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    Avt secondaries analysis2010 Avt secondaries analysis2010 Document Transcript

    • 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
    • © 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.
    •     ‐ 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.  
    • 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
    •   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 
    • -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.
    • -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
    • -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
    • -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
    • -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
    • -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
    • -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
    • - 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
    • - 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
    • - 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
    • 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.
    • “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)
    • PART I:INTRODUCTION
    • 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
    • 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
    • PART II:CHARACTERISTICS OF THE PRIVATE EQUITY SECONDARY MARKET
    • 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)
    • 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
    • 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 $2.5 trillion in 200810.7 The data used are from a historical analysis of the information published by different market participants. Seeappendix 8.3. The selected data are the most accurate and are from recognised and trustworthy sources8 Bain & Company, Inc; «Global Private Equity Report 2010»; 20109 Preqin; «Q1 2010 Private equity Fundraising Update»; 2010 (via Twitter 1 April 2010)10 Including the NAV of the portfolio and the unfunded. Preqin; «Private Equity secondary market: Short-TermBoom, Long-Term Growth»; 2009
    • II. Characteristics of the Private Equity secondary market - 21 - 1.2.2 The size of the secondary market i. Transaction volume in the secondary marketFigure 4: Transaction volume in the secondary market ($ 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
    • 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/ $25 trillion = 0.64%
    • II. Characteristics of the Private Equity secondary market - 23 -Figure 6: Volume raised by secondary Private Equity funds ($ 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
    • 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)
    • 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.
    • 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
    • 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
    • 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
    • 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)
    • 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
    • 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
    • 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.
    • 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
    • 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)
    • 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
    • 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 $130 billion dedicated to the secondary market47. According to a study by Preqin, the majority of the dary managers are from the United States (56%) and from Europe (36%)48. At the end of 2009 the ten largest fund managers dedicated to the secondary market were as follows:45 Cogent Partners; «Secondary Pricing analysis Summer 2009 2009 Secondary 2009»;46 According to the author’s own survey. This percentage is that which they can invest in secondary assets;however, there is no requirement to invest in secondary assets, it is a possibility47 See appendix 2.1 and 2.248 Preqin; «The 2009 Preqin Private Equity Secondaries Review»; 2009
    • II. Characteristics of the Private Equity secondary market - 37 - Table 3: The ten largest dedicated fund managers at the end of 2009 Secondary funds Rank Name of the Manager managed ($ 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
    • 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)
    • 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)
    • 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)
    • 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)
    • 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
    • II. Characteristics of the Private Equity secondary market - 43 -value (NAV) or even at a premium (called “secondary bubble” due to the intensecompetition for quality assets62) and liquidity greatly increased. Reflecting the increasedissuance in the primary market the secondary market became a portfolio management tool.This period witnessed a niche market evolve into an active market with broad supply and theappearance of many specialist participants (buyers or advisers). 1.5.3 The credit crunch (July 2007-2009) i. The crisis: growth driver in the secondary Marleen Groen of Greenpark Capital classifies the secondary market as a“countercyclical”63 market. Since 2007 when the American real estate market collapsed anew market environment has emerged. The financial crisis that was unleashed and theinfamous “credit crunch” with its disastrous consequences in the real economy have beencatalysts to growth of the secondary market.The increasing cost of financing of highly leveraged portfolio companies has put the future ofdouble digit Private Equity returns in doubt. When the financing tap is turned off, the cost offinancing increases and the value of investments64 falls. Opportunities to exit and refinanceinvestments are severely diminished. At the same time that operational risk is increasing thefinancial risk (above all for the LBOs) of Private Equity investments rises; sometimesdramatically. Funds that invested in 2006-2007 (the maximum in the market) purchased athigh valuation levels and now face many difficulties due to a high level of leverage. Guy Handwho heads Terra Firma Capital Partners, a large Private Equity investment firm in London,said during a conference in November 2008 that returns on the trillion dollars invested atthe height of the Private Equity boom in 2006-2007 will be “negative, very negative”65. Manyinvestors began to reduce their exposure to this asset class by seeking another risk/returntrade-off and this benefited the secondary market. Furthermore, active portfoliomanagement, the denominator effect, and the lack of liquidity helped push the secondarymarket upwards.Moreover, listed Private Equity funds have suffered from the reduction fund distributionsand financing restrictions. Without access to new financing they have had to sell assets byresorting to the secondary market66.62 Greenpark Capital; «With debt market tightening, what is the likely impact on the primary PE / secondariesmarket?»; 200763 Catherine Craig, Private Equity news; «Contrarian Secondaries firms harvest golden opportunities»; 11/02/0864 If the discount rate (WACC) of the cash flows increases, the value of the asset falls mechanically65 Kosman Josh; «The buyout of America» p 129; Penguin; 200966 Goldman Sachs Asset Management; «Observations on the Private Equity Secondary Market»; 2009
    • II. Characteristics of the Private Equity secondary market - 44 -And finally, financial institutions, some wounded severely during the crisis, have beengrowth catalysts in the secondary market. The large bankruptcies and rescues such as thoseof Lehman Brothers, Bear Stearns, Merrill Lynch, Citigroup, ABN Amro, Lloyds, HBOS, RBS orAIG have been a source of acquisition opportunities in the market through the sale of non-strategic assets such as Private Equity portfolios. Furthermore, the Basel II Accords multipliesby approximately 2 to 3 the cost to banks of investing in Private Equity67 providing addedimpetus for secondary sales.Figure 17: Changes to LPs’ exposure to secondary funds over the years 2008-2009 Not committed to Increased secondary 34% funds… Decreased 4% No change 33%Source: Author’s own based on data from Coller Capital; «Global Private Equity Barometer - Winter 2009-2010»; 2009. ii. Falling valuation: a buyers’ market During this period asset valuations have been driven down due impairment ofcompany fundamentals and valuation multiple contraction but also from the imbalancebetween the abundant offers (due to “distressed sellers”) and reduced demand frominvestors in the secondary market.Indeed, according to David Wachter, Managing Director of W Capital Partners, as much as$200 billion of Private Equity commitments will be offered in the secondary market in theperiod 2010-201168 or approximately $100 billion annually. The demand that can bequantified by existing “dry powder” is only about $40 billion69 (for active buyers: secondaryfunds, funds of funds and other investors with programmes dedicated to the secondarymarket) at the beginning of 2009. This supply demand imbalance of close to $60 billion willcreate a buyers’ market in which asset valuations fall.67 Greenpark Capital; «Impact of the credit crunch on the secondaries market»; 2008See section II, part 4.2.2. i. Basel II68 Dow Jones; «Guide to Secondary Market Buyers»; 200969 According to a survey by UBS at the beginning of 2009. UBS PFG; «Secondary capabilities pitchbook»;October 2009
    • II. Characteristics of the Private Equity secondary market cs - 45 -In 2008 and 2009 sellers accepted large discounts to net asset value (NAV) of sold assets.The NAV of their investments refers to the last value published by the GP (published ea eachquarter). Due to valuation reductions from one quarter to another (due to the fall in thevalue of portfolio companies) and their urgent need for liquidity, sellers were forced toaccept high discounts. iii. The lack of visibility prevents carrying out the transactions: the bid-offer spread t Uncertainty regarding the economic outlook causes investors to be very selectiveregarding the quality of assets they buy and the pace of transactions subsequently fell In fell.some cases buyers that signed a sale agreement withdrew by exercising the Material wAdverse Change clause (MAC) abandoning a transaction agreed a few months earlier71. 70To compensate for risk incurred by this lack of economic visibility return requirements on otheir investments increases and high discounts to NAV are offered. Sellers that have higher higher ellersprice expectations do not agree and due to the wider bid/offer spread transactions are notcarried out as demonstrated by a study undertaken by Triago indicating that 86% oftransactions in 2008 were not carried out due to low valuations.Figure 18: Proportion of investors who ruled out transactions in 2008 because of pricing concerns : 14% Yes No 86%Source: Author’s own based on data from Triago; «The Secondary Sellers Options»; 2009. iv. The market is perfected During the credit crunch, the Private Equity secondary market is perfected. Manyinvestors in Private Equity now access the market increasingly making structuredtransactions or direct (synthetic) transactions of entire portfolios. The specialist participantssuch as advisers have develop developed new strategies to create value by means of complexstructured transactions.70 See legal considerations, material adverse change clause71 Private Equity Online; «MAC uncertainty grips sellers in secondary market 03/11/08 MAC market»;
    • II. Characteristics of the Private Equity secondary market - 46 - 2. The transactions on the market: Description of the different structures and sale processes 2.1. Different types of transactions In the market transactions are classified into two groups according to the type oftransferred asset; the sale of limited partnership interests and the sale of direct interests.Figure 19: Two types of secondary transactions: sale of limited partnership interest and direct saleSource: Author’s own 2.1.1 Sale of limited partnership interests This type of transaction occurs when an investor in a fund (LP) is willing to sell hisinterest or a portfolio of interests to another investor that becomes the new LP. Thedistinguishing feature of this type of transaction is that the buyer purchases the funded partof the fund but also commits to assume the unfunded commitments that the interestentails. 2.1.2 Direct sale Previously called synthetic sales, these transactions occur with the sale of a portfoliocompany directly by a Private Equity fund to another Private Equity fund. The object of thesale may be part or all of the interest in a company or in a portfolio of companies directlyheld by a fund. The sale can be carried out by creating a special purpose vehicle which willbuy the companies or interests in the companies and use a new manager (GP) hired to
    • II. Characteristics of the Private Equity secondary market cs - 47 -manage and ultimately sell the vehicle’s assets72. A sale can also be accomplished byacquiring the assets with a vehicle managed by specialised direct sales managers.A GP may also create an annex fund that takes ownership in companies of the other fund. Intimes of crisis underlying companies may need additional investment but the GPs may not nvestmenthave the fund resources to back follow on investments. Therefore many create annex funds follow-onthat invest in the portfolio companies with preferred conditions of returns (1.5 to 2 timesthe initial investment) and management fees (low management fees and carried interest). (lowIf the GP wants to sell direct company interests out of funds managed there are differentsales structures that can be adapted to the manager’s needs.According to UBS the sales of limited partnership interests, by transaction volume, usuallyrepresent close to two thirds of the total transactions while direct transactions represent theother third. However, in 2009, direct transactions only represented 15% of totaltransactions73.Figure 20: Transaction volume breakdown – (Limited partnership interest and Direct sale) (2007 to :2009)Source: Author’s own based on UBS data; «Adams Street Secondary Networking Event»; 2010. 2.2. Different sale structures There exist different structures that allow finding liquidity for an interest or aportfolio of interests in companies or funds.72 Wharton Knowledge; «Private Equity Secondary Funds: Are They Players or Opportunistic Investors?»; 9 Private orAugust 2009. http://knowledge.wharton.upenn.edu/ (last accessed: 20 December 2009)73 UBS Private Funds Group; «Adams Street Secondary Networking Event»; 10 February 2010 Event»;
    • II. Characteristics of the Private Equity secondary market - 48 -Figure 21: Different sale structures in the secondary marketSource: Author’s ownAll the structures from the table above can be applied to each type of transaction: sale of alimited partnership interest or direct sale. The exception is securitisation of the unfundedwhich is a structure that can only be applied to the sale of a limited partnership interestgiven that it is the only type of transaction that would entail an unfunded commitment.
    • II. Characteristics of the Private Equity secondary market - 49 -Figure 22: Comparison of the characteristics of the different sale structuresSource: Author’s ownAs can be seen in the table above each sales structure depends on the type of asset sold andon the objectives and concerns of the different parties. The structures presented in the tabledemonstrate there are various options available to satisfy a seller’s requirements. 2.2.1 Straight sale This sale structure is the most common and widely used. It consists of the straightsale of an interest or of a portfolio of interests in portfolio companies or funds. In the case ofa sale of a limited partnership interest the seller sells all his interest to the buyer who paysfor the funded part of the fund and commits to assume the unfunded commitments that thefund’s interest entails. In a direct sale the buyer acquires the entire portfolio company.
    • II. Characteristics of the Private Equity secondary market - 50 -Figure 23: Traditional sale structure: straight sale of a limited partnership interestSource: Author’s own 2.2.2 Strip Sale74 In this structure, the buyer purchases a part of the interest of a fund in one, some orall the interests of the manager (funds or companies). The buyer selects the funds orcompanies in which he wishes to invest and buys part of the interest of the fund in these.This structure is usually used more for direct sales transactions (of portfolio companies) inorder to generate valuable liquidity to back the manager’s investments in a much lessdilutive manner than by means of an annex fund with preferred return.However, it can also be accomplished through the sale of limited partnership interests. Withthis structure, the manager of the limited partnership interests may reduce his overallexposure while maintaining close relationships with the underlying fund managers75. 2.2.3 Stapled Secondary In this structure, the buyer acquires an interest or a portfolio of interests in portfoliocompanies or funds combined with an investment commitment in a new fund managed bythe seller. This structure, imposed by the GPs, allows them to facilitate their nextfundraising. This type of transaction also requires the secondary buyer to have the capacityto fund primary investments.This transaction structure was very popular in the years 2006-2007 but is infrequently usedin the current environment due to existing supply/demand imbalances in the market.74 Probitas; «Second thoughts newsletter»; 200975 Campbell Lutyens; «The Private Equity Secondaries market: a complete guide to its structure transaction andperformance»; PEIbooks, 2008
    • II. Characteristics of the Private Equity secondary market - 51 -Figure 24: Structure of a stapled secondary sale of a portfolio of limited partnership interestsSource: Author’s own 2.2.4 Structured secondary sale76 These structures are innovative and becoming more frequent since they allow sellersto achieve much more attractive prices than in a traditional transaction. Additionally theyallow carrying out large transactions by offering downside protection. They vary from onetransaction to another but as a general rule the seller establishes a special purpose vehicle(SPV) with a company specialising in the secondary market (the buyer) to create a singlelegal and financial framework that fulfils seller objectives. The vehicle, typically financed bythe buyer, acquires the assets of the seller, who in exchange receives the proceeds of thesale in cash and an interest in the capital of the new entity.In order to successfully execute a structured transaction, the seller must determine his mostimportant objectives– sale price, liquidity, relief of future capital calls, administrative burden– and suitably structure the variables of the transaction taking into account legal, tax77,accounting, administrative and regulatory considerations. It is therefore very advisable towork with an experienced adviser on these structures.Each structure is tailor-made according to the asset and the objectives and concerns of thedifferent parties. Therefore, each is unique but some important common variables standout. Agreement on the shareout of cash flows:In several structured transactions a cash flow shareout agreement is defined which governsall future capital calls and distributions of the assets that belong to the NewCo78. Depending76 See appendix 7.1, which summarises the call to UBS (26 November 2009)77 The investor may have the chance to use the losses as a tax shield78 UBS Private Funds Group; «Private Equity Secondary Market Review»; 2009
    • II. Characteristics of the Private Equity secondary market - 52 -on the seller’s objectives - liquidity, reduction of risks, relief from capital calls, etc. - theterms can be highly specific to each structure.Figure 25: Structured joint-venture sale of a portfolio of limited partnership interestsSource: Adapted from UBS Private Funds Group; «Private Equity Secondary Market Review»; 2009.For example, if a seller cannot assume large capital calls, the buyer may finance it. Inexchange the buyer receives all the distributions up to 100% of the capital invested. Then,depending on the asset and the terms of the transaction, he receives the vast majority of thedistributions (between 80% and 90%) until reaching a preferred return of between 1.5 to 2times his investment. When this return has been exceeded, the distributions change withthe LP receiving the majority of the distributions (between 70% and 90%)79. Seller financing or financing by a third party80:When structuring a transaction the financing variable is crucial. In order to finance the assetacquisition, the buyer may request financing in order to leverage the acquisition, lower itsfinancing cost and obtain some downside protection. Besides the loan, he may request acredit line in order to finance any imbalance that may appear between the capital calls anddistributions.79 Dow Jones; «Guide to secondary market Intermediaries»; 200980 See appendix 7.1, which summarises the call to UBS (26 November 2009)
    • II. Characteristics of the Private Equity secondary market - 53 -He may request this financing from a third party or, since credit availability is currentlyrestricted, from the seller. 2.2.5 Total return Swaps81 These are derivatives contracts designed to swap the cash flows between twoparties. In this structure, a floating interest rate is swapped for all the cash flows of aportfolio of interests in funds or in companies. The protection buyer keeps the asset butexchanges the cash flows from the asset (capital calls, follow-on, dividends and distributions)for a variable interest determined as benchmark + spread. The protection seller receives thecash flows of the asset but assumes the risk of valuation fluctuations (capital gain and loss).This derivative contract seeks to transfer the credit and market risk of the underlying assetto another party that seeks exposure to this asset. It changes the nature of the asset on eachparty’s balance sheet but it does not remove it from the balance sheet of the counterpartyseeking to reduce risk.Figure 26: Total return swaps for a portfolio of limited partnership interestsSource: Author’s own using data from Probitas Partners; «Routes to liquidity»; 2009.Advantages: Maximises the asset price Rapid execution (it does not need the GP’s approval)Drawbacks: It does not remove the asset from the “seller’s” balance sheet and does not generate liquidity upfront (there is no initial payment) The contract entails the creation of counterparty risk.81 Kelly DePonte; Probitas Partners; «Routes to liquidity»; 2009
    • II. Characteristics of the Private Equity secondary market - 54 - 2.2.6 Securitisation: CFOs In this structure the buyer acquires the assets via a SPV and later refinances theacquisition by issuing CFOs (Collateralised Fund Obligations). This structure divides the cashflows of the asset into strips or tranches that have different payment priorities and differentrisk/return profiles82.Figure 27: Securitisation by means of CFOsSource: Adapted from Probitas Partners; «Routes to liquidity»; 2009. 2.2.7 Securitisation of the unfunded83 This structure, which can only be used in the sale of limited partnership interests,divides the interests between the funded and the unfunded commitments. The LP keeps hisfunded interest but the unfunded is securitised and sold off. The secondary investor buysthese new securities by creating a special purpose vehicle of which he can become themanager.Figure 28: Securitisation of the unfundedSource: Author’s own82 Kelly DePonte; Probitas Partners; «Routes to liquidity»; 200983 Private Equity Analyst; «Secondary firms cook up new ways to close deals»; 2009
    • II. Characteristics of the Private Equity secondary market - 55 -NYPPEX has also developed a certain type of derivative contract called NYPPEX GICCO(Guaranteed Capital Call Obligation) that acts as insurance. An LP that does not wish tofinance its unfunded commitment can buy a GICCO protection for a defined period of time.This contract transfers the financing obligation (the unfunded commitments) to the buyer ofthe contract who, should the GP make a capital call during the period of the contract,provides capital funding and in exchange receives a preferred return on the distributions ofabout 1.5 to 2.0 times the investment made. For this transaction NYPPEX charges acommission of close to 2.5% of the unfunded and mostly to the buyer.This structure developed by Probitas and NYPPEX is very innovative but has not yet beenimplemented. 2.2.8 Spin-out The term spin-out is used in the Private Equity secondary market when the buyeracquires an entire portfolio of captive assets. Generally buyers are the previous fundmanagers alongside a secondary investment firm. The most famous example of this type oftransaction is that of MidOcean Partners which acquired alongside AlpInvest in 2003 theportfolio of assets that their managers previously managed in Deutsche Bank for €1.3 billion.One of the most recent is that of the Venture Capital group of Lehman Brothers (LehmanBrothers Venture Partners) whose management team and HarbourVest bought in January2009 for an undisclosed amount84 and called the new entity Tenaya Capital. The secondaryinvestor may or may not include the management team in the transaction.This sale structure is usually accompanied by a stapled secondary given that the fundmanagers wish to secure interests in subsequent funds in order to continue their investmentactivity85. 2.2.9 Tail-end This sale structure refers to the sale of the remaining assets in a fund that isapproaching or has exceeded its expected life. In this type of transaction the GP seeks to sellthe remaining assets of the fund by means of an accelerated traditional sale that preservesthe IRR already achieved by the fund.84 Harbourvest press release: http://www.harbourvest.com/news_and_events/pressreleases/1029.htm; lastaccessed: 10 January 201085 Campbell Lutyens; «The Private Equity Secondaries market: a complete guide to its structure transaction andperformance»; PEIbooks, 2008
    • II. Characteristics of the Private Equity secondary market - 56 - 2.3. The different sale processes86 When selling one or more interests in a fund or funds, or selling a part or all of one ormore portfolio companies, there are different options for accessing the secondary market.Figure 29: Comparison of the characteristics of the different sale processesSource: Author’s own; data from Triago; «The secondary seller’s options»; 2009 and Clark, Geoffrey, andChristopher Kojima; «Opportunities and challenges in Secondaries» Goldman Sachs in The Journal ofAlternative Investment, 74-86; 2003. 2.3.1 GP option: arrange a sale through the manager This process is only applicable to the sale of limited partnership interests. The LPcontacts the GP to discuss his intention to sell the interest and seeks the manager’sassistance in finding a buyer. The GP has no obligation to assist the seller in the sale butusually accepts because in this way he can control who is going to be his new LP after thesale. Generally the manager attempts to sell to the existing LPs of the fund (or of another ofthe manager’s funds) or to other outside “friendly” investors.The limited competition in this process makes it uncertain that the LP will achieve the bestprice for his interest. 2.3.2 Exclusive sale with a secondary buyer The seller (LP or GP) decides to negotiate with a single potential buyer. This exclusiveprocess is usually carried out with a buyer with whom the seller already has a goodrelationship. It allows the buyer to obtain more information, meet the seller, understand thereasons for selling, and potentially offer better pricing and a tailored transaction. However,due to the absence of other alternatives, execution risk is high.86 Triago; «The secondary seller’s options»; 2009
    • II. Characteristics of the Private Equity secondary market - 57 - 2.3.3 Open auction In this process the potential seller organises and manages an auction which is open tomany potential buyers. The selection of the potential buyers is therefore a critical step.Furthermore, the seller must manage the flow of information efficiently to ensure that theprocess is competitive. A typical auction is carried out in two rounds. In the second round(the short list) two or three buyers are selected to submit binding bids.Although this process lacks confidentiality and can be very intense, it allows the seller toreceive many bids and make an informed decision on pricing. However, for confidentialityreasons, it may not be used in a direct sale. 2.3.4 Targeted auction This process, although very similar to the open auction, has two notable differences: It is managed by a secondary adviser The name of the seller is unknown to the potential buyersIn this process the secondary adviser targets the auction to a group of selected potentialbuyers and in this way increases the chance of maximising the asset price. Furthermore,confidentiality and anonymity allows the seller cancel the asset sale (if he does not like thetransaction terms) without the market or GP realising the identity of the seller. 2.4. The execution of the transaction A typical sale process in the secondary market lasts between two weeks87 and threemonths and advances through the following stages88: Analysis of the assets being sold according to the buyers’ returns expectations. Verification of the portfolio according to the buyer’s investment criteria89. Verification of the LPA conditions and of the transferability of the assets. Choice of the sale structure and of a suitable process: GP option, exclusivity, limited or public auction. Preparation of due diligence documents and of the transaction: syndication, joint venture, etc.87 Web page Financial Planning; «Private Equity gets liquid»; www.financial-planning.com; 200988 Carta Diem; «Private Equity Solutions»; 2005Triago; «The secondary seller’s options»; 200989 Moreno-Barberá Participaciones Financieras; «El Mercado secundario de capital riesgo»; January 2006
    • II. Characteristics of the Private Equity secondary market - 58 - The process of due diligence in a secondary transaction is crucial to be able to evaluate the quality of the fund’s underlying assets, the quality of the GPs, the existing agreements and to determine a suitable price. Selection of the bidder through different secondary buyers in the market. Obtaining GP consent for the transaction. Assistance and coordination with legal advisers and drafting of contracts. Finalising the documents and negotiations. Closing of the transaction: signing the contract, payment of the final price and change of ownership of the assets. 3. Legal and tax considerations A Private Equity fund entails many legal and tax considerations flowing from thelimited partnership agreement (LPA) which relate to the transferability of the asset. For thisreason, when buying or selling limited partnership interests in the secondary market, it maybe necessary to review all legal documentation prior to a transaction. 3.1. Legal considerations in the revision of the LPA The LPA or formation agreement of a fund describes the structure and characteristicsof the fund and governs the relationship between the LPs and the GP. It contains thedifferent rights and obligations of the respective parties and the different operatingconditions of the fund. Additionally, there may be side letters or other such separateagreements which can clarify or modify terms of the LPA. For this reason, when selling aninterest it is essential to obtain all legal documentation prior to the transaction. 3.1.1 The Consent of the GP90 LPAs generally require the consent of the GP in order to exchange a limitedpartnership interest. In some cases the GP cannot reject a transaction as long as it does notviolate LPA terms but in others consent is left to the GP’s discretion.Usually, the GP does not exercise its veto right given that a secondary sale typically reducesthe default risk of its LPs91. According to a survey by Preqin published in 2009, 94% ofmanagers say that they have never used their right to veto a secondary sale92.90 Wilmer Cutler Pickering Hale and Dorr LLP; «Trends in the Private Equity Secondary Market»; 200991 See appendix 7.10, which summarizes the meeting with SJberwin (14 December 2009)92 Preqin; «The 2009 Preqin Private Equity Secondaries Review»; 2009
    • II. Characteristics of the Private Equity secondary market - 59 - 3.1.2 Pre-emption rights: Right of First Refusal (ROFR) In some funds (for example those of Blackstone) the LPA contains a right of firstrefusal clause. When an LP sells their interest, these clauses oblige the LP to first offer theinterest to the existing LPs in the fund on the same terms as those agreed with the potentialbuyer. If this requirement exists, it must be honoured unless the GP waives it (the GP canwaive this clause).Furthermore, in the case of a direct sale (interest in a company) there may be shareholdersyndication agreements with pre-emption rights. If so, they too must be honoured unlessshareholders waive them. This clause may delay the closing of the transaction. 3.1.3 Legal reporting requirements In the case of a secondary transaction some LPAs require that a legal opinionregarding the transfer be rendered to certify the transaction will not contravene a securitieslaw or tax laws. In practice it is very rare for the GP or his legal counsel to request it93. 3.1.4 Sale notification requirements The LPA may require prior notification of the sale within a certain time period. In anycase, in order to finalize the sale, the new and previous LP will have to notify the GP of thetransfer. The new LP will have to comply with the GP’s information requirements andprovide necessary information to complete different documents. 3.1.5 Payment of costs incurred by the transaction The GP may ask the buyer and selling limited partner to pay the costs incurred by thetransaction which is generally limited to the legal fees associated with the TransferAgreements. This fee is generally split between the buyer and seller. 3.2. Legal considerations in the negotiation of the Purchase and Sale Agreement Once the buyer and the seller agree on price both parties sign a Purchase and SaleAgreement (PSA). This contractual document specifies the price, subject assets, closing date,representations and future commitments. Besides the price and subject assets this contractincludes key legal terms of the transaction.93 VCFA group; «Secondary sales of Private Equity interests»; 2002
    • II. Characteristics of the Private Equity secondary market - 60 - 3.2.1 The contingent conditions94 These conditions are those that if not fulfilled cancel the agreed contract. They maybe divided into two sections: conditions precedent or those acts that need to happen beforethe contract closes, and conditions subsequent or those acts that need to happen after thecontract closes. In a secondary transaction, the normal contingent conditions are thefollowing: Consent of the fund general partner to the transfer Satisfaction or waiver of any rights of first refusal Waiver of penalties regarding any defaults by the seller (such as a late capital call payment) 3.2.2 Material Adverse Change clauses95 These clauses allow a buyer to withdraw from a transaction if the fund (mainlyportfolio companies) undergoes substantial changes between the signing and the closing ofthe transaction. These clauses can vary from broad coverage to more specific points such asthe resignation of a key manager. 3.2.3 Clawback provisions96 Clawback clauses are provisions included in the LPA that require LPs to refunddistributions due to special conditions. In the PSA it is essential to indicate that if theseclauses are exercised the seller will compensate the buyer by refunding distributions madeprior to the cutoff date.The parties can also agree on a mechanism to calculate the liability for a clawback of fundsthat are not attributable to a particular distribution according to a pro rata share of thedistributions received. The caps in these refund requirements are often heavily negotiated. 3.2.4 Threshold funds97 In a transaction involving a portfolio of fund interests, threshold funds may beidentified. These are funds that must be transferred before having to buy any other funds inthe portfolio. It enables the buyer to acquire only the funds he is focusing on without beingforced to buy less attractive interests.94 VCFA group; «Secondary sales of Private Equity interests»; 200295 Kaye Scholer LLP; «Key legal and transactional issues in secondary Private Equity fund transaction»; 200996 Wilmer Cutler Pickering Hale and Dorr LLP; «Trends in the Private Equity Secondary Market»; 200997 Wilmer Cutler Pickering Hale and Dorr LLP; «Trends in the Private Equity Secondary Market»; 2009
    • II. Characteristics of the Private Equity secondary market - 61 - When sellers are distressed they may use thresholds in an attempt to obligate buyersto purchase less attractive assets when acquiring an interest in a high-quality fund. 3.2.5 Indemnifications98 General partners request indemnifications for breaches of covenants,representations, and warranties in the sale agreement. Buyers and sellers seek to limit theseindemnification requirements. However the seller and the buyer have little room tonegotiate with the GP given that the same must consent to the transaction. 3.2.6 Joint liability: French legal framework99 In France the law considers the seller jointly liable with the buyer for capital calls ofthe transacted fund interest (in an FCPR) during the two years after the transaction. Thislegal provision requires the parties to reach an agreement on this particular issue whendrafting the PSA. 3.2.7 Stapled transaction clauses100 This clause obliges the buyer to commit to invest in a new fund managed by the sameGP in order to obtain the GP consent of the secondary transaction. Although more popular in2006-2007 it has become less common today due to the supply/demand imbalance in themarket. 3.3. Tax considerations101 Besides the LPA, each secondary sale must comply with the taxation regime of thecountry for which it is considered resident. The parties must determine the sale does notalter the fund’s tax status or its exemption from registration requirements. 3.3.1 Taxation of Private Equity funds In most jurisdictions, Private equity funds (PEF) are subject to favourable regulatorytreatment that exempts them from paying tax on dividends received from portfoliocompanies or capital gains generated from the sale of companies (elimination of the entity-level tax). Typically capital gains and losses and net operating income or loss is taxed in thehands of the LP.98 Wilmer Cutler Pickering Hale and Dorr LLP; «Trends in the Private Equity Secondary Market»; 200999 Private Equity magazine; «L’envol du secondaire»; August 2008100 Wilmer Cutler Pickering Hale and Dorr LLP; «Trends in the Private Equity Secondary Market»; 2009101 Dow Jones; «Guide to secondary market buyers»; 2009
    • II. Characteristics of the Private Equity secondary market - 62 - 3.3.2 The United States: the 2% law102 In the USA, under IRS regulation (section 1.7704), no more than 2% of a privatepartnership’s capital commitment can be transferred each fiscal year without thepartnership being considered to be publicly traded. Should this rule be broken thepartnership will be deemed a corporation thus losing the benefits of a flow through entity. i. The Qualified Matching Service Transactions in a fund can only be carried out between qualified investors and limitedpartner transfers may only occur among 2% of the fund’s capital commitment unless theyoccur via a Qualified Matching Service (QMS). A Qualified Matching Service is approved bythe tax authorities and allows exchanging an additional 8% of the fund’s capitalcommitment. A QMS provides management services for a secondary transaction.In consenting to a transfer, the GP will make sure it complies with tax laws in order toprotect the fund’s fiscal status. For this reason an LP, before initiating a sale of interests,must verify the volume of transferred interests in the fiscal year to ensure that it complieswith regulation and that the transaction can take place. ii. Block transaction A fund may allow a transaction of more than 2% of the fund’s capital commitment ifthe transferred interest represents more than 2% thereof.Other exemptions to this 2% law are applied in some specific cases, such as in the sale of aninterest due to the death of its owner or between family members. 4. The future of the market 4.1. Empirical demonstration: The primary market drives the secondary As mentioned in 1.1.3, there seems to be a mathematical relationship between fundsraised in the primary market and transaction volume in the secondary market. In order toproduce future growth predictions, the author has developed a model to identify therelationship between the two markets.102 Dow Jones; «Guide to secondary market intermediaries»; 2009
    • II. Characteristics of the Private Equity secondary market - 63 - 4.1.1 Secondary market projections model103 The model is based on an analysis of historical data between 1995 and 2009(globally). The analysis focuses on primary fundraising and on transaction volume in thesecondary market. Analysis of these data and the projections model are available inappendices (8 and 9).The model analyses the historical relationship between primary fundraising volume andtransaction volume in the secondary market in order to determine a correlation that allowsfuture estimates to be made.In order to identify a relationship between the secondary and primary market, primarycommitments most likely to be transacted on the secondary market were determined. Thecommitments most likely to be sold are those between three and seven years old being themost often exchanged in the secondary market. It was assumed that transactions will takeplace over the life of the fund with the following probability distribution.Table 4: Distribution of the transaction probabilities during the life of a fund Year of the 1 2 3 4 5 6 7 8 9 10 Total fund Probability 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 100% Year average 0.0 0.1 0.3 0.8 1.5 1.2 0.7 0.4 0.0 0.0 5.0Source: Author’s ownThis distribution hypothesis is designed to target an average fund age of 5-years. Thisaverage transaction age of a fund is justified by historical averages that have fallen over time(they were previously above 5 years; today they are closer to 4.5 years).By multiplying the probability percentage by funds raised in the primary market in thecorresponding years, the potential volume of primary commitments that are likely to be soldin the secondary market can be deduced. This potential transaction volume will be called thesecondary base.103 Model available in appendix 9. Based on a study by Cogent Partners: «Secondary market model projections»(2006) and a study by Alex Sao-Wei Lee: «Private Equity secondary funds and their competitive strategies»(2003)
    • II. Characteristics of the Private Equity secondary market cs - 64 - 4.1.2 Historical relationship between the secondary base and the relationship volume in the secondary market Upon comparing the historical data of the secondary base with the secondarytransaction volume between 1995 and 2009, two trends stand out: From 1995 to 2002, an average of 3.4% of the secondary base was exchanged in the secondary market. From 2003 to 2009, the last relationship was not maintained; an average of 6.4% of the secondary base was exchanged.Since 2009 was an atypical year, the mathematical relationship was not maintaine due to maintainedthe crisis in the financial markets that prevented the natural turnover of primary assetstowards the secondary market. For this reason it is also interesting to analy the period market. analyze2003-2008 in which 7.2% of the secondary base was exchanged in the secondary market. 2008 4.1.3 Secondary market transaction volume: 2010 2010-2014E In order to be able to estimate volumes within the next five years, it was assumedthat volume raised in the primary market will remain constant after 2009; that is between2010 and 2013 the primary fundraising volume will be the same as in 2009. Since 2009 was a etough year for primary fundraising in Private Equity, it is a conservative hypothesis thatallows factoring the possible decline in investment by financial institutions in Private E Equitydue to new regulations (Basel II, “Volcker Rule”). Based on this fundraising data, thesecondary base is calculated.Figure 30: Secondary base (in bn$) 400 350 300 250 200 150 100 50 0 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014ESource: Author’s own
    • II. Characteristics of the Private Equity secondary market - 65 - The present downside case assumes a historical turnover rate for the period 1995 to2009 of 5.6%. This hypothesis is very conservative given that it does not take into accountthe new dynamic of the secondary market. It estimates a compound annual growth rate(CAGR) of 13% in volumes transacted in the secondary market which translates to anaverage of $17.5 billion per annum in the next five years. The base case uses the most recent trend from 2003 to 2009 in which 6.4% of thesecondary base was exchanged in the secondary market. If this trend is confirmed, it isforecast the market will represent an average of $20 billion per annum during the next fiveyears. This assumption which represents the base or most realistic case estimates acompound annual growth rate (CAGR) of 16% in the volumes exchanged on the secondarymarket. The present upside case uses the turnover rate of the assets for the period 2003-2008. Taking this hypothesis of a 7.2% turnover rate allows taking into account the differentfuture growth catalysts that have appeared mainly due to the crisis effects (denominatoreffect, financial pressure on investors due to a fall in distributions, and acceleration of capitalcalls) and the new regulations in force (Basel II, “Volcker Rule”). According to this scenario,the market will grow 19% per annum (CAGR) and will represent an average of $22.5 billionper annum of secondary transactions during the next five years.Figure 31: Estimates of the secondary market transaction volume according to the historicalrelationship ($ billions) 30 25 Downside case (5.6%) 20 Base case (6.4%) 15 Upside case 10 (7.2%) Secondary 5 transaction volume 0 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014ESource: Author’s own using data from: Dow Jones; «Guide to Secondary Market Buyers»; 2009 (1996-2008)/UBS Private Funds Group; «Adams Street Secondary Networking Event»; 2010 (2009)/ Author’s ownprojections.
    • II. Characteristics of the Private Equity secondary market - 66 -This historical relationship is used by different market participants to estimate secondarydealflow potential. This relationship relies on the main driver of the secondary market: thenatural turnover of primary assets in the secondary market due to portfolio management,changes in investment strategy, and need for liquidity.However, it must be noted that although these projections are based on the existingrelationship of historical data, the model is somewhat limited due to the uncertainty of thehistorical data.In conclusion, this model demonstrates that the primary market has been the historicaldriver of the secondary market. This verified relationship allows us to estimate that thesecondary market should witness an average transaction value of between $17.5 and $22.5billion per annum over the next five years (2010-2014)104. 4.2. Future growth catalysts As stated, due to the historical relationship and the large volumes raised in theprimary market in the last few years, if the historical relationship is maintained it is forecastthat market transactions will represent an average of between $17.5 and $22.5 billion perannum during the next five years. But what will be the main catalysts of this growth in thesecondary market? 4.2.1 The “denominator effect” Since public market valuations fell, the percentage of other assets in portfoliosincluding Private Equity funds has increased on a relative basis exceeding the asset allocationconstraints of many institutional investors. This phenomenon, known as the “denominatoreffect”, has forced many investors to restructure their portfolios leading to the potential forsale of LP interests105.According to a survey by Fidequity, at the end of the third quarter of 2009 20% of investorsin Private Equity (except secondary funds and fund-of-funds) were overexposed to the assetclass and may lead to an increase in secondary market opportunities106.According to a survey by Coller Capital, at the end of 2010 31% of American investors and15% of European investors forecast having Private Equity commitments higher than theirallocation targets107.104 Using the estimates of the downside and upside cases of the projections model.105 Ari Nathanson, Reuters; «LPs rush for exits, overwhelming secondary market»; 15 December 2008,www.reuters.com (Last accessed: 6 November 2009)106 Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009107 Coller Capital; «Global Private Equity Barometer - Winter 2009»; 2009
    • II. Characteristics of the Private Equity secondary market - 67 -Figure 32: LPs’ anticipated level of Private Equity commitments at the end of 2010 100% 90% 80% Lower than target 70% allocation 60% 50% Equal to target 40% allocation 30% 20% In excess of target 10% allocation 0% North American LPs European LPs Asia-Pacific LPsSource: Author’s own based on data from Coller Capital; «Global Private Equity Barometer - Winter 2009»;2009.However, some investors, in order to rebalance their portfolio, have increased their PrivateEquity allocation (for example, the pension fund CalSTRS had an allocation of 14.4% of itsportfolio when the threshold for this asset class was only 11%; they finally increased theirallocation limit to 15%108). Other pension funds and insurance companies over-allocated tothis asset class have also forced some GPs to lower their NAVs in order to reduce their totalexposure to this asset class.Figure 33: Plans to address the over allocation issue Consider sale on the secondary market Wait for problem to Investors in Private correct itself through Equity (except "numerator" effect fund-of-funds and secondary funds) Increase allocation Fund-of-funds Wait and see 0% 20% 40% 60% 80%Source: Author’s own based on data from Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009.108 Preqin; «Global Private Equity review»; 2009
    • II. Characteristics of the Private Equity secondary market - 68 -According to a survey by Fidequity carried out in the third quarter of 2009, only 10% ofinvestors in Private Equity (except secondary funds and funds of funds) and 22% of the fundsof funds considered accessing the secondary market to solve their over allocation to PrivateEquity. 4.2.2 The new requirements of the financial institutions Banks and other financial institutions are selling more and more Private Equity assetsdue to a desire to strengthen their balance sheets in order to comply with the new solvencyratio requirements and the recently approved Volcker rule. It is estimated on the balancesheets of the six largest American banks and AIG there is currently more than $130 billioninvested or committed in Private Equity funds for sale109. i. Basel II Since the implementation of the new Basel II accords which modify the weighting ofassets, the cost of financing Private Equity investments has been multiplied byapproximately 2.0x to 3.0x110. Private Equity assets weigh between 190% and 400%(depending on the regulator in each country and on the interpretation of Basel II) of theirNAV more than their unfunded part111. In order to comply with the solvency ratios (CT1, Tier1, Tier 2) banks have to strengthen their balance sheets by increasing capital resources orselling assets. Private Equity assets, in addition to being illiquid, have now become expensiveto own for the banks who had generally invested in this asset class as a means to winbusiness with the funds (“pay-to-play funds”) but have never considered these to bestrategic assets112. ii. “Volcker Rule”: the 3% rule113 In 2010 regulatory changes will be a key element that will have to be monitored.President Obama’s bill called the “Volcker Rule” was approved on the 20th of May by the USsenate and became a law on the 21st of July 2010.Under this rule banks will only be allowed to invest up to three percent of their total Tier 1capital in alternative investments. This bill could result in the secondary sale of proprietaryinvestments in Private Equity of many banks. With exposure to be capped at three per cent109 Sarría, Ignacio; «¿Qué pasa en el mercado “secundario” de capital riesgo?»; 14 April 2009,www.cotizalia.com; (last accessed: 13 January 2010)110 Greenpark Capital; «Impact of the credit crunch on the secondaries market»; 2008111 See appendix 7.13 which summarises the call to Campbell Lutyens (10 March 2010)112 Hoflich Peter; «The search for liquidity focuses on disposing of illiquid assets»; 4 February 2010;http://www.theinvestoraudit.com/ (last accessed: 05 de February 2010)113 Davis Polk & Wardwell LLP; «Senate-House Conference Agrees on Final Volcker Rule»; 25 June 2010
    • II. Characteristics of the Private Equity secondary market - 69 -many banks will be forced to sell off Private Equity assets mostly by spinning out theirPrivate Equity investment group (such as Citigroup did in July 2010) or wait and allow thefunds to harvest their investments and wind-down.Table 5: Tier 1 capital and 3% cap of five major US banks(in billions) Tier 1 3% of Tier 1BoFA ML 155 4.7JP Morgan 131 3.9Citi 119 3.6Goldman Sachs 68 2.0Morgan Stanley 49 1.5Source: Author’s own based on data from Q1 2010 financial statements.The table above provides an estimate of the capacity the five major US banks have to makeproprietary investments in alternative funds. It demonstrates this limit is likely to forcebanks such as Goldman Sachs to divest assets from its Private Equity investments. Also thiscould result in Goldman abandoning its Bank holding charter so as to avoid the Volcker rule.The other aspect of the rule would prevent banks from owning a commitment thatrepresents more than three per cent of the fund’s total capitalization which will force manybanks to sell part of their holdings in Private Equity funds.Banks would have two years to comply with this new rule and can qualify for an additionalperiod of three years. Also, banks can benefit from another five year extension to divestinterests in so-called illiquid funds. Essentially banks may have up to ten years to divestPrivate Equity assets. 4.2.3 An increasing pressure on the investors: fall in the distributions combined with an increase in the capital calls Historically low distributions combined with increased capital calls will increase thefinancial pressure on LPs.In reaction to the credit crunch merger and acquisition volume decreased and IPO exits havebecome challenging due to financial market volatility. Therefore, funds are selling fewerassets which do not allow them to make significant distributions to their investors.
    • II. Characteristics of the Private Equity secondary market - 70 -Figure 34: Distributions as a % of NAVSource: JP Morgan Asset Management; «Secondary Private Equity Discussions»; 2009; Thomson Financial/VentureXpert.Economic uncertainty combined with the high volatility of the markets has slowed the paceof the capital calls. According to a study by Cogent Partners, capital calls in the first quarterof 2009 represented 24% of those made in the fourth quarter of 2007114.However since economic indicators are improving GPs are expected to accelerate capitalcalls within the coming months which, combined with historically low distributions, willincrease financial pressure on LPs115. According to a study by Fidequity in 2009 more than80% of traditional and non-traditional investors forecast that GPs were going to increase thepace of capital calls in the next 12 months116.114 Cogent Partners; «Cogent Research: First Quarter 2009 Valuation and Cash Flow Analysis»; 2009115 Permal Capital Management LLC; «Private Equity observations-Golden age of secondaries?»; August 2009116 Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009
    • II. Characteristics of the Private Equity secondary market - 71 -Figure 35: Anticipated changes in capital calls in the next 12 months Moderatly increase Significantly increase Non-traditional Moderatly decrease Traditional Significantly decrease Stay the same 0% 20% 40% 60% 80%Source: Author’s own based on data from Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009.According to a survey by Coller Capital it is likely that 10% of LPs will not be able to complywith their financing requirements within the next two years117 dramatically increasing theirneed for liquidity. Therefore, in order to prevent default, these LPs are likely to seek liquidityby accessing the secondary market118. 4.2.4 The improving economic outlook After the economic crisis that began in 2007 and following the bankruptcy of LehmanBrothers, the rescue of many banks and insurance companies gave way to great uncertaintyin the markets. Since March 2009 macroeconomic indicators have improved and the publicmarkets have rebounded reflecting better economic conditions. Companies can now lookforward to stabilisation or growth. Due to this improved outlook, the net asset value of theunderlying assets is stabilising.This environment allows for greater optimism regarding investee companies prospects andtheir respective valuation reducing the risk of investments in Private Equity (primary andsecondary).117 Coller Capital; «Global Private Equity Barometer - Summer 2009»; 2009118 The Boston Consulting Group, Inc.; IESE; «Driving the shakeout in private equity: The role of investors in theindustry’s renaissance»; 2009
    • II. Characteristics of the Private Equity secondary market - 72 - 4.2.5 The bid offer spread is reduced In 2008-2009, the spread between bid and offer prices prevented many transactionsfrom being executed. The closing rate for transactions was very low and limited thetransaction volume in the market. This chasm between buyer and seller pricing expectationsprevented many transactions from being carried out in the short term and was the greatestconstraint for the period 2008-2009. According to AlpInvest Partners, only 20% of secondaryinvestment opportunities which came to market in the second half of 2008 actuallyclosed119.In order to understand when this spread can be reduced one must analyze its causes. Thespread has three major explanations: The valuation imbalance: This imbalance is attributable to the lag between the NAV and the market value. When public valuations are falling the value of Private Equity investments fall as well creating a difference between the real market valuation and the last published net asset value (NAV) of the fund. This difference is due to timing (the so-called lag of the NAV120) and the managers’ valuation methods. Although this gap has been narrowing since the application of rule FAS 157, it remains an issue. The uncertainties of public market and global economic outlook. The traditional mechanical imbalance in each market between seller and buyer. As macroeconomic and market conditions are improving, the outlook for theportfolio companies improves as do their fundamentals. Buyers reflect the improvement inthe companies’ fundamentals and the reduction in risk by increasing their valuations. Whenmarket valuations increase, the valuation imbalance (1) is reduced. As the outlook improves,the natural imbalance (2) due to uncertainties in the economic environment is also reduced.Finally, due to the reduction in distributions and increased capital calls121, financial pressureincreases on sellers, which also reduces the traditional bid/offer spread (3). For all thesereasons, we can see the components of the spread are reduced which subsequently reducesthe bid-offer spread.According to a survey by Fidequity in 2009, this spread reduced at the end of 2009122 andwill be sufficiently reduced in 2010 to increase deal flow. Indeed, more than 80% of119 Wharton Knowledge; «Private Equity Secondary Funds: Are They Players or Opportunistic Investors?»; 9August 2009. http://knowledge.wharton.upenn.edu/ (last accessed: 20 December 2009)120 See section III; 3.3.4. The lag of the NAV121 See 4.2.3. An increasing pressure on the investors: fall in the distributions combined with an increase in thecapital calls122 See appendix 7.3 and 7.9 which summarise the call to Breslin (2 December 2009) and Campbell Lutyens (10December 2009)
    • II. Characteristics of the Private Equity secondary market - 73 -traditional and non-traditional investors forecast this spread will have fallen enough at theend of the first half of 2010 to be able to stimulate deal flow123.Figure 36: Timing of the tightening of the bid/offer spread Q3 2009 Q4 2009 Q1 2010 Q2 2010 Traditional Q3 2010 Non-traditional Q4 2010 2011 or later Never 0% 5% 10% 15% 20% 25% 30% 35% 40%Source: Author’s own based on data from Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009.The sellers and the fund managers (GPs) must also have realistic pricing expectationsreflecting future value rather than historical market valuations124. Fund managers mustvalue their investments in a fair manner (fair value) to avoid creating an imbalance betweenthe valuations. When the spread is reduced, participants will be able to agree on valuationsand deal flow will be able to grow to never-before-seen levels in this market. 4.2.6 A market that is becoming a more important asset class for investors Investors are increasingly attracted to this asset class due to its growth andopportunities. According to a study by Coller Capital, 32% of limited partners intend toincrease their allocation to secondary funds within the next two years125.123 Fidequity; «Global Private Equity LP survey – Q3 2009»; 2009124 Wharton Knowledge; «Private Equity Secondary Funds: Are They Players or Opportunistic Investors?»; 9August 2009. http://knowledge.wharton.upenn.edu/ (last accessed: 20 December 2009)125 Coller Capital; «Global Private Equity Barometer - Winter 2009-2010»; 2009
    • II. Characteristics of the Private Equity secondary market - 74 -Figure 37: Anticipated changes to LP’s exposure to secondary funds over 2010-2011 No plans to invest Increase 26% 32% Decrease 5% No change 37%Source: Author’s own based on data from Coller Capital; «Global Private Equity Barometer - Winter 2009-2010»; 2009. 4.3. Ever more structured operations According to UBS’s secondary advisory team, structured transactions are the subjectof growing interest given current risk aversion126. A well-structured transaction providesdesired liquidity, allows maintaining relationships with GPs, and minimizes accountingimpacts of the transaction. Furthermore, it allows for maximization of transaction value forthe seller without impairing the investor’s returns. However, these sophisticated structuresdo require the use of an experienced adviser.126 UBS Private Funds Group; «Secondary capabilities» (Pitchbook); 2009
    • PART III: Valuation in the PrivateEquity secondary market
    • III. Valuation in the Private Equity secondary market - 76 -III. VALUATION IN THE PRIVATE EQUITY SECONDARY MARKET This section focuses on valuation in the Private Equity secondary market. Given that transactions of direct interests in portfolio companies are valued according to well established valuation methods, this section will concentrate on the valuation of limited partnership interests and intends to provide a reliable guide to valuation in the secondary market. 1. Historical market valuations 1.1. Transactions: historical valuation 1.1.1 General trend After an analysis of the available data on secondary market valuations127; it was decided that data from the secondary advisory firm Cogent Partners’ would be used. Since 2003 Cogent Partners has published an annual, and since 2008 a biannual, analysis of Private Equity secondary market valuations. These market valuation analysis reports128 are reference points and provide us with the result of bids that Cogent has received for the assets that it has placed in the market for its clients. Since this company’s dealflow is the largest among all the advisers (in terms of number of transactions), the information provided in these reports allows us to glean an accurate valuation of the market. The reports provide the average of the best, medium and lowest bids from the first rounds of received offers. The valuation in relative terms measures the value of the bid in relation with the asset’s last published NAV129. 127 Analysis in appendix 10. Historical valuations in the secondary market by asset type 128 See Cogent Partners «Secondary Pricing Trends and Analysis» available on Cogent Partners’ website 129 The valuations de the Private Equity portfolios (NAV) are usually published each quarter.
    • III. Valuation in the Private Equity secondary market - 77 -Figure 38: Secondary bids over time (as a % of last fund’s NAV) 110% 100% 90% Average High 80% Average 70% Median 60% Average 50% Low 40% 30% 2003 2004 2005 2006 2007 H108 H208 H1 09 H2 09 H1 10Source: Author’s own using data from Cogent Partners pricing analysis (2007-2008-2009-2010).The figure above portrays the historical trend in the secondary market and the spread in thedifferent bids. One can clearly see a very large increase in valuations from the first half of2009 to the first half of 2010 at 79.6% of NAV.However, this analysis does not take into account the funds’ funding ratios and cantherefore be altered by a change in the mix of the assets placed in the market.Given that the least funded interests entail greater unfunded commitments for buyers, theapplication of a discount on this unfunded part (that must be funded at nominal value)mathematically entails an even larger discount on the asset’s NAV. In order to overcome thiseffect it is necessary to compare the value of the bid plus the unfunded part with the totalvalue of the exposure to the asset (that is, the value of the last published NAV plus theunfunded part of the asset)130.130 Cogent Partners; «Secondary Pricing trends & analysis, January 2010»; 2010
    • III. Valuation in the Private Equity secondary market - 78 -Figure 39: Value of the best bid in comparison with the total exposure to the asset (NAV +unfunded) 110% 100% 90% 80% % of total 70% exposure 60% % of NAV 50% 40% 30% 2003 2004 2005 2006 2007 H108 H208 H1 09 H2 09Source: Author’s own using data from Cogent Partners pricing analysis (2007-2008-2009).Given the liquidity squeeze that has affected many institutions since the market downturn in2007, many institutions have wanted to get rid of the unfunded commitments on theirbalance sheets. This has led to many highly unfunded limited partnership interests beingoffered in the market.This analysis removes the effect of the change in the mix of the assets available in themarket. Upon comparing the two analyses in the graph above, we can clearly observe theeffect of the credit crisis that increased the mix of highly unfunded interests sold in themarket.We can also observe that the recent increase in secondary valuations is not due to a changein the mix of the assets but rather is based on a real increase in the valuation of theunderlying assets.Furthermore it may be highlighted that the current valuation slightly exceeds that of 2003when the market rebounded after the technology bubble burst. Therefore, the current trendseems to be following the historical trend. 1.1.2 The valuation depends on the type of asset Depending on economic conditions, each type of asset behaves in a differentmanner. It would therefore be important to compare the valuations over time across thedifferent fund types according to whether they are leveraged buyout funds (LBO), VentureCapital funds, or other funds investing in real estate, infrastructure or distressed assets.
    • III. Valuation in the Private Equity secondary market - 79 -Figure 40: Historical valuation of the best bids received for each fund type (% of the NAV) 120% 110% LBO 100% 90% 80% Venture Capital 70% 60% 50% 40% Others (Real estate, 30% infrastructure, 20% distressed) 2005 2006 2007 H108 H208 H1 09 H2 09Source: Author’s own using data from Cogent Partners pricing analysis (2007-2008-2009).Clearly, there is an overall trend in the secondary market. We may also highlight in the graphabove a trend for each type of asset exchanged in the secondary market. This is due to thefact that underlying assets of each fund evolve differently according to economic cycles.Valuation of the funds is therefore driven by valuation of the underlying assets.Although sector specific valuations for the years 2003-2004 are not available, the periodafter the technology bubble burst stands out with the low valuation of Venture Capital fundsthat reflect the fall in the valuation of these funds’ underlying assets.Since 2009, the value of leveraged buyout funds has been lower (68.9% of their NAV) thanthose of Venture Capital (75.4% of their NAV) due to the impairment of many portfoliocompanies in these funds which are highly leveraged and therefore have a high default riskin difficult economic conditions combined with high refinancing risk. 1.1.3 The valuation depends on the funding ratio The valuation of an asset in the secondary market largely depends on its fundingratio. This ratio measures the capital funded by the investors against the total commitmentof the investors in the fund.Since investors generally do not know in which assets the unfunded commitment is going tobe invested it represents a “blind pool” that conveys an additional risk producing a negativeeffect on valuation. Furthermore, since the buyer will have to assume this commitment at itsnominal value if acquiring a fund interest, there tends to be a positive correlation betweenthe funding ratio and valuations.
    • III. Valuation in the Private Equity secondary market - 80 -Table 6: Effect of the funding ratio on the valuation (H1 2009) Average of the best bids (% of the NAV) <50% funded >50% funded LBO 27.2% 42.7% Venture Capital 51.7% 36.0%Source: Author’s own using data from Cogent Partners; «Secondary Pricing analysis interim update, summer2009»; 2009.The table above demonstrates that leveraged buyout funds follow this correlation unlikeVenture Capital funds. The additional discount applied to mature Venture Capital funds canbe explained in that buyers discount the risk these mature funds will not have enoughcapital to fund next rounds of financing if required by their portfolio companies. For thisreason the GPs of these funds will have to invest in these companies from subsequent fundsor may need to raise annex funds that usually have preferred conditions131 and are moredilutive. 1.1.4 The valuation depends on the vintage year of the fund As well as depending on the type of asset or on the funding ratio, the valuation of afund also depends on its vintage year. After a period of fundraising a fund enters theinvestment period which is usually five years. Depending on where in the economic cycle thefund places investment, it may be investing funds at high or low company valuations whichdirectly affect its future returns.In addition, a fund with a more recent vintage year would typically have a larger unfundedcommitment for its investors (or a lower funding ratio) when compared to a fund with anolder vintage year.131 Cogent Partners; «Secondary Pricing analysis interim update, summer 2009»; 2009
    • III. Valuation in the Private Equity secondary market - 81 -Figure 41: Valuation according to the vintage year of the fund (H1 2009) in % of its NAV 2008 41.3% 2007 26.1% 2006 39.7% 2005 and before 43.0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%Source: Author’s own based on data from Cogent Partners; «Secondary Pricing analysis interim update,summer 2009»; 2009; average of the best bids received for all the funds.Upon analysing the graph above, it highlights the low valuations for the vintage years 2006to 2008 with 2007 being the lowest (26.1% of the NAV). These valuations may be explainedby the fact that while 2006 vintage funds paid higher multiples for their investee companiesand 2008 vintage funds have a low funding ratio, 2007 is the only vintage year that isaffected by both issues132. 1.2. Listed Private Equity funds 1.2.1 Concept133 Listed Private Equity funds are listed vehicles that allow participation in Private Equityinvestments in unlisted companies or in fund portfolios, without needing to invest muchmoney or be an institutional investor.There are two broad types of listed Private Equity funds: Listed funds that invest directly134: These funds invest directly in companies that together constitute a Private Equity portfolio. Example: HgCapital. Fund of funds135: These funds invest in a portfolio of Private Equity funds that then invest in companies. Example: Pantheon International Participations.132 Cogent Partners; «Secondary Pricing analysis interim update, summer 2009»; 2009133 Listed Private Equity Association; «Eight Steps for analysing Listed Private Equity Companies»; 2009134 See scheme available in appendix 11.1
    • III. Valuation in the Private Equity secondary market - 82 -There are also hybrid funds such as Graphite Enterprise or Electra Private Equity that investdirectly and indirectly (through Private Equity funds) in companies.Listed funds that are invested directly are usually managed by an investment firm that maybe related to the listed vehicle (Beteiligungs AG) or not (Standard Life European PrivateEquity). In any case, even if the listed vehicle has no ownership interest in its investmentfirm, the manager usually has the same name as the listed fund (F&C Private Equitymanaged by F&C Asset Management). 1.2.2 Historical trading: a proxy towards the valuation in the secondary market Since these listed funds are invested in Private Equity assets, they usually represent agood proxy for valuation in the secondary market. Upon comparing the trading average ofsome listed vehicles with their last published net asset value (NAV) it appears they can beuseful in approximating valuation in the Private Equity secondary market.Figure 42: Historical trading of the listed Private Equity funds – Premium / (discount) with its NAV 136Source: UBS; Thomson Datastream (19 July 2010) .As of the 19th of July 2010, these funds on average were trading at 66.4% of their NAV (thatis, with a 33.6% of discount).After comparing the historical trend of the trading average of some listed Private Equityfunds to the best bids received in secondary transactions it is apparent there is a very clearcorrelation.135 See scheme available in appendix 11.2136 The index includes the following listed Private Equity funds: Candover Investment Trust, Dunedin EnterpriseInvestment Trust, Electra Private Equity Investment Trust, F&C Private Equity A Trust, F&C Private Equity BTrust, Graphite Enterprise Trust, HG Capital Trust, Mithras Investment Trust, New Star Private Equity, NorthernInvestors Company, Pantheon International Participations, Prelude Trust plc, Private Equity Investors plc,Standard Life European Private Equity Trust, and SVG Capital.
    • III. Valuation in the Private Equity secondary market - 83 -Figure 43: Comparison between trading of listed Private Equity funds and bids received in thesecondary market 120% 110% Average 100% highest 90% bid on the 80% secondary market 70% 60% Listed 50% Private 40% Equity 30% funds 2006 2007 H108 H208 H1 09 H2 09 H1 10Source: Author’s own using data from UBS and Cogent Partners pricing analysis.Preqin, a firm that undertakes studies and maintains databases of the secondary market,developed an algorithm that provides price indications for interests in the market by usingthe trading activity of listed Private Equity funds. It has demonstrated a correlation betweentrading of these funds and their valuations in the secondary market. However, in order toaccurately estimate the real value of these assets, the following elements need to beconsidered: fund type (VC/LBO/ Other), vintage year, GP’s historical returns, fund’s trackrecord, funding ratio and market effect137. 1.2.3 Limits of comparison with the Private Equity secondary market138 The use of trading activity of listed Private Equity funds provides an approximation ofvalue in the secondary market. However, it integrates components that distort its value andlimit the chances of precisely valuing assets in the secondary market. i. The valuation depends on the underlying asset The valuation of a limited partnership interest or of a portfolio company depends oneach type of asset according to its investment targets (LBO, VC, Other), funding ratio, vintageyear, management team and the quality of the portfolio’s assets.137 See appendix 7.4 which summarises the email from Preqin (2 December 2009)138 See appendix 7.9 which summarises the call with Campbell Lutyens (10 December 2010)
    • III. Valuation in the Private Equity secondary market - 84 - ii. Market effect The trading of Private Equity funds is distorted by market effects. It is distorted by thegeneral mood of the market (bearish/bullish) and the effects of more or less liquidity in themarket. iii. Over-commitment strategies Listed Private Equity funds, particularly those invested indirectly (funds of funds),usually employ an over-commitment strategy in the underlying funds. That is, they commitmore money to the underlying funds than they have to finance their capital calls. Thisstrategy is based on the fact that since not all commitments are called for at the beginning ofthe life of a fund investors can attempt to finance future capital calls with distributions fromother funds.This allows for an increase of the investor’s returns by reducing the negative effect of thecash drag (negative effect of un-invested money) on returns and by efficiently managing theinvestor’s resources. In bullish economic cycles this strategy significantly improves returns.However, when the pace of distributions falls and capital calls increase it may put the fund indanger of not fulfilling its obligations due to investor capital call default. iv. Use of leverage Listed Private Equity funds are usually leveraged vehicles that allow maximization ofreturns in bullish markets but may have the opposite effect in bear markets. This effect,called leverage effect, can distort the trading value of the fund. In view of these limitations, the use of trading activity of listed Private Equity fundsmay not be an entirely accurate measure of the real value of secondary assets. It doeshowever allow approximating the general trend of the market.
    • III. Valuation in the Private Equity secondary market - 85 - 2. How to theoretically value this asset When valuing a limited partnership interest there are two valuation methods. Thetop-down method consists of applying the current discount/premium present in thesecondary market to the last published NAV of the fund manager. In contrast, the bottom-upmethod is based on the intrinsic value of the fund’s underlying assets and values the interestby discounting its cash flows. The bottom-up method can only be applied if the informationnecessary to value the asset is available.Figure 44: Two valuation methods of the secondary assetsSource: Author’s own using data from Clark, Geoffrey, and Christopher Kojima. «Opportunities and challengesin Secondaries»; Goldman Sachs in The Journal of Alternative Investment, 74-86; 2003. 2.1. Top-down method This method focuses on valuing assets using the current market valuation. In thesecondary market this can be done by two main methods: Valuation by comparable transactions Valuation by the historical trading of listed Private Equity fundsAs a traditional valuation using multiples a universe of funds with similar characteristics mustbe established. Characteristics would include investment style (VC, LBO, Other), fundingratio, vintage year, management team track record and fund returns. 2.1.1 The transaction or trading value/NAV ratio Both methods are based on applying the average existing valuations or the tradingvalue divided by the most recent value of the asset (NAV) to the net asset value of the assetthat we wish to value.
    • III. Valuation in the Private Equity secondary market - 86 -However, depending on the manager and the LPA, there may be different ways to value theassets and calculate the NAV. For this reason one must first check that the NAV used in thevaluation reflects the real value of the underlying assets and that they are valued in thesame way as comparable funds.Currently managers use very similar methods to calculate the NAV of their fund given thatorganisations such as the IPEV (International Private Equity and Venture Capital Valuation) inEurope or the PEIGG (Private Equity Industry Guidelines Group) in the United States havecreated Private Equity fund valuation guides which strongly influence the general method tobe followed in calculating the NAV of portfolio assets139. 2.1.2 Comparable transactions method After having determined the characteristics of the fund to be valued, transactions ofcomparable funds in the last quarter are researched in order to compare NAVs for the samequarter and since NAVs are usually published quarterly.The ratio of the price paid divided by the NAV of these comparable transactions (Price/NAV)is determined and this ratio applied to the last published NAV of the fund to be valued.If an interest in the same fund was exchanged, assuming enough public information, theratio is applied in this transaction and corrected for further capital calls or distributions thathave taken place after the transaction. 2.1.3 The valuation method by the trading multiples After having determined the characteristics of the fund to be valued, listed PrivateEquity funds with similar characteristics are researched. The ratio is calculated by dividingthe total value of the fund (market capitalisation + debt) by its last published NAV. This ratiois then be applied to the last NAV of the fund to be valued. 2.2. Bottom-up method: the valuation model In this method the value of a limited partnership interest will be determined by usingthe fundamental value of the fund’s underlying assets and the fund’s individualcharacteristics. These considerations are based on the valuation guidelines developed by theIPEV140 (International Private Equity and Venture Capital Valuation), theoretical and practicalknowledge, present research, and interviews with market participants. The result is avaluation model that can be used to value a limited partnership interest in a Private Equityfund.139 IPEV; «International Private Equity and Venture Capital Valuation Guidelines»; September 2009140 IPEV; «International Private Equity and Venture Capital Valuation Guidelines»; September 2009
    • III. Valuation in the Private Equity secondary market - 87 - 2.2.1 Structure of the bottom-up valuation method of a fund’s interest The bottom-up valuation method consists of the valuing the fund’s interest bydiscounting its future cash flows.Underlying investments and the unfunded commitments are projected over time and atiming of the fund’s cash flows (capital call, distributions) is assumed. After being projected,the cash flows are adjusted according to distribution priority or “waterfall” of the fund andthen discounted at the target gross rate of the secondary investor.Figure 45: Structure of the bottom-up valuation methodSource: Author’s ownThis valuation model, used by the majority of secondary market investors, requires flexibilitythat allows simulation of different assumptions according to the scenario being analysed(upside, base, downside). 2.2.2 Valuing the underlying asset The valuation of a limited partnership interest is based on the collective valuation ofthe fund’s underlying assets. The value of underlying investments needs to be projected overtime; that is, how much the investments are worth in each year of the life of the fund. It
    • III. Valuation in the Private Equity secondary market - 88 -basically consists of projecting the value of the assets over time by using growth andvaluation assumptions.This valuation depends on the type of asset: debt or equity, leveraged buyout, VentureCapital, real estate, infrastructure etc. This paper does not attempt to explain the valuationmethod for each type of underlying asset, but rather for a limited partnership interest. Forthis reason, we shall focus more on the valuation of the two most important funds types inthe secondary market: LBO funds and Venture Capital funds. i. Valuation of investments in leveraged buyouts (LBOs) Leveraged buyout funds usually have recurring and stable cash flows over time. Inorder to value a leveraged investment over time, a projection of the operations of thecompany will be made according to growth assumptions. These assumptions must be basedon discussions with the managers if possible and if not then on reasonable inferences aboutthe sector using public information.In this valuation model, it is assumed that cash flows serve to repay the debt as projectedover time.Each year the equity is valued by applying a multiple (EV/EBITDA) to the EBITDA of thecompany and deducting the existing net debt. The value of the investment is then calculatedby applying the fund’s ownership percentage.If the debt financing of the transaction is traded (the company Cortefiel as an example) thencurrent trading levels141 are considered as they provide insight on how company’s creditorsview the company’s risk profile. If the debt is traded at a deep discount it is inferred thatcreditors do not expect to recover all their money and it is also assumed that the value ofthe shareholders’ investment has fallen dramatically142. ii. Valuation of investments in Venture Capital Venture Capital portfolio companies generally have limited operational track records.They often do not have steady cash flow generation and are valued in a very particular waydepending on their activity and business model. For example, companies that operatewebsites can be valued with multiples such as EV/Number of unique users or EV/Number ofregistered users. The investor must analyse the company’s business plan, its strengths andadvantages over its competitors, the quality of the management team and the likelihood ofbeing diluted in new financing rounds.141 Loan trading levels can be found on Markit (https://products.markit.com/home/login.jsp)142 Clark, Geoffrey, and Christopher Kojima; «Opportunities and challenges in Secondaries»; Goldman Sachs inThe Journal of Alternative Investment, 74-86; 2003
    • III. Valuation in the Private Equity secondary market - 89 -If a recent corporate transaction exists that allows us to value the company (financing, sharetransaction) then this can be used to value the investment143. 2.2.3 Project the unfunded144 Besides the underlying assets, the acquisition of a limited partnership interest entailsfinancing commitments. This part, called the unfunded commitment, must be projected overtime in order to estimate its potential returns to value the limited partnership interest.The unfunded can be invested in two ways: • Follow-on investments: The managers reinvest funds in portfolio companies. The projection of these investments is similar to the projection of the underlying assets and is fairly objective. • New investments: The projection of the returns of these investments is much more subjective and is usually conditioned by the quality of the management team.The secondary investor usually speaks to the manager about his plans for investing theunfunded in order to be able to project as precisely as possible the returns that mayreasonably be expected. However if this information cannot be obtained it is usuallyprojected according to the quality of the fund managers. i. Evaluate the quality of the management team (GP) In order to be able to project the returns of the unfunded commitment, the quality ofthe managers is key given that they decide on future investments. The quality of amanagement team is usually evaluated by examining the previous experience of themembers of the investment team, the track record of their previous funds, and the returnsof current fund. In addition, the risk of that some members of the management team mayleave is usually evaluated (a clause called “Key man clause” can be included in the PSA). Lastbut not least the secondary investor needs to assess if the GP plans to raise further fundssince the managers may not be incentivised to achieve high returns in order to facilitatefurther fundraising145. ii. The projection multiples of the unfunded Discussions with different participants in the market provided insight on theprojection multiples used to project the returns of unfunded commitments over time. These143 Clark, Geoffrey and Christopher Kojima; «Opportunities and challenges in Secondaries»; Goldman Sachs inThe Journal of Alternative Investment, 74-86; 2003144 See appendix 7.1 which summarises the call to UBS (26 November 2009)145 Real Deals; «Secondaries roundtable 2009»; 2009
    • III. Valuation in the Private Equity secondary market - 90 -multiples should be used when available information is not enough to estimate returnsaccording to a more objective criterion than the quality of the management team. The tablebelow provides projection multiples for unfunded commitments over time according to thequality of the management team. However it does not pretend to be exact given that it mayvary by each fund type (VC, LBO, Mezzanine, etc.), size, and average historical returns146 ofthe fund type which change over time.Table 7: Projection multiples of the unfunded according to the quality of the management team Quality of the management team Good Base Bad Return multiple 1.7 1.4 1.2Source: Author’s own based on own survey. 2.2.4 Determine a timing of capital calls/distributions Once the underlying assets have been valued over time according to different growthscenarios and the unfunded commitments have been projected, the timing for differentfund’s cash flows then needs to be determined.If possible, the secondary investor must speak with the fund managers to understand theircapital call/distribution calendar and obtain the most accurate information possible. If it isnot possible to get this information from the GPs a calendar must be estimated. In order tomake a prudent valuation an aggressive calendar of capital calls (managers call for the fundsvery rapidly) and a conservative one for distributions (it takes a bit longer than expected tosell the companies) is usually followed147. 2.2.5 Aggregate the cash flows in the fund’s waterfall Once the underlying assets have been valued over time according to different growthscenarios and unfunded commitments projected throughout the life of the fund, it isnecessary to aggregate the different cash flows in the waterfall. That is, one has to add allthe cash flows of capital calls and distributions of cash in the accounting structure of thefund according to the previously determined timing.This structure, called waterfall, simulates the capital calls and distributions within the fund’svehicle. Basically, the capital calls are cash inflows throughout the investment period and thedistributions are cash outflows during the distribution period. The fund will also havemanagement costs that will be integrated into its structure.146 The historical returns usually come from databases such as Venture Expert147 Cogent Partners; «Pricing private equity secondary transactions» 22 July 2002; www.altassets.com (lastaccessed: 26 January 2010)
    • III. Valuation in the Private Equity secondary market - 91 - i. Capital calls During the investment period, usually the first 5 years of the fund’s life, the fundmanagers will gradually call for the capital committed by the investors every time they findan investment opportunity. They will also call for capital in order to cover fundadministration and management costs. Until distributions outweigh the necessary capitalcalls, they will keep calling on investors. GPs may call for less than what was originallycommitted by the investors (because they cannot find investment opportunities) but cannotcall for more unless the investors agree. ii. Fund management costs Throughout its life, the fund must assume costs that are detailed and explained in theLPA. The three largest categories are the following: • The fund’s annual operating expensesThe determination of costs covered by the fund is completed by examining its LPA. Theyusually seek to cover the basic administrative costs of the fund: administrative staff,accountancy, tax and legal advice, travel costs, communications, etc. • The fund management fees148Management fees are defined in the LPA. They usually represent 2% of the assets undermanagement. This management fee usually evolves throughout the life of the fund.During the investment period, the management fees are usually 2% and are calculated onthe total amount committed to the fund until the deployed capital reaches a pre-determinedthreshold. The logic is that since the managers do not manage many assets, given that theyhave not called for all the commitments, but are actively looking for investmentopportunities, they are remunerated for their work according to the total amountcommitted to the fund.During the distribution period, GPs do not have to seek further investment opportunitiesand therefore it is assumed that their management fee must fall according to thedistributions. For this reason, during this period, the management fees usually fall to 1.5%and are based off the aggregate cost of the portfolio companies, which is reduced with eachdistribution. • The management fees of the portfolio companies:The general partner also charges the portfolio companies consulting fees. This fee may befixed or indexed on an indicator (sales, EBIT). The fund receives the commission (inflow) and148 Tuck School of Business - Center for Private Equity and Entrepreneurship; «Note on limited partnershipagreements»; 2003
    • III. Valuation in the Private Equity secondary market - 92 -usually shares it between the general partner and the LPs (“management fee offset”). Theallocation of the fee is usually 80/20, that is LPs receive 80% and GPs 20%. Currently, thisconsulting fee is controversial and moving more and more towards the return of all of thisfee revenue to the LPs.The key for determining the costs of a fund is to analyse the fund’s documentation (LPA).This provides a better understanding of future costs and allows for a more accurateprojection of the fund’s future cash flows. iii. The waterfall Once the fund has been fully invested, it seeks to sell its investments during thedistribution period in order to distribute sales proceeds to its LPs. The structure of thedistributions (the waterfall) between the managers and the investors is unique to each fundand defined in the LPA. However Private Equity funds usually have a similar structure andallocation of the distributions.There are two distribution models: the American model, which divides the distributions on adeal by deal basis and the European model, which divides the distributions on the total of alldistributions. This paper explains the European model of the waterfalls.The European model of distributions operates as follows: 1. Repayment of the principal of the investment and of the costs borne by the LPs.Once the investor has recovered his investment then distributions are divided out betweenthe fund manager and the investor. The allocation is usually on a 20/80 basis however itvaries according to the type of assets managed (VC, LBO, funds of funds, etc.) and accordingto the quality of the management team. The part the manager receives is called carriedinterest. 2. The investor’s hurdle rate is a minimum preferred return that the investor ispromised in the LPA. It is usually 8% per annum. Therefore, the investor will receive 100% ofdistributions until an IRR of 8% on investment has been provided for. 3. The GP catch-up is a part of the carried interest that the manager receives once thehurdle rate has been paid. The manager then receives 100% of distributions until reachingthe agreed upon allocation of the distributions defined by the carried interest (20/80) withthe investors. If the carried interest is 20/80, he will receive 20% of the hurdle; that is: Carried interest rate Catch up = Total hurdle × Hurdle rate 1 − Carried interest rate Hurdle rate
    • III. Valuation in the Private Equity secondary market - 93 - 4. Other distributions: The distributions that exceed the combined investor hurdle rateand GP catch up are then allocated between the manager and the investors by following theLPA defined allocation of the carried interest (usually 80/20). That is, 80% of the remainingdistributions go to the LP and 20% to the GP.This division of distributions pays investors and the manager on an 80/20 basis in a specificorder that allows the investors to achieve a minimum return first and to provide incentivefor the managers to achieve good returns.It is essential to thoroughly understand the allocation of fund distributions that are beingvalued in order to project the cash flows the investor will receive.Table 8: Cash flows of the fund and distributions - Waterfall Fund’s cash flow - Investment costs - Annual operating cost of the fund - Management fee = Capital funded for the investments and costs + Distributions = Cash available for distributions to investors - Repayment of the principal - Hurdle rate = Cash post hurdle - GP Catch up = Cash post Hurdle and GP Catch up available for distribution - Carried Interest for GP = Distributions to investorsSource: Author’s own 2.2.6 Discount the cash flows by the cost of capital In this part the limited partnership interest is valued by discounting the cash flowsspecific to the secondary investor (capital calls of the unfunded part, distributions) at adiscount rate.The rate used to discount the cash flows depends on the gross returns that the secondarybuyer desires. This rate changes over time according to economic conditions and perceivedrisk (operating and financial) but also depends on the buyer’s cost of capital. If the buyer is asecondary fund its cost of capital will depend on returns committed to its investors.
    • III. Valuation in the Private Equity secondary market - 94 -According to the survey held with different market participants, at the end of 2009 and thebeginning of 2010 this discount rate was about 20% (IRR). The asset’s present value (NPV) iscalculated by discounting the cash flows at the discount rate. Upon multiplying this value bythe percentage of the fund’s interest (% of fund’s interest = Commitment of theinterest/Total amount of the fund) the value of the interest is derived. This value will be themaximum price that may be offered in order to achieve the return rate sought. 2.2.7 Sensitivity valuation analysis At the end of the valuation process a sensitivity test to different key variables isconducted. The aim is to determine the valuation range that can be offered for the assetaccording to different scenarios.The key variables in the sensitivity analysis are the growth scenario figures, valuationmultiples of the portfolio companies, the quality of the management team, and the timing ofcapital calls and distributions.
    • III. Valuation in the Private Equity secondary market - 95 - 3. Real world valuation: empirical contrast of the two methods This section applies the theoretical valuation fundamentals developed in the previoussections to a real world case. A limited partnership interest is valued by applying the twomethods in order to contrast the results and to determine the optimum method of valuingsecondary assets.In this case, the fund is a €40 million European leveraged buyout fund (LBO). The fund beganto invest on 1 June 2008 and has invested in 4 companies to date. It is 30% funded so theinterest comes with a large unfunded commitment. The GPs are of high quality given theirtrack record is in the top IRR quartile of LBO funds. The interest analysed involves acommitment of €2 million. The fund’s last NAV, published on 31 December 2009 is€10,879,000. 3.1. Top-down method: market valuation This 2008 LBO fund has a 30% funding ratio and a quality management team. To findthe market valuation it is necessary to find valuations of transactions of funds that have thesame characteristics. Secondary market specialists use databases which contain the latesttransactions with basic characteristics listed in order to follow the valuations of each fundtype in the market.In this case the most up-to-date available valuations of high quality LBO funds in thesecondary market will be applied. However, we do not have enough updated data to be ableto include the funding ratio in this analysis of the valuation. The funding ratio may have anegative effect on market value and therefore the value of the fund interest from thisanalysis may be higher than that existing in the market.According to Cogent Partners, at the end of the first half of 2010, leveraged buyout fundswere traded on average at 86.4% of their NAV. Upon applying this discount to the lastpublished NAV, the value of the present interest will be €469,973.Table 9: Top-down valuation of a limited partnership interestMarket value of the interest € 000Total fund amount (nominal value) 40,000Commitment of the interest (5%) at nominal value 2,000Last published NAV 10,879Current market pricing 86.4%Value of the fund in the market 9,399Market value of the interest (5%) 470Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 96 -Due to the limitations of the valuation as a result of using the trading activity of listed PrivateEquity funds, this method will not be used to value the interest. However, the currentvaluation of listed funds being 66.4% of the NAV (as of 19 July 2010), the value would beslightly inferior to the one achieved with the comparable transaction method. 3.2. Bottom-up method: valuation using the model149 This method, which requires the use of the valuation model developed with differentmarket experts, needs much more information than the top-down method. However, due tothe flexibility of the developed model, the valuation of a limited partnership interest is verystraightforward150. 3.2.1 Introduce the fund’s financial data and growth estimates The fund’s last report is used to gather the financial data necessary to project andvalue the portfolio companies. These data are introduced into the valuation model.It is first necessary to know the basic characteristics of the fund: date of creation, coststructure, total amount, commitment of the interest, funded commitment, last publishedNAV and other required details. This information can be found in the LPA and in the last fundreport. Talking to the GPs can be a huge advantage in that it allows having more accurateinformation on future investment plans and the state of the portfolio companies and theirgrowth outlook.149 Private and confidential, this valuation model is available upon request to Arnaud van Tichelen:a.vantichelen@gmail.com150 It is only necessary to introduce the data into the grey cells in the hypothesis tab and then sensitise the saleprice of the interest in the tab “command table” in order to stress the returns to the sale price, the quality ofthe manager and the different scenarios (upside, base, downside).
    • III. Valuation in the Private Equity secondary market - 97 -Table 10: Main characteristics of the fundKEY ASSUMPTIONS (€000) Investment periodCreation date of the fund 01/06/2008 Capital already commited 12.000Next Year end of the fund 31/05/2010 Remaining investment years 3 YearManagement fees during commitment period 2,00% 1 33,3% of unfunded 9.333Management fees post commitment period 1,50% 2 33,3% of unfunded 9.333GP Carried interest 20,0% 3 33,3% of unfunded 9.333Prefered return hurdle 8,0%GP Carry catch up 100,0% Investment holding period (Years) 4 Years to liquidation 7Total fund size (committed capital at nominal value) 40.000 Annual partnership Expenses 150,0% of committed capital expected to be called for investments 100% Annual assumed directors fees, 500,0Investor commitment (nominal value) 5% 2.000 transaction fees, investment banking fees, break-up fees, advisory fees,Invested capital 10.413 monitoring fees, or other similar feesOther Capital calls to pay expenses 1.587 Fee income offset 80,0%Total called capital 12.000 Charge on management fee 4,0%Funding ratio 30,0% Charge on capital already commited 5,0%Unfunded commitment 28.000 Last Euribor (1y) 1,30%Source: Author’s ownAfter entering the main characteristics of the fund (table 10), the financial data of theportfolio companies and their growth assumptions must be introduced following 3 differentscenarios (downside, base, upside).For the present analysis, we have used the financial data published in the last fund’s reportof the four portfolio companies. In this part we only present the analysis and the valuation ofCompany A, however it has been done for the four portfolio companies of the fund.The data has been projected using growth assumptions based on the managers’expectations and on the growth rates of the sector of each company (table 11). We haveassumed that only maintenance investments (CAPEX) will be made in the portfoliocompanies and that it will equal depreciation for each year. For all the companies, threegrowth scenarios were developed to be able to sensitise the valuation to different cases. Thevaluation multiple (“exit multiple” in the table) used in the different scenarios is the one paidby the fund to invest in the company +/- 0.5 according to the scenario (upside/downside).
    • III. Valuation in the Private Equity secondary market - 98 -Table 11: Financial data and growth hypotheses of a portfolio companyCOMPANY A (€000) Transaction details Exit multiple Other assumptionsAcquisition date 30/10/2008 Exit multiple 5.11 Spread debt 4.0%Next Year end 30/10/2010 Upside 5.61 Implied Cost of debt 5.3%Funds Share (%) 60.0% Base 5.11 Tax rate 35.0%Total Investment 3,000 Downside 4.61Last NAV reported 3,128Total net debt (last released) 7,322Key financial inputs 30/10/2008 30/10/2009 30/10/2010 30/10/2011 30/10/2012 30/10/2013 30/10/2014 30/10/2015 30/10/2016 30/10/2017Sales 10,014 8,848 8,317 8,151 8,151 8,314 8,564 8,820 9,085 9,358% growth - -11.6% -6.0% -2.0% 0.0% 2.0% 3.0% 3.0% 3.0% 3.0%Upside NA NA -6.0% -2.0% 2.0% 4.0% 5.0% 5.0% 5.0% 5.0%Base NA NA -6.0% -2.0% 0.0% 2.0% 3.0% 3.0% 3.0% 3.0%Downside NA NA -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 0.0% 0.0%EBITDA Margin 3,197 2,468 2,345.5 2,298.6 2,298.6 2,344.6 2,414.9 2,487.4 2,562.0 2,638.9% margin 31.9% 27.9% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2%Upside NA NA 28.5% 28.8% 29.1% 29.4% 29.7% 30.0% 30.3% 30.6%Base NA NA 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2%Downside NA NA 27.8% 27.6% 27.4% 27.2% 27.0% 26.8% 26.6% 26.4%Depreciation/Amortization (implied) 280 239 225 220 220 224 231 238 245 253Exceptionnal Items - - - - - - - - - -EBIT Margin 2,917 2,230 2,121.0 2,078.5 2,078.5 2,120.1 2,183.7 2,249.2 2,316.7 2,386.2% margin 29.1% 25.2% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5%Upside NA NA 26.0% 26.3% 26.6% 26.9% 27.2% 27.5% 27.8% 28.1%Base NA NA 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5%Downside NA NA 25.2% 25.1% 25.0% 24.9% 24.8% 24.7% 24.6% 24.5%CAPEX - - 224.6 220.1 220.1 224.5 231.2 238.2 245.3 252.7Capex as a % of depreciation 0% 0% 100% 100% 100% 100% 100% 100% 100% 100%Net Working Capital 1,001.4 876.0 815.1 790.7 782.5 789.8 805.0 820.3 835.8 851.5Working capital (as a % of sales) 10.0% 9.9% 9.8% 9.7% 9.6% 9.5% 9.4% 9.3% 9.2% 9.1%Change in working capital - (125.4) (60.9) (24.5) (8.2) 7.3 15.1 15.3 15.5 15.7Pension funds and liablities - - - - - - - - - -Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 99 - 3.2.2 The analysis and the valuation of the portfolio companies After entering the company data into the hypothesis tab, each portfolio company isvalued. In this case, the portfolio companies are valued by using a leveraged buyoutvaluation model.First a profit and loss account is created and projected following the case being analysed(downside/base/upside) in order to be able to project and analyse the company’s cash flows:table 12.Then repayment of debt is projected using the operational cash flow to repay outstandingdebt. The enterprise value of the company is then calculated using an EV/EBITDA multiple.By deducting the net debt, we can value the equity of the company over the life of the fund.In order to value the investment the ownership percentage of the fund is applied to theequity value of the company.Finally the exit of the investment is projected according to the timing assumptions (table 10)of distributions151 and returns are calculated: table 13.This analysis of the underlying companies allows us to project their value over the life of thefund according to different scenarios and to estimate the distributions they may generate.151 Depends on the investment holding period (“Investment holding period” in the model), which is usuallyabout four years
    • III. Valuation in the Private Equity secondary market - 100 -Table 12: Analysis and projection of the operating data of a portfolio company (base case)COMPANY AScenario BaseNext year end (Accounting) 30/10/2010Exit Year 30/10/2012Date 30/10/2008 30/10/2009 30/10/2010 30/10/2011 30/10/2012 30/10/2013 30/10/2014 30/10/2015 30/10/2016 30/10/2017Year>>>>> 1 2 3 4 5 6 7 8Profit & Loss (€000)Sales 10,014 8,848 8,317 8,151 8,151 8,314 8,564 8,820 9,085 9,358% Growth - -11.6% -6.0% -2.0% 0.0% 2.0% 3.0% 3.0% 3.0% 3.0%EBITDA 3,197 2,468 2,346 2,299 2,299 2,345 2,415 2,487 2,562 2,639% margin 31.9% 27.9% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2% 28.2%Depreciation/Amortization 280 239 225 220 220 224 231 238 245 253Exceptional - - - - - - - - - -EBIT 2,917 2,230 2,121 2,079 2,079 2,120 2,184 2,249 2,317 2,386% margin 29.1% 25.2% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% 25.5% Interests - - 388 325 263 200 135 65 - - - PBT - - 1,733 1,753 1,815 1,920 2,049 2,184 2,317 2,386 Taxes - - 607 614 635 672 717 764 811 835 - Net Income - - 1,126 1,140 1,180 1,248 1,332 1,420 1,506 1,551Cash Flows (€000)Net Income 1,126.4 1,139.7 1,179.8 1,247.8 1,331.8 1,419.8 1,505.9 1,551.0+ Depreciation/Amortization 224.6 220.1 220.1 224.5 231.2 238.2 245.3 252.7- Change in Working Capital 60.9 24.5 8.2 (7.3) (15.1) (15.3) (15.5) (15.7)- CAPEX (224.6) (220.1) (220.1) (224.5) (231.2) (238.2) (245.3) (252.7)- Exceptional - - - - - - - -= Cash flow for debt repayment 1,187.2 1,164.2 1,188.0 1,240.4 1,316.7 1,404.4 1,490.3 1,535.3Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 101 -Table 13: Projection of the debt repayment and valuation of the investmentDebt repayment and interests (€000) 30/10/2008 30/10/2009 30/10/2010 30/10/2011 30/10/2012 30/10/2013 30/10/2014 30/10/2015 30/10/2016 30/10/2017Opening net debt Opening 7,322 6,135 4,971 3,783 2,542 1,226 - --Cash flow for debt repayment 1,187 1,164 1,188 1,240 1,317 1,226 - -=Closing debt 7,322 6,135 4,971 3,783 2,542 1,226 - - -Interests 388 325 263 200 135 65 - -Investment value (€000) 30/10/2008 30/10/2009 30/10/2010 30/10/2011 30/10/2012 30/10/2013 30/10/2014 30/10/2015 30/10/2016 30/10/2017EBITDA 2,468.2 2,345.5 2,298.6 2,298.6 2,344.6 2,414.9 2,487.4 2,562.0 2,638.9Exit multiple 5.11 5.11 5.11 5.11 5.11 5.11 5.11 5.11 5.11Enterprise Value 12,612.7 11,985.7 11,746.0 11,746.0 11,980.9 12,340.3 12,710.5 13,091.8 13,484.6Net debt 7,322.3 6,135.0 4,970.9 3,782.9 2,542.5 1,225.8 - - -Pensions funds and other liabilities - - - - - - - - -Equity Value 5,290 5,851 6,775 7,963 9,438 11,114 12,711 13,092 13,485Investment Returns (€000) 30/10/2008 30/10/2009 30/10/2010 30/10/2011 30/10/2012 30/10/2013 30/10/2014 30/10/2015 30/10/2016 30/10/2017Funds Share (%) 60%Investment date 30/10/2012Initial investment 3000Market value 3,174 3,510 4,065 4,778 5,663 6,669 7,626 7,855 8,091Cash Flows - 3,000 - - - 4,778 - - - - -Expected IRR 12.3%Return multiple 1.6Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 102 - 3.2.3 Adding of the cash flows in the waterfall of the fund After having valued the underlying companies, it is necessary to add all the cash flowsfrom the capital calls and distributions in the waterfall of the fund. The cash flows of theunderlying investments are added together with the costs and distribution structure of thefund in order to calculate the total cash flows of the fund.First, the different cash flows from the investments and distributions are added together,but so too is the projection of the unfunded part of the fund: table 14.The different costs of the fund are then calculated. If there are not enough distributions tocover these costs, they will have to be funded by the LPs. In the opposite case, the cashflows available for distributions are calculated: table 15.The distributions then pass through the waterfall as previously explained152 (hurdle, catchup, carried interest): table 16.After these intermediate steps, the net cash flow available for LPs is calculated. The capitalcalls are subtracted from the distributions that the limited partners receive (table 17) andthe net cash flow is calculated in each year of the life of the fund.Finally, in order to calculate the gross return of the secondary investment, the cash flow ofthe acquisition of the limited partnership interest is subtracted153 from the net cash flowavailable for LPs: table 18.152 See 2.2.5. iii. The waterfall153 The cash flow of the acquisition of the limited partnership interest comes from the tab “Command table”. Itis calculated as if seeking to value the total fund given that it is later multiplied by the percentage of theinterest that we wish to value. Here 5%
    • III. Valuation in the Private Equity secondary market - 103 -Table 14: Cash flows from the fund’s investmentsDate 31/05/2010 31/05/2011 31/05/2012 31/05/2013 31/05/2014 31/05/2015 31/05/2016 31/05/2017 - - -Year>>>>> 0 1 2 3 4 5 6 7 - - -Cash flows to fund from underlying investments (Year end) Invested capital 10,413 9,333 9,333 9,333 - - - - - - - Capital under management after investment period - - 30,150 28,000 18,667 9,333 0 - - - Distributions - - 14,108 3,939 15,867 15,867 15,867 - - - Invested capital - - 14,108 3,939 - - - - - - COMPANY A - - 4,778 - - - - - - - COMPANY B - - 4,258 - - - - - - - COMPANY C - - 5,072 - - - - - - - COMPANY D - - - 3,939 - - - - - - Unfunded part - - - - 15,867 15,867 15,867 - - - Year 1 - - - - 15,867 - - - - - Year 2 - - - - 15,867 - - - - Year 3 - - - - 15,867 - - - Year 4 - - - - - - -Source: Author’s ownTable 15: Calculation of the costs of the fundFund income & costsDistributions from investments - - 14,108 3,939 15,867 15,867 15,867 - - -Annual partnership expenses (150.0) (150.0) (150.0) (150.0) (150.0) (150.0) (150.0) - - -Annual management fee (800.0) (800.0) (800.0) (420.0) (280.0) (140.0) (0.0) - - -Management fee offset (related to portfolio companys fees) 400.0 400.0 400.0 400.0 400.0 400.0 400.0 - - -Cash available for distribution to LPs (550.0) (550.0) 13,558 3,769 15,837 15,977 16,117 - - -Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 104 -Table 16: Waterfall of the fundFund Cash Flows 31/05/2010 31/05/2011 31/05/2012 31/05/2013 31/05/2014 31/05/2015 31/05/2016 31/05/2017 - - - Capital drawn to fund investment & Expenses 12,000 9,883 9,883 9,333 - - - - - - - Purchase of investments 10,413 9,333 9,333 9,333 - - - - - - - Annual Partnership Expenses (150.0) (150.0) (150.0) (150.0) (150.0) (150.0) (150.0) - - - Annual Management Fee (400.0) (400.0) (400.0) (20.0) 120.0 260.0 400.0 - - - Distributions from Investments - - 14,108 3,939 15,867 15,867 15,867 - - - Cash available for LP distributions - - 13,558 3,769 15,837 15,977 16,117 - - - Repayment of Invested capital - - (13,557.8) (3,768.8) (15,836.7) (7,936.7) - - - - Repayment of Preferred return to LPs - - - - - (8,039.9) (4,549.7) - - - Cash available Post Preferred Return to LPs - - - - - 0.0 11,566.9 - - - GP Catch Up - - - - - (0.0) (3,147.4) - - - Cash available post Preferred Return and GP Catch Up to LPs - - - - - - 8,419.5 - - - Carried Interest to GP - - - - - - (1,683.9) - - - Distribution to LPs - - - - - - (6,735.6) - - -Source: Author’s ownTable 17: Net cash flows available for LPsTotal LPs Cashflows Investment (capital drawn and expenses) (12,000) (9,883) (9,883) (9,333) - - - - - - - Capital repaid in period (Capital drawn and expenses) - - 13,557.8 3,768.8 15,836.7 7,936.7 - - - - Repayment of Preferred Return - - - - - 8,039.9 4,549.7 - - - Distribution to LPs - - - - - - 6,735.6 - - - Total LPs Flows (12,000) (9,883) (9,883) 4,224 3,769 15,837 15,977 11,285 - - -Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 105 -Table 18: Determination of the returns of the secondary investor according to the acquisition priceDate 31/05/2010 31/05/2011 31/05/2012 31/05/2013 31/05/2014 31/05/2015 31/05/2016 31/05/2017 - - -Returns at targeted price Price paid 4,000 Total secondary investor flow (4,000) (9,883) (9,883) 4,224 3,769 15,837 15,977 11,285 - - - Implied IRR 20.04%Capital returns - - - 4,224 3,769 15,837 15,977 11,285 - - -Capital paid (4,000) (9,883) (9,883) - - - - - - - -Total return of the operation 2.15Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 106 - 3.2.4 Determination and sensitisation of the price of the limited partnership interest according to different scenarios The price payable for the entire fund that we wish to value is then entered.Depending on the price used and the different scenarios chosen (of growth of the portfoliocompanies and of quality of the manager), the gross return on the secondary investment willbe determined. The value of the interest is determined by multiplying the price to be paidfor the whole fund by the percentage of the interest being valued.Table 19: Determination of the price to be paid according to scenarios and returnsTarget returns (€000) Price willing to pay (for 100% fund) 4,000 Does investment at this price reache target? Implied price for LP interest 200 Target IRR 20.0% YES Implied IRR 20.04% Target Multiple return 1.8 YES Implied Multiple Returns 2.15 % of reported NAV 36.8% % Discount to NAV 63.2%Command Scenario (Growth assumptions & Exit multiple) Base 2 Investment holding period (Years) 4 Unfunded Multiple Quality of the GP (trackrecord, info available) Good 1 Good 1.7 Multiple of return (x) for unfunded 1.7 Base 1.4 Bad 1.2Source: Author’s ownIn this case, a base scenario (of growth and valuation of the portfolio companies) and a high-quality management team have been chosen.According to present growth assumptions and the timing of capital calls and distributionsapplied, the valuation of the fund that allows achieving an IRR of 20% with a multiple higherthan 1.8 times (typical minimum gross returns that secondary investors seek) is €4,000,000.This values the analysed interest (5%) at €200,000 and represents 36.8% of its last NAV.The model also analyses the sensitivity of the investment returns to the different keyvariables used in this valuation (growth scenario, quality of the manager, and timing of theinvestment).
    • III. Valuation in the Private Equity secondary market - 107 -Table 20: Sensitivity of the returns to the different key variablesSensitivity to Price and other assumptions Scenario (IRR) 0.20 3,700 3,800 3,900 4,000 4,100 4,200 4,300 Upside 1 23.4% 23.2% 23.0% 22.9% 22.7% 22.5% 22.4% Base 2 20.5% 20.4% 20.2% 20.0% 19.9% 19.7% 19.6% Downside 3 16.0% 15.8% 15.7% 15.6% 15.4% 15.3% 15.2% Scenario (Returns) 2.15 3,700 3,800 3,900 4,000 4,100 4,200 4,300 Upside 1 2.29 2.28 2.27 2.26 2.25 2.24 2.23 Base 2 2.18 2.17 2.16 2.15 2.14 2.13 2.12 Downside 3 1.94 1.94 1.93 1.92 1.91 1.91 1.90 Quality of the GP 0.20 3,700 3,800 3,900 4,000 4,100 4,200 4,300 Good 1 20.5% 20.4% 20.2% 20.0% 19.9% 19.7% 19.6% Base 2 17.0% 16.8% 16.7% 16.5% 16.4% 16.2% 16.1% Bad 3 14.9% 14.7% 14.6% 14.5% 14.3% 14.2% 14.1% Investment holding period (Years) 0.20 3,700 3,800 3,900 4,000 4,100 4,200 4,300 3 3 28.9% 28.6% 28.4% 28.1% 27.9% 27.6% 27.4% 4 4 20.5% 20.4% 20.2% 20.0% 19.9% 19.7% 19.6% 5 5 16.9% 16.8% 16.7% 16.5% 16.4% 16.3% 16.2% 6 6 14.8% 14.7% 14.6% 14.5% 14.4% 14.4% 14.3%Source: Author’s own
    • III. Valuation in the Private Equity secondary market - 108 - 3.3. Comparison of the results: explanation of the difference 3.3.1 Comparison of the results By applying the two valuation methods to the same limited partnership interest wefind very different results. The market valuation method (top-down) values the interest at86.4% of its NAV, although the bottom-up valuation method using the valuation modelvalues it at 36.8% of its NAV.Table 21: Contrast of the valuation according to the different methods Method Top-down Bottom-up Value of the interest (5%) 469,973 200,000 % of the NAV 86.4% 36.8%Source: Author’s ownIn view of these results, it seems clear that valuation method is very important when buying(or selling) in the secondary market. But, why is there such a difference between the twomethods and which is more trustworthy? 3.3.2 The concept of NAV is subjective The top-down method is based on the valuation of the manager. However, althoughthere are portfolio valuation guidelines, GPs value their portfolio in very different ways.Some leave the assets at their investment price, other at their market value, and some at theprice of the latest share issuance. The valuation of their portfolios is also very subjective154given that the manager himself may make very optimistic/pessimistic estimates of thegrowth of portfolio companies.For these reasons, the concept of NAV is very subjective and cannot be used as the base forthe valuation as in the top-down method. It is therefore very advisable, when possible, for abuyer to make his own valuation of the investments in the portfolio using the bottom-upmethod. 3.3.3 Each asset is different One of the key considerations when choosing a valuation method is the uniquenessof each asset. Indeed, each asset is different given that it has different underlying assets,management teams of differing quality, different cost structures, and different allocations ofthe distributions. Despite trying to compare similar assets, the top-down method does not154 “Valuation [of the NAV] remains part science, part art”: Triago; «The secondary seller’s options»; 2009
    • III. Valuation in the Private Equity secondary market - 109 -take into account the singularity of each asset and therefore does not constitute an accuratevaluation method. The only method capable of valuing the intrinsic value of the assets is thebottom-up method that takes into account all the characteristics of the fund and itsunderlying assets.The following table clearly demonstrates that the assets’ value cannot be generalised giventhat for a single type of asset there are significant variations in the valuation according to theasset being exchanged.Table 22: Discrepancy in the valuation of the assets (H1 2009) % of bids on funds Bids ≤0% of the NAV Bids <20% of the NAV Bids >60% of the NAV All 7% 17% 13% LBOs 8% 20% 12% Venture 4% 17% 13% Other 5% 5% 21%Source: Author’s own using data from Cogent Partners; «Secondary Pricing analysis interim update, summer2009»; 2009. 3.3.4 The lag of the NAV The top-down method applies the valuations of the market to the last published NAV.However, there may exist a difference between the last published NAV and the assets’current market value due to the time that passes between the publication of the NAV andthe valuation of the asset. Since GPs usually take between 1 and 4 months to publish theNAV of their assets the last NAV available may be up to four months old.In a bear market valuations fall over time so that is very probable the next NAV will be lowerthan the last published. The concept of NAV is very static given that it gives the value of theasset at the end of each quarter. Although it is not very accurate as a rough proxy to marketvalue, the performance of a basket of public market comparables can be considered. Thegain or decline in that basket from the day of the last valuation can provide an indication ofhow the NAV may have changed155.However, because the top-down method does not take into account the change in valuebetween the valuation and the publication of the last NAV, it does not constitute a robustmethod to value assets in the secondary market.155 Cogent Partners; «Pricing private equity secondary transactions» 22 July 2002; www.AltAssets.com (lastaccessed: 26 January 2010)
    • III. Valuation in the Private Equity secondary market - 110 - 3.3.5 A buyers’ market In the secondary market there currently exists an imbalance between large supplyand limited demand that negatively impacts valuations.According to a study by Probitas Partners in February 2010, it was estimated that about $75billion of assets were being offered on the secondary market156. The imbalance of capitalavailable to purchase funds in the secondary market minus the transaction volume closedduring the year is the capital overhang, or dry powder. This is calculated in Figure 46 below.Figure 46: Dry powder in the secondary market in 2010 ($ billions) 60 50 40 18.5 (9.1) 30 50.8 20 41.4 10 0 Dry powder at the Secondary transaction 2009 secondary Dry powder at the beginning of 2009 volume in 2009 fundraising beginning of 2010Source: Author’s own; data: Dry powder and secondary transactions 2009: UBS Private Funds Group; «AdamsStreet Secondary Networking Event»; 2010 – Secondary funds raised in 2009: Preqin; «Private Equity SpotlightJanuary 2010»; 2010.Compared to the offerings of some $75 billion, the dry powder of the secondary funds in2010 is about $50.8 billion. There is therefore an imbalance of some $25 billion that providesa clear advantage to the buyers, creating a buyers’ market.However, in view of the forecasts for 2010, it is interesting to compare this same $75 billionof offerings with the dry powder that is expected in 2011.156 Probitas Partners; «Adams Street Secondary Networking Event»; 2010
    • III. Valuation in the Private Equity secondary market - 111 -Figure 47: Estimate of the dry powder in the secondary market in 2011 ($ billions) 60 50 27 40 (20) 30 57.8 50.8 20 10 0 Dry powder at the 2010 Estimated 2010 Estimated Dry powder at the beggining of 2010 transaction volume secondary fundraising beginning of 2011Source: Author’s own; data: Dry powder and secondary transactions 2010: Author’s own estimates – Secondaryfunds raised in 2010: Probitas Partners; «Adams Street Secondary Networking Event»; 2010.If we assume that the transaction volume will be about $20 billion (forecast with the modelassuming the base scenario) and that secondary funds raise about $27 billion in 2010(estimate by Campbell Lutyens157 and Probitas Partners158), it is forecast that dry powder atthe beginning of 2011 will be about $57.8 billion. This represents a $17.2 billion imbalance inthe market. Therefore it is clear that the imbalance in the market will slowly be reduced. Thereduction of this imbalance will gradually end the buyers’ advantage in the market159. Abuyers’ market may change even more rapidly if transaction volume in 2010 is lower thanforecast.However, due to the imbalance in the secondary market, valuations are distorted from thereal value of the assets and therefore cannot be used to provide an accurate value of anasset in the secondary market: the inefficiency of the top-down method is once moredemonstrated.157 See appendix 7.13 which summarises the call to Campbell Lutyens (10 March 2010)158 Probitas Partners; «Adams Street Secondary Networking Event»; 2010159 See appendix 7.13 which summarises the call to Campbell Lutyens (10 March 2010)
    • III. Valuation in the Private Equity secondary market - 112 - 3.3.6 Key valuation method: bottom-up These explanations of the difference in valuations of a limited partnership interestwhen using the two methods clearly demonstrate that the bottom-up method is the mostappropriate method to ascertain the value of assets on the secondary market. Indeed, it isthe only method that allows us to take into account the uniqueness of the assets and thegrowth perspectives of each underlying company. Furthermore the bottom-up methodminimizes the valuation distortion attributable to the imbalance between buyers and sellersin the market and NAV lag.However when there is not enough information available to make a bottom-up valuation,the top-down method should be used.
    • PART IV:CONCLUSIONS
    • IV. Conclusions - 114 -IV. CONCLUSIONS 1. Conclusions 1.1. Analysis of the secondary market: an opportunity for the Private Equity industry Analysis of the theoretical characteristics of Private Equity, its history and of current conditions highlights the growing importance of the secondary market and its crucial role in the development and maturity of the Private Equity industry. The existence of a secondary market has a beneficial effect on primary assets. It allows investors to find liquidity without needing to sell the underlying assets. This liquidity in the market has many advantages both for LPs and GPs. It supports the investments and prevents LPs from defaulting thereby building a strong investor base for future funds. Moreover, this market provides value indication, price discovery, and facilitates future fundraising160. By reducing the liquidity risk inherent in the Private Equity asset class, investment in Private Equity is made much more attractive transforming the secondary market into a driver of growth in the primary market. In view of the capital raised in 2009, the secondary market is the only segment that grew in comparison with 2008. Therefore it not only benefited the industry by attracting more capital by reducing the liquidity risk but also by raising further capital in this growing market segment. For all of the reasons mentioned above, it is in the best interest of general partners to facilitate transactions in their funds and allow limited partners to turnover within their fund161. 1.2. The future: growth and sophistication A constantly growing market Although 69% of investors hoped that 2009 would be a record year in the secondary market162, the transaction volume ($9.1 billion in 2009163) has been disappointing due to 160 Campbell Lutyens; «The Private Equity Secondaries market: a complete guide to its structure transaction and performance»; PEIbooks, 2008 161 Ansbacher, Richard I. and Rosh, Kenneth I. and Neuschatz Zelenka, Rebecca; «Heightened Managers Concerns for Secondary Transfers»; Fried Frank PEP Talk, 2010 162 Dow Jones; «Guide to secondary market intermediaries»; 2009 163 UBS Private Funds Group; «Adams Street Secondary Networking Event»; 2010
    • IV. Conclusions - 115 -market circumstances (low valuations, large bid/offer spread, FAS 157, lack of visibility).However, it seems that 2010 will be the record year that participants in the market havelonged for to prove that it is not a current trend, nor an ephemeral market.According to the results of the application of the present statistical correlation model, it isprojected that the market may have an average volume of between $17.5 and $22.5 billionper annum during the next five years (2010-2014) which represents a compound averagegrowth rate (CAGR) of between 13% and 18.8%.Regulated financial institutions will be the main sellers in 2010 due to the need to repaypublic funds and restructure their balance sheet. Moreover, the cost of financing PrivateEquity assets, the need to liquidate “pay to play” funds combined with an increase insecondary valuations will promote activity in the market. An increasingly sophisticated market The market is becoming increasingly sophisticated and innovative sales structures areused to better realize all parties’ objectives. This market sophistication is reflected in thegrowing importance in the use of an adviser experienced in secondary transactions. In themedium term it is forecast that there will be more spin-outs164 of captive Private Equitymanagers of financial institutions. But there will also be more direct sales of interests incompanies165 as current market conditions necessitates their use to generate valuableliquidity for managers. Monitor regulatory changes In 2010, regulatory changes will be a key element that will have to be monitored. In theUS the famous “Volcker Rule” limits banks’ proprietary investments and will have a majorimpact on Private Equity activity. Although there is a transition period to comply with thisrule many financial institutions are considering selling their Private Equity investmentdivisions and holdings. Any change that increases regulatory pressure on financialinstitutions’ investments will have a direct effect on the sale of their Private Equity assets inthe secondary market and the spin-out of several captive Private Equity managers.164 Probitas Partners; «Adams Street Secondary Networking Event»; 2010165 Probitas Partners; «Adams Street Secondary Networking Event»; 2010
    • IV. Conclusions - 116 - 1.3. Valuation in the secondary market: trend and method Market valuations: a controlled rebound? After having fallen to 36% of the NAV in the first half of 2009 the market has rebounded.During the first half of 2010, pricing for limited partnership interests in the secondary marketincreased steadily to 80%166 of NAV anticipating an increase in the valuations of LP interests.However, valuations are expected to halt their increase in the medium term due to thesupply/demand imbalance that acts as a natural ceiling167.Although we are currently in a buyers’ market due to the supply/demand imbalance itsevolution must be tracked closely. Indeed, this imbalance may be reduced due to volumesbeing raised in secondary funds and the large amount of dry powder accumulated bysecondary buyers (“There are a lot of secondary buyers that have a lot to deploy”168 JeffreyBollerman; SecondMarket).According to a survey by Probitas Partners published in November 2009, 16.4% of investorsfear there is too much dry powder in the secondary market and that it will have a negativeimpact on returns169. Valuation method for secondary assets: the supremacy of the bottom-up valuation method When valuing LPs’ interests in the secondary market, the bottom-up method is the mostappropriate method to ascertain the intrinsic value of the assets. This method, which isbased on analysis and valuation of the underlying assets, allows the investor to produce aninformed valuation and gives him a clear advantage. If he has the resources, experience andnecessary information, he may have more confidence in his valuation and be moreaggressive in his bid because he has a greater chance of achieving his returns170. However,the top-down method is a good method to approximate valuations and the mood of themarket in the absence of information required for the bottom-up method.In this context access to information becomes a significant challenge in order to be able tomake a bottom-up valuation and highlights the importance of having strong relationshipswith GPs. For this reason successful secondary managers usually have primary capacitiesthat allow them to have relationships with GPs and get access to the necessary information.166 See appendix 7.13, which summarises the call to Campbell Lutyens (10 March 2010); Cogent Partners;«Secondary pricing trends and analysis, July 2010»; 2010167 Probitas Partners; «Adams Street Secondary Networking Event»; 2010168 Deal Flow Media; «The Distressed Debt Report, Volume VI Nº4»; 2010169 Probitas Partners ; «Private Equity Market Review and Institutional Investor Survey»; 2009170 Clark, Geoffrey and Christopher Kojima; «Opportunities and challenges in Secondaries»; Goldman Sachs inThe Journal of Alternative Investment, 74-86; 2003
    • IV. Conclusions - 117 - 2. Future research Being an initial analysis of this segment of Private Equity, some suggestions for futureresearch are in order.This dissertation has discussed throughout the Private Equity secondary market but it wouldalso be useful to study other secondary markets such as those of hedge funds or assetsinvested in debt (syndicated loans, private placements, etc.).In studying the Private Equity industry the funds’ cost structures were examined and thisbrought up the tensions currently experienced between GPs and LPs the most significantbeing fees. There have been many concerns raised with respect to GP compensation and itwould be interesting to analyse the debate in the context of future fundraising.
    • Glossary - 118 -GLOSSARYBlind pool: investment commitments with no stated investment target. In Private Equity theunfunded commitment is a blind pool given that the managers’ exact future investments areunknown.Bottom-up: information-processing strategy that begins by analysing the individual parts inorder to then analyse larger components. Applied to asset valuation, it consists of analysingthe underlying assets in order to then value the fund.Capital calls: request from fund managers to draw down a part of the committed capital tofund an acquisition or funds’ costs.Carried interest (“Carried”): the share of profits of the fund managers in the capital gainsresulting from the operations carried out by the fund. In Private Equity funds the "carried" isusually about 20% of the capital gains obtained by the fund.Cash drag: negative effect caused by cash balances (or money invested in treasury assets) onthe overall return of a portfolio.Catch up: part of the carried interest that the manager receives once the principal and ahurdle rate has been paid to LPs. The manager typically receives 100% of the distributions upto a shareout of the distributions defined by the carried interest (20/80). Catch up = Total hurdle ×Clawback provision: clause in the LPA by which the GP can require the LPs to return somedistributions in special circumstances.Collateralized Fund Obligation (CFO): debt securitization of Private Equity fund or hedgefund assets.Covenants: agreements between a company and its creditors that indicate the financialconditions that the debtor must observe.Credit crunch: squeeze in the availability of credit that causes the economy to contract.Deal flow: flow of transactions.
    • Glossary - 119 -Denominator effect: in a portfolio when the value of one asset class falls, the percentageallocation to other assets rises mechanically in the portfolio, exceeding the allocation targetsof the portfolio which then requires re-balancing.Distressed: an asset or an investor that lacks liquidity to finance short-term commitments.Dry powder: capital reserves available to invest.Due diligence: process of auditing financial, legal and tax aspects of a transaction.EBIT: earnings before interests and taxes. Operating profit.EBITDA: earnings before interest, taxes, depreciation and amortisation.Endowment: institution’s investments that seek to cover a part or all the needs of theinstitution to which it belongs with its investment returns.Equity: part of the company that belongs to the shareholders once they have paid theirfinancial obligations. Asset minus liabilities.Fair value: amount or value for which an asset may be exchanged between interested andfully-informed parties.Family office: a company that offers advisory services to family assets.Follow-on: is said of an investment when it backs an existing investment.Funding ratio: ratio of capital funded by investors to the total commitment of investors inthe fund.Fundraising: activity that consists of raising funds in the market.General Partners (GPs): Private Equity fund managers.Hurdle rate: also called preferred return, is the minimum amount of return sought by theinvestor. It is usually an Internal Rate of Return (IRR) of 8%. Before this return is earned bythe LP, the fund manager can not receive any share in the capital gains.Internal Revenue Service (IRS): tax authority in USA.Key man clause: clause within an agreement that indicates if one or more specific keynamed managers stops dedicating a required level of time to the management of a fund, theinvestment activity is halted.Know Your Customer (KYC): due diligence requirement that financial institutions mustperform to identify their client and ascertain relevant information in order to transactfinancial business with them. This policy is intended to prevent money laundering andterrorist financing.
    • Glossary - 120 -Lag: a delay caused in a communication. In the case of Private Equity funds, the lag refers tothe delay between the publication of the NAV and the current asset valuation (between 1and 4 months) that makes the valuation process more difficult.Limited Partners (LPs): institutions or individuals that contribute capital to a Private Equityfund.Limited Partnership Agreement (LPA): formation agreement which sets out in detail legallybinding relations between the LPs and GP (investment policy, profit sharing, fees andexpenses, etc.).Lock-in performance: process that consists of realizing the existing return on an asset (byhedging, selling the asset).Material Adverse Change (MAC): in a sale contract it is a legal provision that allows theacquirer to withdraw from the transaction if the target suffers a substantial change.Over-commitment: allocation of resources to an asset class in excess of the capacity.Pay-to-play funds: funds which the banks had invested as a way to get business with thePrivate Equity funds (advisory mandate, leverage) but that have never been a strategic asset.Pre-emption right: right of first refusal.Qualified Matching Service: approved management services for secondary transactions bythe tax authorities. The use of a QMS allows exchanging an additional 8% above thestatutory 2% of a fund’s capital commitment in a single fiscal year.Representations and warranties: statements by which one party gives certain assurances tothe other, and on which the other party may rely.Right of First Refusal (ROFR): right that gives its holder the option to enter a transactionwith the owner of an asset before the owner can enter into that transaction with a thirdparty.Seniority: order of repayment in the event of bankruptcy. In the capital structure, this refersto the subordination level. When one is more senior it means that it is less subordinated.Side letter: separate agreement that is used to clarify or modify the terms of a previousagreement.Special Purpose Vehicle (SPV): legal entity created to fulfil a temporary and specificobjective. It may be owned by one or more persons.Spin-out: when a division of a company becomes an independent business. In the secondarymarket it is a sale structure in which the buyer acquires an entire portfolio of captive assets.Stapled secondary: sale structure in which the buyer acquires assets of a fund together withinvestment commitments in the next fund of the manager (GP).
    • Glossary - 121 -Straight sale: traditional sale structure of one or more interests in funds or companies.Strip sale: sale structure in which only a part of one or more portfolio companies or interestin funds are sold.Tail end: sale structure in which a fund sells its remaining assets.Top-down: information-processing strategy that analyses the system as a whole withoutgoing into subsystem details. Applied to asset valuation, it consists of analysing marketvaluations and applying them to the asset being valued.Total Return Swap: derivative contract in which two parties swap the cash flows. A floatinginterest rate can be exchanged for the cash flows of an asset.Track record: past performance. In the case of a fund manager, it refers to the past returnsof previously managed funds.Unfunded: uncalled part of the committed capital.Venture Capital (VC): Private Equity investment style that invests in the early stages ofcompanies.Vintage year: the year in which the fund makes its first investment.Waterfall: structure of how distributions are shared between the GPs and the LPs. It isdefined in the LPA.
    • REFERENCES
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    • References - 129 -- VCFA Group. «Secondary sales of private equity interests.» AltAssets. 18 February 2002. www.AltAssets.com (last accessed: 14 January 2010).- Weil, Gotshal & Manges. «Secondary investing in private equity funds: Primary issues for general partners.» 28 January 2004. www.AltAssets.com (last accessed: 06 February 2010).- Wharton Knowledge. «Private Equity Secondary Funds: Are They Players or Opportunistic Investors?» 09 August 2009. http://knowledge.wharton.upenn.edu/ (last accessed: 20 December 2009). 4. Databases- Preqin- Private Equity Analyst- Venture Expert- Thomson financial
    • APPENDIX
    • Appendix - 131 -APPENDIX171 1. DATABASE OF THE ADVISERS IN THE PRIVATE EQUITY SECONDARY MARKET133 1.1 Database of the financial advisers ............................................................133 1.2 Database of the legal advisers ....................................................................135 1.3 Database of the private marketplaces .....................................................136 2. DATABASE OF THE BUYERS IN THE PRIVATE EQUITY SECONDARY MARKET137 2.1 Database of the dedicated secondary buyers (LPs interest and direct) ...................................................................................................................137 2.2 Database of the dedicated secondary buyers (only direct transactions) ......................................................................................................139 2.3 Database of firms investing part of their funds in the secondary market...................................................................................................................140 3. REQUEST FOR SPONSORSHIP .......................................................................... 143 4. NEWSLETTER Nº1 ........................................................................................... 144 5. SPONSORS OF THE STUDY AND INTERVIEWS................................................. 146 6. MEETING GUIDELINES..................................................................................... 147 7. SUMMARIES OF CALLS AND MEETINGS .......................................................... 149 7.1 Call with UBS (26 November 2009) .........................................................149 7.2 Call with Secondmarket (01 December 2009) .....................................151 7.3 Call with Breslin AG (02 December 2009).............................................153 7.4 Email from Preqin (02 December 2009) ................................................155 7.5 Call with Fidequity (03 December 2009) ...............................................157 7.6 Meeting with Altamar (07 December 2009) .........................................159 7.7 Call with Pantheon Ventures (09 December 2009) ...........................161 7.8 Call with Headway Capital (09 December 2009) ................................164171 Every appendix is available upon request to Arnaud van Tichelen: a.vantichelen@gmail.com
    • Appendix - 132 - 7.9 Call with Campbell Lutyens (10 December 2009)..............................165 7.10 Meeting with SJberwin (14 December 2009) .......................................168 7.11 Call with UBS (02 February 2010) ............................................................170 7.12 Call with HarbourVest Partners (09 March 2010) .............................172 7.13 Call with Campbell Lutyens (10 March 2010)......................................174 7.14 Meeting with Arcano Capital (18 March 2010) ...................................176 8. ANALYSIS OF PUBLISHED HISTORICAL DATA ................................................ 178 8.1 Historical transaction volume in the secondary market ..................178 8.2 Secondary fundraising...................................................................................180 8.3 Primary fundraising .......................................................................................181 9. SECONDARY MARKET PROJECTION MODEL ................................................... 182 10. HISTORICAL VALUATIONS IN THE PRIVATE EQUITY SECONDARY MARKET186 10.1 LBO funds ...........................................................................................................186 10.2 Venture capital funds .....................................................................................186 10.3 Other funds (real estate- infrastructure- distressed)........................187 11. STRUCTURE OF LISTED PRIVATE EQUITY FUNDS ......................................... 188 11.1 Structure of listed direct Private Equity fund ......................................188 11.2 Structure of listed indirect Private Equity fund (listed fund of funds) ....................................................................................................................189
    • Appendix - 133 -1. Database of the advisers in the Private Equity secondary market 1.1 Database of the financial advisersCompany Name Position MailAlmeida Capital Richard Sachar Managing Director rsachar@almeidacapital.comAlpha Associates AG Peter Derendinger CEO peter.derendinger@alpha-associates.chAltitude Capital Advisory Brett A. Nelson Managing Director bnelson@altitudecap.comAriane Capital Partners Donald W. Kraftson Managing Director dwk@arianepartners.comAugusta & Co John Edwards Partner info@augustaco.comAutumn Capital Partners Matthew Longhurst Partner info@autumncapital.comAxon Partners Andrew Kellett Partner andrew.kellett@axonpartners.bizAxonia Partners Alexandre Alfonsi Partner contact@axonia-partners.comAzla Advisors David Waxman Managing Director dwaxman@azla-advisors.comBoyd & Co Todd Boyd Managing Partner todd@boyco.netBluetower Capital Tim Griggs Managing Partner timgriggs@bluetowercapital.comBreslin AG David Karabelnik CEO karabelnik@breslin.chCampbell Lutyens Thomas Liaudet Principal Liaudet@campbell-lutyens.comCapital Dynamics Olav Koenig Managing Director okoenig@capdyn.comCapstone Partners David Chamberlain Managing Director dchamberlain@csplp.comCarta Diem Philippe d’Hémery Managing Principal pdhemery@cartadiem.frChamplain advisors Terence M. Crikelair Managing Partner terry@champlainadvisors.comCogent Partners Bernhard Engelien Managing Director bengelien@cogent-partners.comContinental Capital Partners Roger Luscombe Managing Partner roger@dealmaker.co.ukCredit Suisse Group Mike Custar Director mike.custar@credit-suisse.comFidequity Francois Garcin Partner francois.garcin@fidequity.comGlobal Finance Matthias Stanzel Managing Director stanzel@globalfinance.deGreenhill & Co. Patrick S. Dunleavy Managing Director pdunleavy@greenhill.comGriffin Private Equity Group Paul Delaney Managing Director pfd@go2griffin.com
    • Appendix - 134 -Company Name Position MailHoulihan Lokey Paul Sanabria Managing DirectorLancea Partners Pascal Isbell Partner pascal@lanceapartners.comLazardMatrix Group Edward Holdsworth Partner edward.holdsworth@ matrixgroup.co.uk 1Mercury Capital Advisors Enrique Cuan Managing PartnerMHT Partners Secondary Advisors James Lee Principal jlee@mhtpartners.comMummert & Company Harald Maehrle Managing Partner info@mummertcompany.comNakatomi Capital Monica Vinje Managing Partner mv@nakatomi-capital.comPalomar Corporate Finance Markus Kroll Partner kroll@plmr.comPark Hill Group Lawrence Thuet Managing Principal thuet@parkhillgroup.comPatronus Capital Paul Delaney Managing Director pdelaney@patronuscap.complurisvaluation Espen Robak President erobak@pluris.comPreqin Mark OHare Managing Director mohare@preqin.comProbitas Partners Kelly DePonte Parner kkd@probitaspartners.comRainmakers Partners Jim Soleymanlou Managing Partner jsoleymanlou@rainmakerspe.comRichmond Park Partners David Morton Partner david.morton@richmondparkpartners.comRothschildRoux Capital Francois Roux Managing Principal francois.roux@rouxcapital.comScalar Partners Nick Hatch Vice President nick.hatch@scalarpartners.comSecondcap Francois Gamblin CEO francois@secondcap.com 2Setter Capital Simren Desai Associate sim@settercap.comSomerset Capital James Miller Managing Partner james@som-cap.comThe Camelot Group International info@thecamelotgroup.comTriago Mathieu Dréan Managing Principal md@triago.comUBS Private funds Group Nicolas Lanel Executive Director nicolas.lanel@ubs.com 1. Spin Out of the Merrill Private Placement team 2. Only BrokerageSource: Author’s own- Dow Jones; «Guide to Secondary Market Intermediarie.»; 2009 – Companies websites
    • Appendix - 135 - 1.2 Database of the legal advisersCompany Name Position MailSJberwin Nigel van Zyl Partner nigel.van.zyl@sjberwin.comGoodwin Procter Rufus C. King Partner rking@goodwinprocter.comWilmer Cutler Pickering Hale and Dorr Thomas A. Beaudouin Partner thomas.beaudoin@wilmerhale.comFried Frank Richard I. Ansbacher Partner richard.ansbacher@friedfrank.comCovington & Burling Hilary Prescott Partner hprescott@cov.comDebevoise & Plimpton David J. Schwartz Partner djschwartz@debevoise.comOMelveny & Myers John Daghlian Partner jdaghlian@omm.comWeil, Gotshal & Manges Shukie Grossman Partner shukie.grossman@weil.comKirkland & Ellis Michael D. Belsley Partner michael.belsley@kirkland.comKaye Scholer Emanuel S. Cherney Partner echerney@kayescholer.comSource: Author’s own
    • Appendix - 136 - 1.3 Database of the private marketplacesCompany Name Position MailIlliquidX Zachary Latif Partner info@illiquidx.comICAP Alternative Investment Group Laura Prager Managing Director laura.prager@us.icap.comNYPPEX MaryAnn Sapione Vice President msapione@nyppex.com 1SecondMarket J. Bollerman Director jbollerman@secondmarket.comTrusted Insight info@trustedinsightinc.com 2PEFOX Kishore Kansal Managing Partner kishore.kansal@pefox.com1. Biggest marketplace for Limited partnerships2. Marketplace to negotiate derivatives on fundsSource: Author’s own
    • Appendix - 137 -2. Database of the buyers in the Private Equity secondary market 2.1 Database of the dedicated secondary buyers (LPs interest and direct) A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsLexington Partners 15,900 Marshall Parke Partner mwparke@lexpartners.comGoldman Sachs Private Equity Group 12,000 chris Kojima Managing Director chris.kojima@gs.comHarbourVest Partners 10,000 Peter Wilson Managing Director pwilson@harbourvest.comColler Capital 8,400 Sebastien Burdel Principal sebastien.burdel@collercapital.comCredit Suisse Strategic Partners 8,200 Stephen Can Managing Director stephen.can@credit-suisse.comLandmark Partners 6,700 Ian Charles Principal ian.charles@landmarkpartners.comPartners Group 6,000 Marc Weiss Partner marc.weiss@partnersgroup.comAlpInvest Partners 4,644 Philip Viergutz Investment Manager philip.viergutz@alpinvest.comAXA Private Equity 5,000 Olivier Decannière Managing Director olivier.decanniere@axa-im.comPantheon Ventures 4,600 Elly Livingstone Partner elivingstone@pantheonventures.comPaul Capital Partners 4,400 Guy Rico Partner grico@paulcap.comAdams Street Partners 3,500 Gregory J. Holden Partner gholden@adamsstreetpartners.comPomona Capital 3,000 Mark McDonald Principal mmcdonald@pomonacapital.comNeuberger Berman 2,800 Brian Talbot Managing Director brian.talbot@nb.comLGT Capital Partners 2,750 André Aubert Principal andre.aubert@lgt.comGreenpark Capital 1,589 Matthew Arkinstall Investment Director arkinstall@greenparkcapital.comAIG PineStar Capital 1,800 Harvey Lambert Managing Director harvey.lambert@aig.comLiquid Realty Partners 1,500 Jeff Giller Chief Investment Officer jeff@liquidrealty.com Only Real EstateMorgan Stanley Alternative Investment Partners 1,500 John Wolak Managing Director john.wolak@morganstanley.comSVG Advisers 1,222 Sam Robinson Director sam.robinson@svgcapital.com Listed PE vehicleFondinvest Capital 978 Charles Soulignac CEO c.soulignac@fondinvest.comJP Morgan Asset Management 1,060 Jarrod Fong Portfolio Manager jarrod.fong@jpmorgan.comArcis Group 917 Henri Isnard Managing Partner hisnard@arcisgroup.comHamilton Lane 1,000 Tom Kerr Principal tkerr@hamiltonlane.comRREEF Private Equity 775 Charles Smith Managing Director charles.f.smith@rreef.comMontauk Triguard 750 Edgar J. Pfohl Principal ed@montauktriguard.comVCFA Group 730 Dayton T. Carr Founder carr@vcfa.comNewbury Partners 702 Richard Lichter Managing Partner lichter@newbury-partners.com
    • Appendix - 138 - A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsMillennium Technology Ventures 700 Dan Burstein Managing Partner burstein@mtvlp.comPEIFunds 684 Chuck Stetson Managing Director cstetson@peifunds.comAuda Private Equity LLC 600 Thimothy Brody Managing Director brody@auda.comJP Morgan Private Equity Limited 544 Troy Duncan Managing Director troy.duncan@jpmorgan.com Listed vehiclePermal Capital Management 575 Robert DiGeronimo Managing Director rdg@permal.comWillowridge Partners 535 Jerrold Newman Managing Member jnewman@willowridge.comIndustry Ventures 500 Justin Burden Principal justin@industryventures.comUnigestion 279 Hanspeter Bader Managing Director hpbader@unigestion.comMadison International Real Estate 300 Michael Siefert Managing Director inquiries@madisonint.com Only Real EstateHeadway Capital Partners 244 Christiaan de Lint Founder and Partner christiaan@headwaycap.comVintage Investment Partners (Ex Vintage Ventures) 225 Abe Finkelstein General Partner abef@vintageventures.com Only Israeli fundsBeleveron Real Estate Partners 200 Paul Oldland Managing Director info@belveronpartners.com Only Real EstateRCP Advisors 200 Tim Danis Senior Managing Principal timdanis@rcpadvisors.comSymmetry Investment Advisors 171 Marshall Greenwald Principal mgreenwald@symmetryfunds.comBEX Capital 122 Benjamin Revillon Managing Partner revillon@bexcapital.comAnchor Capital 100 Jens A. Wilhelmsen Managing Partner jaw@anchorcapital.co.ukCubera Private Equity 100 Jørgen Kjærnes Managing Partner jk@cubera.noNottingham Capital Management 100 Michael T. Pilson Managing Partner mtpilson@ncmpartners.com Raising 1st fundNorgesInvestor 37 Dylan Wolff Managing Director dw@norgesinvestor.comGutmann Group 32 Friedrich Strasser Partner friedrich.strasser@gutmann.atMidCoast Capital 12 Michael Cuneo Managing Partner mcuneo@midcoastcapital.comThe Aldenwood Group Jamie Hale Managing Partner info@aldenwood.comAnt Global Partners Shunsa Hayashi Managing Director info@agp.sg Focus on AsiaCapital Dynamics David Woolford Managing Director dwoolford@capdyn.comHollyport Capital John Beatty Chairman jbeatty@hollyportcapital.comTMT Capital Partners Thomas M. Turmell Managing Partner tturmell@tmtcapital.comLive Oak Secondary Harbert Mulherin Managing Partner harbert@liveoaksecondary.comPerformance Equity Management Charles Froland CEO cfroland@peqm.comTOTAL 117,974Source: Author’s own- Dow Jones; «Guide to Secondary Market Buyers»; 2009 – Companies website
    • Appendix - 139 - 2.2 Database of the dedicated secondary buyers (only direct transactions) A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsVision Capital 2,444 Alister Wormsley Managing Partner alister.wormsley@visioncapital.comSaints Capital 1,300 Ken Sawyer Managing Director ken@saintsvc.comW capital partners 1,100 David Wachter Managing Director dwachter@wcapgroup.comProtostar Partners 1,000 Joseph Haviv Managing Partner joe@protostarpartners.comNova Capital Management 880 Michael Kelly Managing Director m.kelly@nova-cap.comVerdane Capital Advisors 489 Bjarne Lie Chief Investment officer bjarne.k.lie@verdanecapital.comLake Street Capital 400 Gretchen Knoell General Partner gknoell@lakestreetcapital.comTempo capital partners 269 David Tate Managing Partner annette.schneider@tempo-cap.comOmega funds 250 Otello Stampacchia Managing Director os@omegafunds.net Only healthcare companiesHeidelberg Capital 122 Martin Weiblen Managing Partner kontakt@hdcpe.deAnnex Capital 131 mail@annexcapital.comEndeavor Capital Management 120 Anthony Buffa Managing Partner abuffa@endeavorcap.comAccretive Exit Capital Partners 110 Andrew Reilly Managing Director reilly@accretiveexit.comSMAC Partners 100 Dietrich Ulmer Managing Partner dulmer@smacpartners.comAzini Capital 88 Michael Bennett Managing Partner michael.bennett@azini.comShackleton Ventures 55 Michael Low Partner michael.low@shackletonventures.comMorning Street Capital 20 Paul Misir Managing Partner pmisir@morningstreet.comChamonix Private Equity Jane Crawford Managing Partner jane.crawford@chamonixpe.comCipio Partners Tom S. Anthofer Managing Partner tanthofer@cipiopartners.comMustang Capital Partners Parker Brophy Managing Partner parker.brophy@mustangcapital.comS1 Capital Partners David Baum Managing Partner dwbaum@s1capitalpartners.com Preferred equity and mezannine financing to PE17Capital Pierre-Antoine de Selancy Managing Partner selancy@17capital.com portfolio ownersTOTAL 8,878Source: Author’s own- Dow Jones; «Guide to Secondary Market Buyers»; 2009 - Companies website
    • Appendix - 140 - 2.3 Database of firms investing part of their funds in the secondary market A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsPortfolio Advisors LLC 1,100 Paul R. Crotty Managing Director pcrotty@portad.comStepstone Group 800 Tom Keck Chief Investment Officer tkeck@stepstonellc.comSL Capital Partners 340 Patrick Knetchi Investment Director patrick_knetchi@standardlife.comAltamar 244 José Luis Molina Partner jmolina@altamarcapital.comKey Capital Corp 250 Bart Shirley Managing Director bshirley@kppinvest.comVenCap International 250 Tim Cruttenden Director tim.cruttenden@vencap.comVenture Investment Associates 250 Cliff Gilman Managing Director cgilman@viafunds.comWilshire Private Markets Group 237 Amanda Ulczynski Associate aulczynski@wilshire.comThomas Weisel Asset Management 200 Clifford Meijer Managing Partner cmeijer@tweisel.comNorthen Trust Corp 200 Brad Dorchinecz Vice President bmd3@ntrs.comAGF Private equity 147 Christophe Simon Investment Manager christophe.simon@agfpe.comKensigton Capital Partners 100 Tom Kennedy Managing Director tkennedy@kcpl.caFort Washington Capital Partners 85 Stephen Baker Managing Director steve.baker@fortwashington.comAltius Associates 75 Garth Troxell Partner gartht@altius-associates.comMontagu Newhall Associates 75 Ashton Newhall General Partner ashton@montagunewhall.comLLM Capital Partners 73 Frederick Moseley Managing Director rmoseley@llmcapital.com Only directsAbbott Capital Management 72 Charles van Horne Managing Director cvanhorne@abbottcapital.comParagon Partners 61 Edin Hadzic Managing Partner eh@paragon-partners.de Only directsAccess Capital Partners Philippe Poggioli Managing Partner ppoggioli@accesscp.comACP Investment Group trading@acptrs.comAldius Capital Saul Meyer Managing Partner info@aldusequity.com.Allianz Private Equity Partners Claus Zellner Managing Director claus.zellner@apep.comAlpha Associates AG Peter Derendinger CEO peter.derendinger@alpha-associates.chAmundi Private Equity Funds Richard Dalaud Manager richard.dalaud@amundi.com
    • Appendix - 141 - A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsArcano Capital Vanessa Campion Analyst vcampion@arcano.esATP Pivate Euqity Partners Torben Vangstrup Partner tva@atp-pep.comAviva Investors Nick Mansley Director nick.mansley@avivainvestors.com Only Real EstateBarclays Private Equity Paul Goodson Managing Director paul.goodson@barcap.comBay Hills Capital Albert Chiang Partner achiang@bayhillscapital.comBlue Capital vertrieb@wealthcap.com Only directsCalifornia State Teachers Retirement System Set Hall Portfolio Manager shall@calstrs.comCalpersCanada Pension Plans Mark Wiseman csr@cppib.caCarlyle GroupCentinela Capital Partners Robert D. Taylor Partner admin@centinelacapital.comCMS Fund Advisors Inc. William A. Landman Principal wal@cmsco.comDanske Private Equity John Danielsen Managing Partner jd@danskeprivateequity.comDuPont Capital Management Carmen Gigliotti Managing Director carmen.gigliotti@usa.dupont.comF&C Private Equity Hamish Mair Diirector info@fandc.comFinama Private Equity info@finama-pe.frFrontiers Capital Partners Herman Spruit Managing Partner info@frontierscapital.comGuggenheim Partners Amit Dabas amit.dabas@guggenheimpartners.com Interest in India fundsHovde Private Equity Advisors Joseph Thomas Managing Director jtomas@hovde.comHorsley Bridge Partners Dan Reeve Managing Director dan@horsleybridge.comInvesco Private Capital Phillip M. Shaw General Partner phil_shaw@invesco.comItaventure Capital Partners Michele Gardelli Managing Director privateequity@itaventure.itMacquarieMSD Capital Glen R. Fuhrman Managing Partner investments@msdcapital.com
    • Appendix - 142 - A.U.M ($m) dedicated toCompany secondaries Name Position Mail CommentsNatixis Private Equity Jean Duhau de Berenx CEO jean.duhau@natixis-pe.comNew Jersey State Investment Council Maneck Kotwal Investment Officer maneck.kotwal@treas.state.nj.usNorthsea Capital Patrik Nevsten Partner patrik.nevsten@northseacapital.comOak Hill Jeffrey M. Mills Principal jmills@oakhillcapital.comOntario Teachers Pension Plan Erol Uzumeri Senior Vice President teachersprivatecapital@otpp.comOPSEU Pension TrustParish Capital Charles Merritt Managing Partner cmerritt@parishcapital.comPathway Capital Management Philip Godfrey Director philipgodfrey@pathwaycapital.comPCG Asset Management Michelle Davidson Managing Director pcg@pcgfunds.comQuay Partners Stephen White Managing Partner quaypartners@quaypartners.com.auRho Capital Partners Gordon Hargraves Partner ghargraves@rho.comRobeco Capital Henk Saeijs Partner private.equity@robeco.nlSusquehanna International Group garrett.allen@sig.comTeacher Retirement System of TexasTriginta capital Clemens von Berger CEO cvberger@avida-group.com Only directsTuran Corporation Robert Towler Partner rtowler@turancorp.com Emerging marketVon Braun & Schreiber Private Equity Partners Timothy J. Reynolds Managing Director timothy.reynolds@braunschreiber.comHermes Private Equity Andrew Raisman Director andrew.raisman@hermes.co.uk Only DirectsInstitutional Venture Partners Tod Chaffee General Partner tchaffee@ivp.com Only directsVentizz Capital Partners Helmut Vorndran CEO h.vorndran@ventizz.de Only directsBregal Investments management@bregal.comConversus capital ccap@conversus.com Listed PE vehicleNordea Private Equity private.equity@nordea.comSource: Author’s own- Dow Jones; «Guide to Secondary Market Buyers»; 2009 - Companies website
    • Appendix - 143 -3. Request for sponsorship
    • Appendix - 144 -4. Newsletter nº1
    • Appendix - 145 -
    • Appendix - 146 -5. Sponsors of the study and interviewsCompany Agent type Contact Position Mail Comment1. UBS Private funds Group Adviser Stéphane Vojetta Executive director stephane.vojetta@ubs.com IBD Team Nicolas Lanel Executive director nicolas.lanel@ubs.com Call on 19th January 2010. Meeting 3rd March 2010 at 14:00 Francesca Paveri Analyst francesca.paveri@ubs.com Meeting 3rd March 2010 at 14:00 Conf call on 26th Nov. 2009 15H00 UK Time. Other call made in December. Call on 19th January 2010. Call on 8th Jasmine Hunet Analyst jasmine.hunet@ubs.com March 2010. Model and sale structures comments2. Arcano Capital Buyer Vanessa Campion Analyst vcampion@arcano.es Meeting on 18th March 2010 18:00 Steve Sceery Vice President ssceery@arcano.es Meeting on 18th March 2010 18:00 Ricardo Miró-Quesada Associate rmiro@arcano.es Meeting on 18th March 2010 18:003. Fidequity Adviser Francois Garcin Partner francois.garcin@fidequity.com Christophe Tymen Partner christophe.tymen@fidequity.com Conf. call on 3rd December 2009 16:00 UK time Amit Sanghvi Associate amit.sanghvi@fidequity.com Conf. Call 3rd December 2009 16h00 UK Time4. Breslin AG Adviser David Karabelnik CEO karabelnik@breslin.ch Call on Wednesday 02nd Dec. 2009 at 10:00 AM5. Headway Capital Partners Buyer Christiaan de Lint Founder and partner christiaan@headwaycap.com Call Wednesday 9th Dec. 2009 17:006. Preqin Adviser Mark OHare Founder and Managing Director mohare@preqin.com Kerry Pogue Head of research kpogue@preqin.com Call on Wednesday 2nd Dec. 2009.7. Campbell Lutyens Adviser Thomas Liaudet Principal Liaudet@campbell-lutyens.com Call Thursday 10th Dec. 2009 15:30 (UK time). Call on the Julien Marencic Vice President marencic@campbell-lutyens.com 10th March 2010 at 14:00 UK time. Comments on model8. Altamar Buyer José Luis Molina Principal jmolina@altamarcapital.com Meeting Monday 07 Dec. 2009 17:00 Ignacio de la Mora Senior Associate idelamora@altamarcapital.com Meeting Monday 07 Dec. 2009 17:00. Model comments9. Pantheon Ventures Buyer Francesco Di Valmarana Principal Call on Wednesday 09th Dec. 2009 13:00 UK Time Arantxa Prado Senior Associate aprado@pantheonventures.com Call on Wednesday 09th Dec. 2009 13:00 UK Time10. Secondmarket Marketplace Jeffrey C. Bollerman Director LP interest jbollerman@secondmarket.com Call Tuesday 01st Dec. 2009 at 21:3011. SJberwin Legal adviser Isabel Rodriguez Partner isabel.rodriguez@sjberwin.com Meeting on Monday 14th Dec, 2009 17:30 Roberto Pomares Botana Partner roberto.pomares@sjberwin.com Meeting on Monday 14th Dec. 2009 17:3012. Lexington Partners Buyer José Sosa del Valle Senior Associate jsosadelvalle@lexpartners.com Call on 15th and 20th of January 201013. HarbourVest Partners Buyer Peter Wilson Managing Director pwilson@harbourvest.com Call on 9th March 2010, 14:00 UK time
    • Appendix - 147 -6. Meeting guidelinesMeeting guidelines1) Presentation: a) The project: Thesis, Model, sponsors. b) Company profile: Leading buyer on the secondary market, AUM, targeted assets (size, funding ratio), funds, last closed operations, sourcing of transactions.2) Market insight: a) Could you send me historic data of primary and secondary fundraising? b) What was the transaction volume on the market from 2000 to 2009? c) Correlation between primary fundraising and secondary transaction volume (turnover rate, average age of funds sold)? d) How do you see the future of the market? (Tightening of the Bid/Offer spread, Growth, correlation between primary and Secondary PE market) e) Nowadays who are the main sellers on the market? And what is their main reason to sell? f) What about the pricing? (Current and outlook) g) Could you describe a classic transaction process? Obama bank project: Citi deal ($10bn on the sec. market), potential buyers. Will JP Morgan sell its PE unit? $8bn? Will it occur this year? Goldman will give up bank status? Other banks plan to sell h) Which advisers do you work with? i) What are the typical fees of advisers on the market?3) Structuring of the operations: a) What are the different possible structures on the market? b) In case of a structured operation (JV) do you consider the counterparty risk as an issue?4) Valuation Issues: a) Could you describe your valuation method of this asset class? (Bottom-up/Top- down?) Multiples. b) What are the returns and IRR you are looking for? c) How do you project the unfunded commitment? (In order to project cash flows)
    • Appendix - 148 - d) Are listed Investment trusts a good proxy for valuation? e) What are the main components of the value of a secondary asset? (Funding ratio, Growth of underlying, exit timing…)5) Legal issues: a) What are the legal issues when considering buying/selling a LP stake? (pre-emption rights, indemnifications…) b) Does a GP have a right to veto the transfer of a limited partnership interest in a fund?Other: Review and comments of the model
    • Appendix - 149 -7. Summaries of calls and meetings This part contains the summary of the various meetings, calls that have allowed me togain much information of this study. These summaries are in chronological order. Threeother investment funds shared their thoughts with me but asked to remain anonymous. Allerrors are mine. 7.1 Call with UBS (26 November 2009) Call UBS 26th NovemberContact: Jasmine Hunet (UBS Private Funds Group – Secondary Market Advisory, Analyst)When: 26th November, from 16h15 to 17hooSubject: Valuation issues, modelling and structuring of operationsContent: 1. Pricing / Valuationa) Secondary Buyers’ Target ReturnsAll depends on each buyer’s cost of capital, but when modelling, we generally assume that atypical secondary buyer looks for a 1.8x-2.0x return multiple and a 20%+ IRR. These targetreturns are adjusted when modelling non vanilla sale structures which have different riskprofiles.b) Capital Calls & Distribution ProfileYou need to project the future capital calls/distributions profile for your portfolio. Theprofile mainly depends on (i) remaining unfunded to be called, expected return on NAV andexpected return on unfunded (ii) timing of capital calls & distributions.Historical returns data sourced from the “VentureXpert” database can be used to projectreturn multiple and timing.c) Consideration Relative to the Unfunded Commitment:The return multiple assigned to the unfunded part of a commitment mainly depends on theoverall economic outlook, quality of the GP (track record, team stability …) as well as on theexpected use of the unfunded (new investments vs. follow-on investments…).
    • Appendix - 150 -d) Considerations Relative to Management EconomicsTo model the carried interest, you have to do it step by step 1. Hurdle rate or preferred return to LPs is around 8% 2. Then there is a catch up for the GP 3. Lastly profit is shared between LPs and GP (80/20% for a 20% carried interest)There are two different ways of computing the carried interest- US: Deal by deal- EMEA: Calculated at the overall fund level 2. Structuring AlternativesDifferent sale structures can be used to sell a portfolio of LP interests:- Straight sale: Plain vanilla sale. In current market conditions, discounts are still substantial (approx.: 30/40% discount) for average quality buyout funds- Joint-Venture Sale, used to minimize discount. The assets are placed into an SPV owned by seller and buyer. The distribution waterfall is then negotiated (and is often asymmetric)- Seller financing: The seller finances part of the price paid by the buyer via a loan of (for example approx. 30% of the price). You can add a mechanism of “revolver” to cover capital calls as well.- Listing of the Portfolio. Not used today because of market conditions- Securitization. Not used today either.
    • Appendix - 151 - 7.2 Call with Secondmarket (01 December 2009)Call Secondmarket 01st DecemberContact: Mr Jeffrey Bollerman (Head of Limited Partnership Interests Marketplace, NewYork)When: 01st December, from 09:30PM to 10:15PMSubject: Marketplace for illiquid assets.Content: 1. Company Profile Secondmarket is the largest independent marketplace and auction platform forilliquid assets with over 4,000 participants and height asset class traded on its onlineplatform.Secondmarket is a fast growing company providing intermediary services. It competes withevery other intermediary. Other online platforms as Preqin (more based on researchpublication) and NYPPEX (which seems to be quite absent on the market nowadays) aresmaller than Secondmarket.They do not provide advisory on any of those transactions and can offer a low costintermediary service. Instead of all Investment Banks and Boutiques, Secondmarketpositions itself as a fast growing company on a low-cost model based only on intermediaryservices. It employs 100 people. 2. The LP Interest market: a. Size of the market, growth rate: With nearly $2bn in LP interests listed, Secondmarket is the largest marketplace of LPinterest in Private Equity, Venture capital, Funds of funds and Hedge funds. Mr Bollermancould not give me the actual growth of the market because of the confidentiality of thisinformation but he told me it was an exceptional fast-growing market. b. Sellers on the market, reasons to sell Sellers are mostly financial institutions in terms of transaction volume, but are alsoendowments, Corporations, high net worth individuals, pension funds…
    • Appendix - 152 -The main reason to sell is to rebalance the portfolio because of change in the strategy, poorresults, denominator effect… Also many sellers are in distressed situation. c. Pricing on the market Mr Bollerman could not tell us the actual discount on the market because ofconfidentiality but also because it depends on each asset.For him the unfunded is the major determinant of the pricing. Also quality of GPs and ofunderlying assets are other determinants. 3. The process on the market: Participants enter online on the market and meet anonymously on the platform.Once they have agreed on deal conditions (price, other conditions), they get identified andthey close the deal.Fees depends on the sale proceeds, they are generally around 3%. If the transaction price istoo low to cover fixed cost of the platform, then other fees are added.
    • Appendix - 153 - 7.3 Call with Breslin AG (02 December 2009) Call Breslin AG 02nd DecemberContact: Dr. David Karabelnik (CEO Breslin AG)When: 02nd December, from 10:00AM to 11:00AMSubject: Market insight, transaction process.Content: 1. Why this market is a hidden-marketTwo reasons justify why this market is hidden: - It is a New Market: The PE secondary market is all new. Since 2002/2003, the market exploded with much more deals and fund raised. Nowadays it is considered as an established market but because of the wide spread between Bid and offer it remains inefficient. - It is a Private Market: Agents working on this market do not want it to become public. It is a secret market; people do not want their assets to be known as on sale. Confidentiality is a key for success on the market. That is why agents always sign CDAs (Confidential Disclosure Agreements). 2. About Mr Karabelnik and his company Breslin AG: Mr Karabelnik is a Doctor in Biochemistry; he first began as an entrepreneur inBiotech. In 1999 he came back from San Francisco with a background in Venture Capital. Hemet Dresdner Bank and decided to set a vehicle with them to invest in Venture Capital.For this purpose, he founded a Joint-Venture with Dresdner: Breslin Biotech.In 2003, after the bubble crisis, the Private Equity secondary market began to grow becauseof concerns from banks to go out from this asset class. At this time Dresdner sold a portfolioof VC and PE assets (mainly to Axa and Harbourvest).Mr Karabelnik then brought part of the Dresdner team to Breslin AG and they began workingon secondary transactions with a focus on buyers in 2004.They quickly realized fees where much better working for sellers. That is why in 2005, theybegan going out on the market and look for sellers.Their clients include many big companies such as Bayer, Henkel, Roche…
    • Appendix - 154 -In those big companies the realisation of transactions is easier because they are not so muchprice-sensitive and accept discounts of the market.Breslin is an intermediary and an adviser on the market more focused on Venture Capital.Valuation advices are mainly based on the current discount to NAV of the market. 3. Market insight: a. Pricing on the market: The market is clearly offering large discounts to NAV. In the peak of the crisisdiscounts were up to 50/60%. But now things are coming back and discount is tightening, itwill now be around 40% of the existing NAV.The gap between bid and offer is likely to tighten because of the amount of money on themarket. Buyers are sitting on large amounts of money and are likely to invest it revising theirpricing. For example Mr Karabelnik during a process did not accept a bid from a fund and 6months later the bidder came back with a revised and more acceptable price for the sameasset. b. Size of the market: There are clearly a lot of people who want to sell and a lot of money raised by buyers.Mostly transactions led by Mr Karabelnik are likely to realize between 6 weeks and one year.When Breslin goes on the market to find asset for sale he contacts 50 potential sellers, get10 closest conversations and finally sign an exclusive agreement with 3 to 4 sellers. They getc.5-10% of the potential sellers. 4. The transaction process: - Go on the market to find sellers: Advice them on value (give them price range). - Sign an exclusive sale agreement - Get all the info (financials, LPAs…) - Sign a CDA with GPs to allow communication - Go on the buyer market and pitch clients. Database of c. 200 buyers. At this stage of the process Seller and Assets are not disclosed. - Sign a CDA with interested buyers to provide them with more information - Auction of asset - Negotiation with Breslin to agree on a price - Closing: Sign sale and legal agreements. Fees are based on success fees of c. 3,5-5% of the transaction value with addition ofretainers for sale of direct investments of c.4,000 to 5,000€/month because of thecomplexity of the work.
    • Appendix - 155 - 7.4 Email from Preq (02 December 2009) Preqin Mail Preqin 02nd DecemberContact: Kerry Pogue (Head research Secondary PE market)When: 02nd December, by mail to replace a callSubject: Market insight.Content: 1. Preqin Company profile: a. Activity: There has been some talk recently regarding online exchanges and the scepticismaround them. We do not aim to do this. We aim instead to provide an information serviceand network to help inform buyers, sellers and advisors, and to bring them closer togeth together.Preqin’s secondary market monitor service creates leads for buyers and sellers in two ways.Firstly, we call investors to find out their secondary market plans and then we provide thisinformation in the form of a database.Secondly, we have created a confidential network whereby sellers of fund interests cancome anonymously to the service and submit fund interests for indicative valuations, bothfrom Preqin’s algorithmic model and from third party buyers subscribed to our service. Abuyer can submit a rough price indication and make initial contact with the seller but anytransaction is not completed through Preqin’s service. It is completed between the buyerand seller externally. b. Competitors Other participants in the market are Secondmarket, Investor Flow and some other Investoronline trading platforms (often initially set up for the trading of hedge fund interests) whichhave begun to look at adding private equity fund interests to the assets they trade.However, as far as I know, we are the only service to offer free pricing indications. NYPPEX toacts as our exclusive pricing partner and guarantee to provide price indications to anyonethat submits a portfolio for third party price indications. We do not provide advice on thesecondary market. Rather, we proprovide information and data. 2. Valuation method: A proxy to Listed FoF’s With regards to the online algorithm, we have demonstrated a correlation betweenlisted private equity and secondary market pricing and therefore use listed private equity asa proxy and take the following into consideration: type of fund; vintage year of fund; fundmanager track record; fund performance; amount of capital called. We also assess markettrends and factor these in accordingly.
    • Appendix - 156 -We feel that while this method cannot be substituted for a thorough due diligence of thefund’s underlying assets, it does give a good general indication of the fund interest’sapproximate worth on the secondary market and we have received lots of good feedbackregarding the accuracy of the indications. I’m unable to go into any more depth with anexplanation of the model, unfortunately. 3. Market insight: The research report which will be released next week freely on the website will coverthis point. 4. who are the main sellers and why: a. Reasons to sell: I would say there are two types of reasons for selling fund interests: a) liquidityrequirements b) strategic purposes.Strategic purposes would include rebalancing investment portfolio, reducing administrativeburden, gaining exposure to top managers that the LP may have missed in the primary roundof commitments etc. b. Who are the main sellers: I would say that all LPs could benefit from selling for strategic purposes, providing theprices are right, but there are a few firm types that are particularly susceptible to selling,mainly for liquidity requirements. Endowments: ‘a closed box’, with no income and they often employ an over commitmentstrategy. A decrease in distributions from fund investments has therefore hit themparticularly hard.Banks: Banks tend to enter and leave the PE market in cycles. For example, one secondariesmanager has purchased portfolios from the same bank 3 times over the past 15 years. Inorder to generate liquidity, banks have been keen to offload illiquid assets including privateequity fund interests. Furthermore, many banks were initially attracted to the private equitymarket by the opportunity to provide finance in the form of leveraged buyout deals.However, the financial turmoil of 2008 rendered them unable to fulfil the role of financier,prompting many to reduce their exposure to an asset class that never did form a core part oftheir investment strategies. Listed FOFs: another closed box until they issue additional securities. Again, they employ anover commitment strategy and have probably borrowed too much. They’re a good indicationfor the volume of selling we should expect and their selling activity is generally well-documented as a result of their public status.
    • Appendix - 157 - 7.5 Call with Fidequity (03 December 2009)Conference call Fidequity 03rd December nceContact: Mr Christophe Tymen (Partner) and Mr Amit Sanghvi (Associate)When: 03rd December, from 5:15PM to 5:45PMSubject: Valuation, structuring, legal.Content: 1. Fidequity company profile Fidequity is an adviser in Private Equity which mainly focuses on Secondaryoperations and fundraising.It is a global group with offices in London, Paris and New York. 2. Valuation issues In general the GP do not release enough information in its financial reports to valueeach underlying asset.In this case, the valuation process is to make a market valuation. Depending on the Fundingratio of the fund, the market discount of same vintage funds is used. The market discount isthen applied to the NAV of the fund provided by the GP. The lowest the funding ratio, thelowest the price because investors do not like backing managers they do not know.In the case of enough financial information a available, a bottom-up valuation is done valuing upunderlying assets. A new NAV is estimated and depending on the capital call/distributionprofile of the fund, cash flows are discounted at the targeted IRR and the NPV is the pricethe buyer is willing to pay. A sensitivity analysis is done on growth assumptions of underlying .assets and Capital Call/distribution profile. 3. Structuring of the operations:Mainly two structures: -Straight sale - Joint venture: Buyer and seller share the economics. The buyer answer all capitalcalls but gets a preferred return until he reaches a targeted return, then the distribution isshared. 4. Legal issues: It mainly depends in which jurisdiction the fund belongs to. It also depends if thefund is an FCR or a limited Partnership Partnership.
    • Appendix - 158 -Basically pre-emption rights and remaining liabilities of previous LPs are issues consideredduring secondary transactions.The GP do have a veto right on a secondary transaction of a LP stake in its fund.A Limited Partnership does not have to pay tax, but the limited partners pay it. It meansthere is no double taxation on income. In order to be considered as a Limited Partnership,you have to prove that your fund is illiquid and not traded on a public place. That is why aLimited Partnership can’t transfer more than 2% of committed capital each fiscal yearwhether it will be considered as a Public traded partnership (and taxation also) by the IRS.However, by using a qualified service (defined by the IRS) on the secondary market, a fundcan add 8% on the previous percentage of transferable assets.
    • Appendix - 159 - 7.6 Meeting with Altamar (07 December 2009)Meeting Altamar 07th DecemberContact: Mr José Luis Molina (Partner) and Mr Ignacio de la Mora (Investment Director)When: 07th December, from 5:00PM to 6:45PMSubject: Market insight, Valuation, legal, structuring, modelling.Content: 1. Altamar company profile Altamar is a Private Equity fund of fund founded in 2004. Altamar currently has threefunds and asset under management of approx. € 1bn. invested mainly in LBOs (80% of AUM)and Real Estate (20% of AUM). Its funds have a capacity to invest until 20% of committedcapital in secondary transactions.Recently they opened a new fund dedicated to secondary operations. This fund only investsin funds Altamar already invested in on the primary market. They use to invest in earlysecondary (50/60% funded) looking for 2x returns. 2. Market insight The size of the secondary market is really difficult to determine, however it seemsthat the volume of transaction was c. $16 bn. in 2008 and c. $4 bn. in H1 2009. For MrMolina, no clear correlation exists between the primary Private Equity market and secondarytransactions because each market relies on different drivers.Main reasons of selling were distressed situations and the denominator effect. Today thedenominator is no longer a reason because boards voted to lift threshold of the PrivateEquity allocation and also because large pension funds forced GPs to write-down their NAV.Today sellers are mostly listed fund of funds (because of over commitment strategy and highleverage breaching of covenants) and family offices (mainly distressed sellers).They believe the tightening of the bid/offer spread will happen when the visibility andmacroeconomic conditions will better.It is a market similar to the Real Estate one because it is a buyer market where agents arelooking to buy quality assets and where sellers are mostly distressed and have to sell with adiscount to the real price of those assets in the future.
    • Appendix - 160 - 3. Valuation issues In order to value this asset class, a simple market valuation (applying a discount onthe GP’s NAV) is not a good method. A bottom-up valuation has to be performed in order tovalue underlying assets. Underlying is valued via EBITDA multiples; it is not possible to do itvia a DCF method because we need to approach the value of the assets in the time.A new NAV is estimated and depending on the capital call/distribution profile of the fund,cash flows are discounted at the targeted IRR and return. The NPV is the price the buyer iswilling to pay. A sensitivity analysis is done on growth assumptions of underlying assets andexit timing.The cash is not an issue because it is always an insignificant part of the fund and usually thefinal price paid for the asset is corrected by the existing cash. 4. Legal issues:Two most important legal issues: - Existing legal agreement of the fund: not applicable for Altamar because they only invest in funds where they already invested in primary. - The Share Purchase Agreement (SPA) Particular attention has to be paid if remaining LPs have pre-emption rights (ex:Blackstone).GP consent is required in secondary transactions.Also fiscal issues have to be considered, for example, when buying in the US, if you want tobenefit from the local tax treatment you have to buy a resident vehicle. 5. Structuring of operations: Altamar only buy assets via straight sale. Structures where the buyer and the sellershare the economics (like JV) are not used because of the risk of bankruptcy. Also for fiscalreasons because an FCR cannot invest in a structured note; they have to invest in PrivateEquity funds if they want to keep their tax treatment. 6. Modelling: Mr de la Mora reviewed the valuation model. Discussions were on the followingelements: - Growth assumptions - Cash flow for debt repayment - Waterfall - Management fees/Carried
    • Appendix - 161 -7.7 Call with Pantheon Ventures (09 December 2009) Conference call PantheonVentures 09th DecemberContact: Mr Francesco Di Valmarana (Principal) and Mrs Arantxa Prado (Senior Associate)When: 09th December, from 11:00AM to 12:00AM (UK time)Subject: Market insight, structuring, Valuation, legal.Content: 1. Pantheon company profile Pantheon Ventures is a Private Equity primary and secondary fund-of-funds managerfounded in 1982. Pantheon currently manages approx. $ 23bn. invested mainly on theprimary (80% of AUM) and on the secondary market (20% of AUM).Pantheon has been a pioneer on the Private Equity secondary market beginning its activitieson this market in 1988. Today Pantheon is the fourth biggest player by assets dedicated tothis market. On the secondary market they mainly invest (85%) in funds where they alreadyparticipate in the primary. They use to invest in late secondary (60/70/80% funded).Generally Secondary funds perform better than Primary in terms of return. 2. Market insight The size of the secondary market is really difficult to determine, however it seems thatthe volume of transaction (Purchase Price + Unfunded) was c. $23,5 bn. in 2008 and c. $5,5bn. in H1 2009. In 2010 the market is likely to be much more important than in 2009.Transaction volume should be approx. $30 bn.Quoted investment trusts give a good proxy for valuation, in 2006-2007, a 5 to 15% premiumto NAV was paid. Pricing on the secondary Private Equity market was very similar. Todaylisted investment trusts show a reduction in the discount to NAV, which should be likely totighten the gap between the bid and offer on the secondary market.Players mainly sell on the secondary market for three different reasons: - Cash flow distressed: It can be every players but it is mainly the case for family offices. - Balance sheet issues: Risk capital allocation. Regulation. Banks and insurance companies. - Portfolio allocation: Rebalance portfolio, change strategy. Pension funds, insurance companies and endowments.
    • Appendix - 162 -There are two types of classic transaction process depending on where the deal is sourced: • Deal sourced via an intermediary: The transaction process last mainly 3 months. - Intermediaries come up with a list of assets and their characteristics - If the buyer is interested by an asset he makes an initial bid: 1month - More information is given to the different parties who have to make a final bid: 1month - Closing of the deal: Legal (SPA,…) 1 month. • Deal sourced by Pantheon: Same steps as the previous process but is usually a lot more complicated and longer (can last years).Typically adviser fees are c.1 to 2% of NAV + Unfunded depending on the size of thetransaction. 3. Structure of transactions Pantheon mainly buys assets agreeing on a price with differed payments. They havealso used other different structures using SPV and sharing the economics where thecounterparty risk is carefully assessed. Generally deal structures are proposed and accordedwith the seller. 4. Valuation issues In order to value this asset class, a bottom-up valuation is performed to value theunderlying. Underlying is valued via multiples; it is not possible to do it via a DCF methodbecause we need to approach the value of the assets in the time.A new NAV is estimated and depending on the capital call/distribution profile of the fund,cash flows are discounted at the targeted IRR (20/25% for Pantheon) and return (1,8x to 2xfor Pantheon). The NPV is the price the buyer is willing to pay. A sensitivity analysis is doneon growth assumptions of underlying assets and exit timing. The unfunded is separated and valued in two parts: - The part which will be used to back existing investments: This part is projected as per returns expected of each investment in existing business. - The capital for new transactions: On this part the return applied is usually bigger.The cash is not an issue because it is always an insignificant part of the fund however it isincluded in the model.For Pantheon, as a late secondary buyer, the main component of the value of a secondaryasset is the quality of the underlying. For an early secondary the main component would bethe funding ratio. 5. Legal issues: - Indemnities: In case a GP sold an asset and need to call back distribution. - Fiscal issues: Tax situation of the vendor, buyer and underlying assets. - Composition and agreements in the investor base
    • Appendix - 163 -Depending of the LPA, the GP can have a veto right.In the US, the 2% transfer law is applicable to limited partnerships and 8% can be added tothis percentage if the transaction is advised by a Qualified Matching Service (QMS) definedby the fiscal authorities.
    • Appendix - 164 -7.8 Call with Headway Capital (09 December 2009)Call Headway Capital 09th DecemberContact: Mr Christiaan de Lint (Founder and Partner)When: 09th December, from 5:00PM to 5:15PMSubject: Market insight, ValuationContent: 1. Headway Capital company profile Headway Capital is a Private Equity secondary fund-of-funds manager founded in2004. Headway currently manages two funds totalling c.€ 200 million invested mainly inDirect secondary (75% of AUM) and in LP Positions (25% of AUM). They specialize in small tomid-size transactions (<€40m). 2. Market insight For Mr de Lint a correlation exists between the primary and the secondary market ofaround 3 to 5%. However it is difficult to determine its future.Sellers are cyclical; before it was corporations, then banks and today it is everybody.Reasons are also changing in the time; before people were selling for portfolio management,today people are selling for distressed reasons. 3. Valuation issues In order to value this asset class, a bottom-up valuation is performed to value theunderlying. A new NAV is estimated and depending on the capital call/distribution profile ofthe fund, cash flows are discounted at the targeted IRR and return (which for Headway aresimilar to a primary Private Equity fund). A sensitivity analysis is done on growthassumptions of underlying assets and exit timing.The valuation of the unfunded depends on the quality and the reliability of the GP: - If the GP has a good track record and is likely to make good investments then the unfunded is not taken into account. - If the GP is not that good then the unfunded is projected at an inferior return to the target one in order to penalise the value for the risk taken.
    • Appendix - 165 -7.9 Call with Campbell Lutyens (10 December 2009)Call Campbell Lutyens 10th DecemberContact: Mr Julien Marencic (Vice President)When: 10th December, from 02:30PM to 03:30PM (UK time)Subject: Market insight, Transaction process, Structuring, Valuation.Content: 1. Campbell Lutyens company profile Campbell Lutyens is an advisory firm founded in 1988 focused on Private Equity andInfrastructure. The company specialises in raising private equity and infrastructure fundsfrom institutional investors worldwide and in advising on the secondary sale or restructuringof portfolios of direct or fund investments.On the Private Equity secondary market it advises on the sale or restructuring of portfolios ofPrivate Equity fund or direct investments. They recently closed the sale of the European VCportfolio of 3i and the restructuring and refinancing (c.€200m) of APEN, a listed vehiclepreviously affiliated with AIG. 2. Market insight The size of the secondary market is really difficult to determine, however it seemsthat the volume of transaction (Purchase Price + Unfunded) was c. $14/15 bn. in 2008 andwill be around $5/6 bn. in 2009 (apart from sales of single interests). In 2010 the market islikely to be much more important than in 2009.The Bid/Ask spread is already tightening but its evolution in the near future will depend onmacroeconomic developments and on the change in NAVs (How GPs mark their investment).Nowadays the average discount for a portfolio of buyout funds is ca. 20/30%, and can evenbe closer to NAV in certain cases.In 2010 sellers will mainly be Banks and endowments. Indeed, many banks are now focusingon their core business (and are likely to divest non-core activities) and seeking liquidity (forinstance to repay government’s loans). Endowments should mainly be affected because oftheir overcommitment strategy to Private Equity and the denominator effect (Public marketsdropped more than Private Equity NAV).Reasons for selling are the following:
    • Appendix - 166 - - Liquidity concern - Over-commitment strategy - Denominator effect - Change of strategy / Exit of non-core activities 3. Transaction Process All transactions are unique but most transactions can be divided in 4/5 phases: 1. Preparation Phase: Adviser’s due diligence and preparation of the data room 2. Marketing Phase: An NDA (Non Disclosure Agreement) is signed with each investors to enable them to access the data room. Investors then review the information contained in the data room and submit an indicative offer for the assets. 3. Due Diligence Phase: A short list of investors is made and the short-listed investors get access to more information on the data room so they can refine their due diligence and submit a binding offer. 4. Negotiation and Closing Phase: The preferred party(-ies) enters in exclusive SPA negotiations with the seller until the document is signed. 5. (Funds transfer)Typically adviser fees are c.1,5 to 3,5% of NAV + Unfunded depending on the size andcomplexity of the transaction. 4. Structure of transactions Straight sales are used but also different structures using SPV and sharing theeconomics. Economic-swap agreements (in which the legal ownership and economics of theassets are decoupled) or Top slicing (in which an investor buys a part of each of the vendor’sLP interests) are also used. 5. Valuation issues In order to value this asset class, a bottom-up valuation is performed to value theunderlying assets. A secondary price is calculated, which depends on the level of undrawn ofthe fund, future cash flows are discounted at the targeted IRR (depending of buyers’ cost ofcapital, and target IRR marketed to their own investors) to achieve the target MM return(typically between 1,8x to 2x).When more visibility on the future use of cash flows is available, the unfunded componentcan be separated and valued in two parts: - The part which will be used to back existing investments: This part is projected as per returns expected of each investment in existing business. - The capital for new transactions: On this part the return depends on how the GP plans to invest it.Quoted investment vehicles can be used as a proxy to secondary market pricing, bearing inmind the following caveats:
    • Appendix - 167 - - the NAV of a listed vehicle is based on the underlying NAV of the underlying assets available at the time of reporting (e.g. usually NAV from the previous quarter) - the share price of listed investment vehicles can be distorted by the lack of liquidity in the shares and/or the structure of the vehicle itself (such as use of leverage, overcommitment strategy…).The value of a secondary asset is mainly driven by its underlying assets: trading activity(growth outlook), economic environment (entry multiples…), manager’s experience andreputation, exit market (M&A and IPO); but also by the unfunded part (depending on theaccess to investment plans of the GP and on the quality of GPs) and the exit timing.
    • Appendix - 168 -7.10 Meeting with SJberwin (14 December 2009)Meeting SJberwin 14th DecemberContact: Mrs Isabel Rodríguez (Partner) and Mr Roberto Pomares (Partner)When: 14th December, from 05:30PM to 06:45PMSubject: Market insight, legal issues.Content: 1. SJ Berwin company profile SJ Berwin is a leading international law firm founded in 1982 delivering legal advice tofinancial institutions and international companies. With c. 600 lawyers, SJ Berwin is presentin 12 different countries. SJ Berwin is a leading adviser in the primary Private Equity sector.They also advise their clients (GPs) and sellers in their client fund on secondary transactions.As a participant on the secondary market they are also involved on the buy-side. 2. Market insight They advise on transactions of LP interests but also on synthetic transactions wherethe GP is selling a part or an entire portfolio.The Spanish Private Equity market is really a small market (Biggest fund: Magnum Capital€850m), secondary operations are reduced and players mainly sell for distressed reasons.GPs also sell because of poor performance in their portfolio.Reason to sell is mainly because of distressed situation; however for GPs it can also be to sella non performing asset/portfolio. Nowadays for a straight sale, discounts are c.25% of NAV. 3. Legal issues Basically in a transaction process, lawyers have two major roles: - To analyse the existing LPA (Limited Partnership Agreement) of the fund: Indeed at the very beginning of a transaction, the GP or even the seller requires to understand what are the transfer conditions and possibilities. Also the potential buyer requires understanding the LPA and will need a summary of all its conditions and characteristics. - To redact the SPA (Share Purchase Agreement): The buyer when closing the transaction will have to redact the adequate legal document transferring assets and remaining liabilities. This part is much more complicated in the case of a synthetic sale (GP direct sale) than in a straight sale of a LP interest. Pre-emption rights: In general funds do not have pre-emption rights in their LPA.However if they do it is a crucial issue when planning to sell a LP position.
    • Appendix - 169 -GPs generally have a right to veto the transfer but they generally do not use it. Indeed theymore often help the LP to find an investor for its interest in order to reduce the risk of adefault in their fund.In case of a LP default, the GP can generally choose between different options: - A secondary sale of the LP interest - A reduction in the LP’s capital account, typically 25/50% of its investment. Also incurred costs are reducing the investment.In the case of a synthetic sale, GPs usually do not give much representation (Reps) orwarranties to the buyer because they want to get rid of sold investments.In their opinion, the IAFM proposal is not likely to become a law because of the importanceof other markets (US and emergent ones).Legal advisers usually work about 30/50 hours on a straight sale of LP interest. For asynthetic sale they work c.500/1000 hours.
    • Appendix - 170 -7.11 Call with UBS (02 February 2010) Call UBS 02nd FebruaryContact: Nicolas Lanel (UBS Private Funds Group – Head of European Secondary MarketAdvisory Team), Jasmine Hunet (UBS Private Funds Group – Secondary Market Advisory)When: 02nd February 2010, from 3:30PM to 4:30PM (UK time)Subject: Advisers, Market insight, valuationContent: 1. UBS PFG profile UBS PFG is the advisory group in charge of raising private equity funds frominstitutional investors worldwide and is advising on the secondary sale or restructuring ofportfolios of direct or fund investments.The secondary advisory team is composed of 22 professionals across London and New York.It was founded 6 years ago in New York by Nigel Dawn.The Secondary advisory team focuses primarily on large or structured transactions and haspioneered a number of innovative solutions to maximise value or achieve sellers objectives.The team competes primarily with Campbell Lutyens in Europe and Cogent Partners in theUS. 2. Market insight Dry powder: According to UBS estimates $45bn of dry powder was available to buyers at the beginningof 2010. 2009 transaction volumes decreased to app. $9bn from a peak in 2008 of $20bn. Correlation between the primary and the secondary market: It is estimated that historically, +/-3 to 5% of primary fund commitments are ‘turningover’ in the secondary markets. This number had been rising steadily up to 2009 whenmarket conditions made it prohibitive to use the secondary markets as a portfoliomanagement tool.UBS estimates that volumes should bounce back to in excess of $20bn, driven by theresurgence of large portfolio deals. Outlook for the next years:
    • Appendix - 171 - As the economic outlook further improves and capital calls resume, liquidity pressure willrise again on certain over-committed investors. This, combined with sustained regulatorypressure on banks will drive deal flow which will be facilitated by rising valuations supportedby rising public markets and underlying NAV’s. However, as deal flow reaches record levels,sellers’ ability to drive deal terms will be eroded by human resource limitations at buyerswho will have to carefully elect where to deploy their limited human capital. Volcker Rule: Mr Lanel does not think that the Volcker Rule will lead to a sudden wave of transactionsby banks given the time horizon which has been granted to them to transaction out ofrestricted areas. However, regulatory pressure imposed by Basel II had already put things inmotion for banks to dispose of non-core assets in particular in PE and a number of legacy“pay to play” programmes have already been sold down. 3. Valuation issues Listed Investment trusts: Listed investment trusts have provided a good proxy for the secondary markets untilrecently where they have failed to ‘catch up’ with the marked reduction in discounts. Expected returns: During the crisis, returns targeted by buyers went up because of the lack of visibility andthe associated risk. Nowadays, it went back to ‘normalized’ levels of 15 to 20% IRR and app.1.8x return for LP portfolios and app. 25% and in excess of 2x for ‘secondary directs’.
    • Appendix - 172 -7.12 Call with HarbourVest Partners (09 March 2010)Call HarbourVest Partners 09th MarchContact: Mr Peter Wilson (Managing Director)When: 09th March 2010, from 2:00PM to 2:30PM (UK time)Subject: Market insight, Valuation.Content: 1. HarbourVest Partners company profile HarbourVest Partners is one of the biggest independent buy-side firm that providesprivate equity solutions to its clients. Founded in 1982 as an investment division of JohnAncock insurance company, the firm spun out and became independent in 1997. Up to dateit manages $32bn in primary, secondary and direct investments. Its secondary program iscurrently investing its seventh fund: Dover Street VII, a vehicle of $2.9bn dedicated tosecondary investments. Their secondary investments include LP interests, direct investmentsbut also hybrid structures. HarbourVest who already invested $7bn in the secondary markethas a dedicated secondary team of 24 professionals. 2. Market insight 2009 secondary transaction volume: $6-8bn was transacted in 2009 on the secondary market which represents a 25% decline from previous year. Correlation between the primary and the secondary market: Historically, +/-3 to 4% of primary fund commitments are exchanged in the secondary market after an average 4 to 5 years. Considering historical data Mr Wilson also see an increase in the percentage of exchanged commitment as per last years. The Bid/Ask spread is tightening; current discount trend is about 20% to NAV on the market and should remain similar this year because of the constant perceived risk in the market. Market imbalance: The secondary market is still a buyer market. The dry powder should be around $20bn in dedicated secondary capital and c. $35-40bn is potentially available on an opportunistic basis. This total $55-60bn of dry powder which will be invested on average in the next 4 years should be compared with a potential transaction volume of about $100bn in the next 4 years which clearly evidences an imbalance on the market The Volcker Rule: Mr Wilson does not think this project will be translated in a similar law. It should not urge banks to sell their PE division/assets. However, the trend clearly
    • Appendix - 173 - indicates that regulated financial institutions have to watch carefully if they want to keep those assets because of its cost of capital and regulatory concerns (Basel II). 3. Valuation issues In order to value this asset class, a bottom-up valuation is performed to value theunderlying assets. They never use a market valuation method (applying the existing discountof asset class and vintage year to the fund’s NAV). Listed Investment trusts: Listed investment trusts do not reflect an accurate trend of the secondary market. Indeed, the market value of these assets is distorted by market effects and used leverage. Expected returns: Returns depend on the type of assets (LP portfolio/Direct deal). However as a general rule, they are looking to generate mid twentieth IRR and c. 2x multiple.
    • Appendix - 174 -7.13 Call with Campbell Lutyens (10 March 2010)Call Campbell Lutyens 10th MarchContact: Mr Julien Marencic (Vice President)When: 10th March, from 02:00PM to 03:00PM (UK time)Subject: Financial adviser market, Market insight.Content: 1. Financial adviser market Key advisers on the market are UBS PFG, Cogent and Campbell Lutyens. Distinctionbetween secondary advisers and brokers should be made. Several firms offer secondarytransactions brokerage services but few are able to advise and handle large, structured orcomplex deals.As the placement agent activity was dramatically reduced in late 2008/2009, manyplacement agents have tried to develop a secondary advisory practice, in an attempt tooffset their declining fundraising revenues. 2. Market insight Nowadays the average discount for a mid-quality portfolio of buyout funds is ca.10/20% and can be closer to NAV in certain cases (best quality funds); certain funds eventrade at a premium. Sellers: Mainly financial institutions In 2010 most of the secondary deal flow should come from banks. Indeed, in 2009 bankswere facing much pressure because of public recapitalization, M&A, restructuring activitiesor even bankruptcy. Since then, banks have been busy trying to survive in a hostileenvironment by cleaning up their balance sheet and repaying the public loans they received.Since September 2009, a number of banks have started to re-assess their PE strategy andpotential solutions could include a sale of all or part of their private equity assets. Indeed,under Basel II RWA rules, PE assets held by banks typically attract capital requirements from190% to 400% (depending on the regulator and on each bank’s interpretation andapplication of the rules). Since this weighting is applicable to NAV+Unfunded, holding PEassets requires a lot of capital and is therefore very expensive for regulated financialinstitutions. Because of this regulation and of the volume of PE assets on their balancesheets (for instance, banks used to invest in PE funds in order to gain access to leveragefinance deals), many financial institutions are starting to consider their PE assets as non
    • Appendix - 175 -“core” and are likely to divest all or part of their holdings. Additionally, the recovery ofsecondary market pricing could accelerate/reinforce this trend. Still a buyer market… but not for a long time The market is still a “buyer’s market”, however some signs that competition isintensifying are being perceived in recent transactions. As of Q1-2010, CL estimates that thedry powder available for secondary transactions is about $41-42bn (including announcedinterim closes for current fundraisings). Secondary current and future fundraisings for 2010could add ca. $27bn to this amount, should most of the secondary fundraising targets bereached.In terms of volume of transactions, we estimate that there will be ca. $20bn of transactionsper year over the next 3 years, which is consistent with the current dry powder available forsecondaries (up to $60bn, if secondary fundraisings are on target) and a historical averagedeployment period of 3 years.
    • Appendix - 176 -7.14 Meeting with Arcano Capital (18 March 2010) Meeting Arcano Capital18th MarchContact: Vanessa Campion (Analyst); Steve Sceery (Vice President); Ricardo Miró Quesada (Associate)When: 18th March, from 06:00PM to 07:15PMSubject: Fund of fund activity and approach on the secondary market.Content: 1. Arcano company profile The Arcano group, founded in 2003 is an independent company with three divisions:I) Corporate Finance Advisory, (II) Alternative Investment Management, (III) Multi-familyOffice Advisory.Arcano Capital is a Private Equity fund of funds manager. They currently have assets undermanagement of approx. € 800 m. invested globally. Its funds have a capacity to invest up to20% of the committed capital in secondary transactions. 2. Approach on secondary assets: Arcano Capital invests on an opportunistic basis in secondary assets. They prefer toinvest in funds where they have already invested in on the primary market. They usuallyinvest in early secondary looking for at least 25% IRR.To this date they have closed one secondary transaction in November 2009 buying an LPstake in a fund where they already have a primary commitment. The secondary market is forthem a way to re-balance their portfolios, take advantage of market inefficiencies, gain moreexposure to managers they like and to enter funds where they previously did not invest inthe past.Main sources of secondary opportunities are portfolio GPs and family offices. Advisers arealso an important source of opportunities. 3. Market insight NAV levels: Last quarter the general trend of NAV surge 15% mainly due to the increase in EBITDAand valuation multiples of portfolio companies.
    • Appendix - 177 - Primary fundraising Primary fundraising in 2009 did not meet expectations. 2010 is expected to improvealthough it is also expected to be a difficult year in terms of fundraising. Valuing the dry powder of opportunistic buyers in the secondary market Opportunistic buyers such as mainly primary fund of funds represent a big part of thesecondary market volume. However this part of the secondary volume is difficult to valuebecause of the size of deal and of their opportunistic condition.By applying a discount to the traditional allocation of fund of funds (c. 20%) to the secondarymarket on the total dry powder of mainly primary fund of funds, we could get a good proxyto the money they can dedicate to this market.
    • Appendix - 178 -8. Analysis of published historical data As the volumes in the market are very difficult to value precisely, I analyzed the data published by different participants,compared it and used the most reliable. In the following analysis the data used for this study is in the grey cells.8.1 Historical transaction volume in the secondary marketIn $bnSource 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000Inside the growing market for VC 0.6Dow Jones Guide to sec MarketPermal capital MangementUBS (presentations)Carta Diem (Lexington Estimates) 0.2 0.4 0.4 0.8 0.5 1 0.5 0.6 1.4 2.2 2.8PE Magazine (PE Analyst)PEI Manager (Cogent/Capital Dynamics)Triago 2.2 2.8Dow Jones Guide to sec Market Buyers 0.579 0.71 1.494 2.35 3.09Capital DynamicsGreen Park CapCampbell Lutyens (Mail Mr Marencic)Lexington Partners (Distressed debt report)HarbourVest Partners (Mr Wilson call)Cogent Partners (Cogent and VentureXpert) 0.5 0.6 1.4 2.2 2.8Selected data 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 0.2 0.4 0.4 0.8 0.5 1 0.579 0.71 1.494 2.35 3.09Source: Author’s own
    • Appendix - 179 -In $bnSource 2001 2002 2003 2004 2005 2006 2007 2008 2009Inside the growing market for VC 8Dow Jones Guide to sec Market 10/15Permal capital Mangement 6.5 7 6.5 8 11 14UBS (presentations) 8 12 15 20 9.1Carta Diem (Lexington Estimates) 2.1 1.9 5 6.9PE Magazine (PE Analyst) 5 7 6.7 10 18PEI Manager (Cogent/Capital Dynamics) 6.5 7 6.5 12 13.5 20Triago 2.1 2.8 7 7.7 7.5 10 13 14.5Dow Jones Guide to sec Market Buyers 2.278 2.092 6.904 8.38 7.468 10.268 13.35 16.116Capital Dynamics 4 5.1 11 17 18 17Green Park Cap 1.9 15Campbell Lutyens (Mail Mr Marencic) 6Lexington Partners (Distressed debt report) 8.8HarbourVest Partners (Mr Wilson call) 6/8Cogent Partners (Cogent and VentureXpert) 2.1 1.9 5 7 6.7 10 18 30 6/7Selected data 2001 2002 2003 2004 2005 2006 2007 2008 2009 2.278 2.092 6.904 8.38 7.468 10.268 13.35 16.116 9.1Source: Author’s own
    • Appendix - 180 -8.2 Secondary fundraisingSource (in $bn) 1995 1996 1997 1998 1999 2000 2001 2002Probitas Partner 0.8 0.8 0.4 2.6 2.2 2.1 4.5 4.1UBSPE Magazine (PE Analyst)Dow Jones Guide to sec Market Buyers 1.068 0.653 2.741 2.021 2.445 6.405 3.961Green Park CapJP Morgan AM (Thomson Reuters; VentureXpert) 2.9 5.3 3.6Preqin (Private Equity spotlight January 2010)Selected data 1996 1997 1998 1999 2000 2001 2002Dow Jones Guide to sec Market Buyers (1996-2008)/Preqin (2009) 1.068 0.653 2.741 2.021 2.445 6.405 3.961Source (in $bn) 2003 2004 2005 2006 2007 2008 2009Probitas Partner 3.5 8.4 5.6 6.1 15.1 7.4UBS 7.7 8.6 9.1 20.2 26.7 30.2PE Magazine (PE Analyst) 3.1 9 6.3 10.7 16.2Dow Jones Guide to sec Market Buyers 7.425 7.812 7.245 12.955 12.316 8.893Green Park Cap 20JP Morgan AM (Thomson Reuters; VentureXpert) 6 5.5 6.9 7 14.2 5.5Preqin (Private Equity spotlight January 2010) 18.5Selected data 2003 2004 2005 2006 2007 2008 2009Dow Jones Guide to sec Market Buyers (1996-2008)/Preqin (2009) 7.425 7.812 7.245 12.955 12.316 8.893 18.5Source: Author’s own
    • Appendix - 181 -8.3 Primary fundraisingIn $bnSource 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999Partners GroupPermal Capital ManagementCarta Diem (Fuente Private Equity Analyst) 21.1 13.9 17.4 17.8 33.3 38.6 49.5 80.5 117.2 132.7Preqin 93 143 180JP Morgan AM (Thomson Reuters; VentureXpert)Selected data 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999Carta Diem/Partners Group/Preqin 21.1 13.9 17.4 17.8 33.3 38.6 49.5 80.5 117.2 132.7In $bnSource 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Partners Group 250 140 70 80 120 255 370 455 375 200Permal Capital Management 265 155 75 85 125 250 340 395 255Carta Diem (Fuente Private Equity Analyst) 243 167.8 91.8 82.3 126.7Preqin 250 190 146 135 206 344 535 644 629 246JP Morgan AM (Thomson Reuters; VentureXpert) 333 244 175 133 183 334 449 585 636 221 Selected data 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Carta Diem/Partners Group/Preqin 250 140 70 80 120 255 370 455 375 246 Data: Thomson Reuters; AVCJ; EVCA; Asia Private Equity; NVCA; Dow Jones PE Analyst; Preqin (2009)Source: Author’s own
    • Appendix - 182 -9. Secondary market projection modelI. Historical Data$ bn 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Primary fundraising (Thomson Reuters; AVCJ; EVCA; Asia Private Equity; NVCA; Dow Jones PE Analyst; Preqin (2009)) 21.1 13.9 17.4 17.8 33.3 38.6 49.5 80.5 117.2 132.7 250 140 70 80 120 255 370 455 375 246 Secondary transaction volume Dow Jones Guide to Sec. Market Buyers(1996-2008)/ UBS (2009) 0.2 0.4 0.4 0.8 0.5 1 0.579 0.71 1.494 2.35 3.09 2.278 2.092 6.904 8.38 7.468 10.268 13.35 16.116 9.12. Assumption - Probability of transaction distributionFund year 1 2 3 4 5 6 7 8 9 10 TotalProbability 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 100%Average age of fund purchased (years) 0 0.10 0.30 0.80 1.50 1.20 0.70 0.40 0.00 0.00 5.003. Historical turnover Probability 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1990 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1991 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1992 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1993 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1994 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1995 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1996 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1997 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1998 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 1999 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 2000 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 2001 0% 5% 10% 20% 30% 20% 10% 5% 0% 2002 0% 5% 10% 20% 30% 20% 10% 5% 2003 0% 5% 10% 20% 30% 20% 10% 2004 0% 5% 10% 20% 30% 20% 2005 0% 5% 10% 20% 30% 2006 0% 5% 10% 20% 2007 0% 5% 10% 2008 0% 5% 2009 0%
    • Appendix - 183 -Vintage funds potentially brought to market Primary raised 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1990 21.1 - 1.06 2.11 4.22 6.33 4.22 2.11 1.06 - - - - - - - - - - - - 1991 13.9 - - 0.70 1.39 2.78 4.17 2.78 1.39 0.70 - - - - - - - - - - - 1992 17.4 - - - 0.87 1.74 3.48 5.22 3.48 1.74 0.87 - - - - - - - - - - 1993 17.8 - - - - 0.89 1.78 3.56 5.34 3.56 1.78 0.89 - - - - - - - - - 1994 33.3 - - - - - 1.67 3.33 6.66 9.99 6.66 3.33 1.67 - - - - - - - - 1995 38.6 - - - - - - 1.93 3.86 7.72 11.58 7.72 3.86 1.93 - - - - - - - 1996 49.5 - - - - - - - 2.48 4.95 9.90 14.85 9.90 4.95 2.48 - - - - - - 1997 80.5 - - - - - - - - 4.03 8.05 16.10 24.15 16.10 8.05 4.03 - - - - - 1998 117.2 - - - - - - - - - 5.86 11.72 23.44 35.16 23.44 11.72 5.86 - - - - 1999 132.7 - - - - - - - - - - 6.64 13.27 26.54 39.81 26.54 13.27 6.64 - - - 2000 250 - - - - - - - - - - - 12.50 25.00 50.00 75.00 50.00 25.00 12.50 - - 2001 140 - - - - - - - - - - - - 7.00 14.00 28.00 42.00 28.00 14.00 7.00 - 2002 70 - - - - - - - - - - - - - 3.50 7.00 14.00 21.00 14.00 7.00 3.50 2003 80 - - - - - - - - - - - - - - 4.00 8.00 16.00 24.00 16.00 8.00 2004 120 - - - - - - - - - - - - - - - 6.00 12.00 24.00 36.00 24.00 2005 255 - - - - - - - - - - - - - - - - 12.75 25.50 51.00 76.50 2006 370 - - - - - - - - - - - - - - - - - 18.50 37.00 74.00 2007 455 - - - - - - - - - - - - - - - - - - 22.75 45.50 2008 375 - - - - - - - - - - - - - - - - - - - 18.75 2009 246 - - - - - - - - - - - - - - - - - - - -Historical turnover rate 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Total Potential - 1 3 6 12 15 19 24 33 45 61 89 117 141 156 139 121 133 177 250Effective Secondary transactions 0.2 0.4 0.4 0.8 0.5 1 0.579 0.71 1.494 2.35 3.09 2.278 2.092 6.904 8.38 7.468 10.268 13.35 16.116 9.1Effective Turnover rate 6.5% 3.1% 2.9% 4.6% 5.3% 5.0% 2.6% 1.8% 4.9% 5.4% 5.4% 8.5% 10.1% 9.1% 3.6%Weighted average turnover rate from 1995-2002 3.38%Weighted average turnover rate from 1995-09 5.60%Weighted average turnover rate from 2003-09 6.41%Weighted average turnover rate from 2003-08 7.20%Source: Author’s own
    • Appendix - 184 -ProjectionsAssuming constant fundraising in 2010E/2011E/2012E as of 2009 246Probability of future transaction distribution Fund raised 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014E 1999 132.7 20% 10% 5% 0% 0% 2000 250 30% 20% 10% 5% 0% 0% 2001 140 20% 30% 20% 10% 5% 0% 0% 2002 70 10% 20% 30% 20% 10% 5% 0% 0% 2003 80 5% 10% 20% 30% 20% 10% 5% 0% 0% 2004 120 0% 5% 10% 20% 30% 20% 10% 5% 0% 0% 2005 255 0% 5% 10% 20% 30% 20% 10% 5% 0% 2006 370 0% 5% 10% 20% 30% 20% 10% 5% 2007 455 0% 5% 10% 20% 30% 20% 10% 2008 375 0% 5% 10% 20% 30% 20% 2009 246 0% 5% 10% 20% 30% 2010E 246 0% 5% 10% 20% 2011E 246 0% 5% 10% 2012E 246 0% 5% 2013E 246 0%
    • Appendix - 185 -Commitments available to transact on the secondary market 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014E 1999 26.5 13.3 6.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2000 75.0 50.0 25.0 12.5 0.0 0.0 0.0 0.0 0.0 0.0 2001 28.0 42.0 28.0 14.0 7.0 0.0 0.0 0.0 0.0 0.0 2002 7.0 14.0 21.0 14.0 7.0 3.5 0.0 0.0 0.0 0.0 2003 4.0 8.0 16.0 24.0 16.0 8.0 4.0 0.0 0.0 0.0 2004 0.0 6.0 12.0 24.0 36.0 24.0 12.0 6.0 0.0 0.0 2005 0.0 0.0 12.8 25.5 51.0 76.5 51.0 25.5 12.8 0.0 2006 0.0 0.0 0.0 18.5 37.0 74.0 111.0 74.0 37.0 18.5 2007 0.0 0.0 0.0 0.0 22.8 45.5 91.0 136.5 91.0 45.5 2008 0.0 0.0 0.0 0.0 0.0 18.8 37.5 75.0 112.5 75.0 2009 0.0 0.0 0.0 0.0 0.0 0.0 12.3 24.6 49.2 73.8 2010E 0.0 0.0 0.0 0.0 0.0 0.0 0.0 12.3 24.6 49.2 2011E 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 12.3 24.6 2012E 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 12.3 2013E 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 TOTAL 140.5 133.3 121.4 132.5 176.8 250.3 318.8 353.9 339.4 298.9ProjectionsYears 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014EDownside case (5.6%) 5.60% 7.5 10.3 13.4 16.1 9.1 14.0 17.9 19.8 19.0 16.7Average 17.5Base case (6.4%) 6.41% 7.5 10.3 13.4 16.1 9.1 16.0 20.4 22.7 21.7 19.1Average 20.0 Upside case (7.2%) 7.20% 7.5 10.3 13.4 16.1 9.1 18.0 23.0 25.5 24.4 21.5 Average 22.5Source: Author’s own
    • Appendix - 186 -10. Historical valuations in the Private Equity secondary market10.1 LBO fundsSecondary bids for LBO funds over time (in % of NAV): 120% 110% 100% Average 90% High 80% Average 70% Median 60% Average 50% Low 40% 30% 20% 2005 2006 2007 H108 H208 H1 09 H2 09 H1 10Source: Author’s own based on data from Cogent Partners pricing analysis (2007-2008-2009-2010).10.2 Venture capital fundsSecondary bids for venture capital funds over time (in % of NAV): 110% 100% 90% Average high 80% Average 70% median 60% Average low 50% 40% 30% 2005 2006 2007 H108 H208 H1 09 H2 09Source: Author’s own based on data from Cogent Partners pricing analysis (2007-2008-2009).
    • Appendix - 187 -10.3 Other funds (real estate- infrastructure- distressed)Secondary bids for real estate, infrastructure and distressed funds over time (in % of NAV): 110% 100% 90% Average high 80% Average 70% median 60% Average 50% low 40% 30% 2005 2006 2007 H108 H208 H1 09 H2 09Source: Author’s own based on data from Cogent Partners pricing analysis (2007-2008-2009).
    • Appendix - 188 -11. Structure of listed Private Equity funds11.1 Structure of listed direct Private Equity fundSource: Website of LPX Group
    • Appendix - 189 -11.2 Structure of listed indirect Private Equity fund (listed fund of funds)Source: Website of LPX Group