, unfunded part, complexity) and according to the base used to calculate thecommission (NAV + unfunded; transaction price + unfunded; transaction price). The data28 Preqin; «The 2009 Preqin Private Equity Secondaries Review»; 200929 Dow Jones; «Guide to secondary market intermediaries»; 200930 “As a general rule the most successful man in life is the man who has the best information.” – BenjaminDisraeli
  35. 35. II. Characteristics of the Private Equity secondary market - 31 -gathered for this analysis indicates commissions are usually between 1% and 3.5% of thesale amount defined as the NAV + unfunded31.Table 1: Financial advisers in the secondary market32 Financial advisers (alphabetical order) Almeida Capital Cogent Partners Patronus Capital Alpha Associates AG Continental Capital Partners plurisvaluation Altitude Capital Advisory Credit Suisse Group Preqin Ariane Capital Partners Fidequity Probitas Partners Augusta & Co Global Finance Rainmakers Partners Autumn Capital Partners Greenhill & Co. Richmond Park Partners Axon Partners Griffin Private Equity Group Rotschild Axonia Partners Houlihan Lokey Roux Capital Azla Advisors Lancea Partners Scalar Partners Bluetower Capital Lazard Secondcap Boyd & Co Matrix Group Setter Capital Breslin AG Mercury Capital Advisors Somerset Capital Campbell Lutyens MHT Partners Secondary Advisors The Camelot Group International Capital Dynamics Mummert & Company Triago Capstone Partners Nakatomi Capital UBS Private funds Group Carta Diem Palomar Corporate Finance Champlain advisors Park Hill GroupSource: Author’s own ii. The legal advisers In a secondary transaction, the legal adviser mainly manages the review of the fund’sLPA and the drafting of the PSA.Before a sale the LP must ensure the transaction can be carried out according to the LPA;that there are no clauses that prevent it, but also according to current tax laws.Furthermore, the buyer’s legal adviser must analyse the LPA of the fund in which his clientwishes to invest in order to understand how exactly it operates, its management clauses andcompensation and the admission consent.31 See appendix 7, which summarises the calls to Secondmarket (1 December 2009); Breslin AG (2 December2009); Pantheon Ventures (9 December 2009); Campbell Lutyens (10 December 2009); UBS PFG (2 February2010)32 See list of financial advisers in the secondary market in appendix 1.1. This table contains advisers andintermediaries
  36. 36. II. Characteristics of the Private Equity secondary market - 32 -He also advises his client in the drafting of the PSA, in which important clauses such ascontingent conditions, clawback conditions, material adverse change clauses (MAC) orcompensation clauses will have to be negotiated.All these considerations are crucial to the acquisition/sale process in the secondary marketand may be unfamiliar to the counterparties requiring experts be engaged to analyse thesedetails to ensure transaction success.Table 2: Legal advisers on the secondary market33 Legal advisers (alphabetical order) Covington & Burling Howard Rice SJberwin Debevoise & Plimpton Kaye Scholer Weil, Gotshal &Manges Fried Frank Kirkland & Ellis Wilmer Cutler Pickering Hale and Dorr Goodwin Procter ORMelveny & MyersSource: Author’s ownFew legal firms have a practice dedicated to secondary transactions, however in the case ofdirect transactions (acquisition of a direct interest in a portfolio company), legal firms thatadvise on mergers and acquisitions transactions are usually hired.33 See list of legal advisers in the secondary market in appendix 1.2. Only legal firms with a dedicated practiceare included.
  37. 37. II. Characteristics of the Private Equity secondary market - 33 - 1.4.2 The sellers There are two types of sellers in the market: investors in funds (LPs) and themanagers themselves (GPs).Figure 12: Breakdown by seller type in the secondary market (2008 vs. 2009) 100% 3.1% 5.4% 90% 6.8% 12.4% Corporate 10.8% 80% 11.3% Endowment 70% 5.2% 18.9% 60% Family office / 25.8% Foundation 50% 27.0% Pension funds (Public 40% and private) 30% Asset manager 20% 42.3% 31.1% 10% Financial institutions 0% H1 07 to H1 08 H1 08 to H1 09Source: Author’s own based on data from UBS Private Funds Group; «Adams Street Secondary NetworkingEvent»; 2010. Breakdown is based on number of transactions brought to market. Asset managers includePrivate Equity GPs, fund of funds and hedge funds.Investors in funds (limited partners) usually represent close to 75% of the number oftransactions and managers (General Partners) the remaining 25% according to datapublished by UBS34. i. The LPs (investors in funds) Traditionally, financial institutions (banks, pension funds, insurance companies) haverepresented between a third to a half of the secondary transactions. Furthermore,endowments, listed vehicles, foundations, family offices and wealthy individuals act assellers in the market35.34 UBS Private Funds Group; «Adams Street Secondary Networking Event»; 2010. Based on the number oftransactions in the market.35 Real Deals; «Secondaries roundtable 2009»; 2009
  38. 38. II. Characteristics of the Private Equity secondary market - 34 - • Banks36: These entities tend to enter and exit the Private Equity market in cycles. Many of the banks have invested in this asset class to be able to finance leveraged buyouts (LBOs) and to advise on mergers and acquisitions. In periods of crisis, banks are incapable of playing their financing role, which compels them to reduce their exposure to this asset class that has never been a core business. Currently they are the most important sellers in the secondary market. Recent transactions include the sale of a $1.9bn Private Equity portfolio of Bank of America to Axa PE in April 2010 and the $1.1bn sale of Citi’s fund-of-funds, mezzanine fund, feeder fund and co- investment fund interests to Lexington in July 2010. Bank of America was said at the end of July 2010 to be in talks with Lexington Partners and the sovereign wealth fund China Investment Corp (CIC) to sell $1.2bn (€930mn) in commitments made to funds managed by Warburg Pincus according to several people familiar with the transaction. • Pension funds: They are large asset owners that invest capital obtained through the accumulated savings of a group of people in order to make payments to their stakeholders once they have reached retirement age. Preqin details in a report that on average these investors seek to allocate 6.2% of their assets to the Private Equity asset class37. According to a study by the National Association of Pension Funds in the United Kingdom, pension funds in the United Kingdom have reduced their percentage allocation to Private Equity from 2.5% on average in June 2008 to 1% in June 200938. For example, Calpers, the pension fund of the public employees of the state of California ($237.1 billion AUM) sold more than $2 billion of interests in Private Equity funds in 2008. • Insurance companies: These companies offer insurance policies to the public by direct sale or through other sources such as the employees’ benefit plan. They manage large sums of money and invest a portion in Private Equity. According to a study by Preqin, they seek to allocate 3.7% of their assets to the Private Equity39 asset class. • Listed funds of funds40: These are listed investment vehicles. A true “closed box” (it has no income apart from the distributions of the fund in which it is invested) until it issues additional securities. These vehicles employ an over-commitment strategy and are highly leveraged. In the midst of the financial market crisis, they suffered greatly36 See appendix 7.4, which summarises the email from Preqin (2 December 2009)37 Preqin; «2009 Global Private Equity Review»; 200938 Web page: http://www.AltAssets.com/private-equity-news/by-pe-sector/buy-out/article/nz17417.html39 Preqin; «Survey by insurance companies investing in Private Equity»; October 200940 See appendix 7.4, which summarises the email from Preqin (2 December 2009)
  39. 39. II. Characteristics of the Private Equity secondary market - 35 - from reduction in fund distributions and severely reduced access to credit leading to increased use of the secondary market. • Endowments41: These funds seek to cover a part or all the needs of the institutions to which they belong with the returns on their investment portfolios. According to a study by Preqin these funds on average seek to allocate 11.8% of their assets to the Private Equity asset class42. Another “closed box”, these funds have no income and employ an over-commitment strategy. Accordingly they have had the same problem as listed funds because of the reduction in fund distributions. The largest are those of American universities, such as Harvard ($26billion) which has had to access the secondary market to comply with its liquidity needs. • Foundations and family offices: Foundations are non-profit organisations that dedicate their assets to pursuing general aims and family offices are companies that advise wealthy families. On average, these institutions seek to allocate 11.1% of their assets to the Private Equity asset class43. ii. The GPs (fund managers) The General Partners or fund managers may also be sellers in the market whether itmay be selling a fund interest, a direct interest in a portfolio company, or a part of or all theportfolio of the fund(s) they manage. 1.4.3 The buyers Buyers are traditional or non-traditional depending on whether these investors havecapabilities to invest in the secondary market. Traditional buyers are funds dedicated to thesecondary market and funds of funds that invest part of their capital in secondary assets.The non-traditional are diverse institutional investors: foundations, insurance companies,endowments, pension funds, family-offices or GPs (fund managers).According to a survey conducted by Probitas Partners published in November 2009, 50% ofthose surveyed (institutional investors) actively purchase direct positions in funds and 10.8%actively purchase direct positions in companies in the secondary market44.41 See appendix 7.4, which summarises the email from Preqin (2 December 2009)42 Preqin; «Survey by Endowments investing in Private Equity»; October 200943 Preqin; «2009 Global Private Equity Review»; 200944 Probitas Partners ; «Private Equity Market Review and Institutional Investor Survey»; 2009
  40. 40. II. Characteristics of the Private Equity secondary market cs - 36 -Figure 13: Buyer types (by transaction volume - H1 09) :Source: Author’s own based on data from Cogent Partners; «Secondary Pricing analysis Summer 2009»; 2009.According to a study by Cogent Partners, during the first half of 2009, 57% of the investorsby volume were traditional45. i. Traditional buyers According to present analysis of secondary buyers (see in appendix 2), there currentlyare 140 buyers with secondary asset acquisition programmes.• Fund-of-funds: Investment vehicles designed to invest in other funds. In order to nvestment diversify their portfolio and accelerate returns, these funds usually invest a p accelerate portion of their capital in the secondary market. The amount these funds can allocate to secondary se assets (defined in their LPA) has greatly increased over time and is usually about 20%46.• Dedicated secondary funds Analysis of buyers in the market, the list of which is in funds: nalysis appendix (2.1 and 2.2), indicates a total of 77 companies that have funds dedicated to investing in the secondary market. These firms manage a total of close to $130 billion dedicated to the secondary market47. According to a study by Preqin, the majority of the dary managers are from the United States (56%) and from Europe (36%)48. At the end of 2009 the ten largest fund managers dedicated to the secondary market were as follows:45 Cogent Partners; «Secondary Pricing analysis Summer 2009 2009 Secondary 2009»;46 According to the author’s own survey. This percentage is that which they can invest in secondary assets;however, there is no requirement to invest in secondary assets, it is a possibility47 See appendix 2.1 and 2.248 Preqin; «The 2009 Preqin Private Equity Secondaries Review»; 2009
  41. 41. II. Characteristics of the Private Equity secondary market - 37 - Table 3: The ten largest dedicated fund managers at the end of 2009 Secondary funds Rank Name of the Manager managed ($ Billions) 1 Lexington Partners 15.9 Goldman Sachs Private Equity 2 Group 12 3 HarbourVest Partners 10 4 Coller Capital 8.4 5 Credit Suisse Strategic Partners 8.2 6 Landmark Partners 6.7 7 Partners Group 6 8 AlpInvest Partners 5.3 9 AXA Private Equity 5 10 Pantheon Ventures 4.6 TOTAL 82.1 Source: Author’s own These ten firms manage 64.4% of the dedicated secondary funds. ii. Non-traditional buyers According to a study by Cogent Partners, during the first half of 2009 43% of theinvestors by volume were non-traditional49.Non-traditional buyers are considered to be investors that resort opportunistically to thesecondary market. In general, these buyers invest in this asset class in order to diversify theirportfolio or to take advantage of specific opportunities. They usually buy interests in funds(LP Interest) through straight and opportunistic sales. However, some have investmentprogrammes dedicated to the secondary market.49 Cogent Partners; «Secondary Pricing analysis Summer 2009»; 2009
  42. 42. II. Characteristics of the Private Equity secondary market - 38 -Figure 14: Non-traditional buyer types (H1 09) GP 9% Foundation 11% Pension fund Endowment 36% 11% Family Office 16% Insurance company 17%Source: Author’s own based on data from Cogent Partners; «Secondary Pricing analysis Summer 2009»; 2009. 1.4.4 Other emerging participants: the private marketplaces Besides those three groups of main participants, we highlight the ever-growingpresence of private marketplaces. These firms act as intermediaries that bring togethersellers and buyers. On these electronic platforms, interests in funds and direct interests inprivate companies can be exchanged. Since they are private these marketplaces arerestricted to Qualified Institutional Buyers (QIBs) by market regulation authorities50. A list ofthe main marketplaces for exchanging interests in Private Equity funds is in appendix (1.3). i. A source of liquidity for limited partners In these marketplaces, LP interests are transacted between a limited partner (seller)and a secondary investor. The largest in the segment of LP interest transactions (PrivateEquity; Venture Capital, funds of funds and hedge funds) are the firms Secondmarket (c. $2billion of interests for sale) and Investorflow. According to Mr Bollerman of Secondmarket(Head of limited partnership interest group) this market segment’s growth is “exceptionallyimportant”51.In the USA these marketplaces are deemed Qualified Matching Services (QMS) if theycomply with IRS (Internal Revenue Service) requirements. QMS status gives general partnersthe ability to provide additional liquidity to their LPs for trades of their fund interests.50 Dow Jones; «Guide to secondary market intermediaries»; 200951 See appendix 7.2, which summarizes the call to Secondmarket (1 December 2009)
  43. 43. II. Characteristics of the Private Equity secondary market - 39 -Partnerships that utilize QMS can trade an additional 8% of the total amount of the fundbesides the normal 2% each fiscal year without losing the limited partnership status andassociated fiscal advantages52. ii. A source of liquidity for the fund managers (GPs) These marketplaces are also a source of liquidity for fund managers (GPs) of VentureCapital funds (VC) and Leveraged Buyout funds (LBOs) which can sell their fund interests ordirect company interests thus providing an additional exit strategy. The largest marketplacesfor private company stocks are Secondmarket, NYPPEX, Portal Alliances LLC and SharesPost.These marketplaces typically charge an intermediation fee by of about 3% of the sale price(adding other costs if this commission does not cover the fixed costs of the platform)53.According to Daniel Green of Greenpark Capital, one of the key considerations when usingthese platforms is confidentiality of information. In confidentiality clauses of many LPAs theexchange of interests on this type of platform may not be allowed54. Furthermore regulationon trading in these private marketplaces and the financial viability of the process will governthe success of these new market participants.52 See part 3.3.2: Fiscal considerations53 See appendix 7.2, which summarises the call to Secondmarket (1 December 2009)54 AltAssets’ web page: www.AltAssets.com; interview with Daniel Green; (Last accessed: 20/10/2009)
  44. 44. II. Characteristics of the Private Equity secondary market - 40 - 1.5. History According to Wouter Moerel, a partner at AlpInvest Partners, the secondary markethas grown since its beginning due to two main factors55: The growth of the primary Private Equity market as the base of the secondary market. The systemic shocks which compel investors in Private Equity (LPs) to sell their investments for various reasons (liquidity, asset allocation, etc.)Figure 15: History of the Private Equity secondary marketSource: Author’s own using data from: Dow Jones; UBS (Secondary volume 2009); Private Equity Analyst;Preqin; Chicago Board Option Exchange.In light of these two reasons and considering historical volume and volatility in the market(index VIX) we can highlight three major phases of the secondary market.55 Wharton Knowledge; «Private Equity Secondary Funds: Are They Players or Opportunistic Investors?»; 9August 2009. http://knowledge.wharton.upenn.edu/ (last accessed: 20 December 2009)
  45. 45. II. Characteristics of the Private Equity secondary market - 41 - 1.5.1 The beginning of the market (1982-2002) Dayton Carr is considered to be the father of the Private Equity secondary market. Hebegan in the 1970s managing a Venture Capital fund for the president of IBM, Thomas J.Watson Jr.. At the end of 1979 American President Carter named Thomas Watson Jr. asSoviet ambassador. At that time Dayton Carr carried out the first known secondarytransaction by buying the fund that he managed and began to sell the interests. “I realizedthat entering in a posterior phase, when financial difficulties begin to soften, and with adiscount, could generate returns of about 60%” stated Dayton Carr56.In 1982, he founded Venture Capital Fund of America (today VCFA Group), the firstinvestment firm formed to acquire Private Equity interests in the secondary market. In 1984the VCFA Group created the first dedicated secondary fund in the USA with investorcommitments of $6 million. Later other pioneers such as Stanley Anfeld, founder ofLandmark Partners (1989), and Jeremy Coller, founder of Coller Capital (1990), helped todevelop the market. According to Mr. Wilson, Managing Director at HarbourVest, PrivateEquity at that time was “A desert- you could not trade out.”57.In the beginning it was a niche market and there was no established secondary market.There only existed the need to exchange interests in the largest and most popular funds58.There were some isolated transactions and mainly involved one interest in a fund andgenerally between the initial investors. In 1998 Coller Capital launched the first globalsecondaries fund.In the year 2000 Coller Capital and Lexington Partners together led the first secondarytransaction with a value larger than $1 billion by buying the Private Equity portfolio ofNatWest following the bank’s takeover by Royal Bank of Scotland. In 2001 the directsecondary market expanded with the first significant direct (or synthetic) secondarytransaction led by Coller Capital which bought a portfolio of 27 technology companies fromLucent Technologies59.56 Arun Natarajan; Web page: http://www.ventureintelligence.in/blog/2008/01/father-of-pe-secondaires.html;(last accessed; 31 December 2009)57 BVCA, Arshi Thind; «BVCA Research note: The Private Equity Secondary Market»; 200958 Sam Scherwin, Dan Burstein; «Inside the Growing Secondary Market for Venture Capital Assets»; 200759 Coller Capital’s web page; http://www.collercapital.com/assets/html/about_coller/coller_secondaries.html;(last accessed: 5 January 2010)
  46. 46. II. Characteristics of the Private Equity secondary market - 42 -Figure 16: The beginning of the market (1982-2002)Source: Author’s ownFrom the beginning of the market until 2002 the main market driver was growth of theprimary market and only $15 billion was exchanged in the secondary market. It was still a“cottage industry” 60. 1.5.2 The growth of the market (2003-2007) At the beginning of this period the market expanded as a result of the systemicshocks from 2000 to 2001 in which the technology bubble burst and attacks on the twintowers took place. Investors began to seek an early exit of their unpaid commitments toPrivate Equity and in particular to Venture Capital.During this period many of the large financial institutions (Deutsche Bank, UBS AG, AbbeyNational, Bank One, Merrill Lynch, Dresdner Bank, JP Morgan, Bank of America) began sellinglarge portfolios of interests in Private Equity funds and interests in “pay-to-play” funds usedas a mean to obtain lucrative leveraged finance or merger and acquisition mandates but thatgenerated losses in the banks’ accounts.Moreover, growth in the primary market due a period of economic expansion was the maingrowth driver of the secondary market. New investors in this asset class were accessing thesecondary market to create portfolios and relationships with GPs61.During this period the secondary market evolved becoming more efficient and replacing amarket characterised by limited liquidity and highly discounted prices. For the first time inthe history of the Private Equity secondary market assets were exchanged at their net asset60 Coller Capital’s web page; http://www.collercapital.com/assets/html/about_coller/coller_secondaries.html;(last accessed: 5 January 2010)61 Greenpark Capital; «With debt market tightening, what is the likely impact on the primary PE / secondariesmarket?»; 2007

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