June 24 2009
Investors in private equity funds typically acquire their interests directly from a fund in a primary transaction by subscribing for partnership interests at the original launch of the fund. In a secondary transaction, an existing investor in a fund sells its interest in the fund to a third-party buyer. The secondary buyer purchases from the seller its interests in one or more funds at a negotiated price, and usually assumes any unfunded obligations of the seller (for further details, please see "Key Legal and Transactional Issues in Secondary Private Equity Fund Transaction").
In 2008 secondary transaction volume in limited partnership interests in private equity partnerships reached $16 billion. Sales of limited partnership interests in private equity funds had been projected to increase by 68% to $27 billion in 2009. However, it now appears that this projected level will not be reached.
What drives the secondary market?
The recent turmoil in the financial markets and the resulting liquidity crunch are driving many institutional investors to cash out, including pension funds, university endowment funds, corporations and funds of funds.
Investors are increasingly seeking to liquidate some or all of their interests in these funds, in order to reallocate their assets, reduce their unfunded liabilities and gain liquidity.
Investors face the prospect of write-downs in their private equity investments as the funds report their 2008 year-end valuations. The drop in valuations for buy-out firms is reported to be at least 20% to 30%, as the following bear out:
Examples of losses among university endowments include the following:
Fund investors increasingly view secondary funds as an alternative means to gain liquidity and rebalance their portfolios.
Private equity funds are generating lower distributions to their investors in the current market environment due to reduced M&A and initial public offering activity, as well as low portfolio company resale valuations arising from the credit crunch.
Private equity fund interests are illiquid:
Some limited partners may seek to sell their interests because they are in distressed situations, but many are taking proactive steps to avoid a later cash crunch.
Many pension funds and other institutional investors have diversification rules limiting the percentage of their total investment portfolios that may be allocated to private equity investments. The recent sharp stock market decline has lowered the value of their public equity investments, while writedowns of private equity investors have lagged, thus increasing the percentage of portfolios allocated to private equity and similar investments. This is sometimes referred to as 'denominator destruction'. Therefore, many such investors are forced to sell private equity and other alternative investments in order to rebalance their portfolios.
Limited partners also seek to sell private equity interests to reduce balance-sheet liabilities associated with unfunded capital commitments.
Buyers are motivated by the opportunity to purchase fund interests at discounted prices. Secondary purchases are typically made at a 20% to 50% discount on the original purchase price. As a result, secondary investors have the opportunity to purchase an interest in underlying assets at prices below valuations that may have been paid at the height of the market and can earn higher returns than those earned by the fund's original investors.
An article published in the Financial Times on May 10 2009 indicated that this year, deals have averaged 37% of their face value.
A supply/demand imbalance has resulted from a flood of secondary private equity interests being offered by high-profile limited partners as US universities and other institutional investors seek to sell their holdings.
Access to selective funds
Since many general partners and fund managers do not admit limited partners unless they have a pre-existing relationship with the fund, a secondary purchase may give an investor access to a previously inaccessible fund and its successors.
Opportunity for diligence
Unlike original limited partners, secondary buyers may be able to conduct diligence on a particular private equity fund portfolio before making an investment (fund general partners may or may not be cooperative).
Quicker returns on investment
Secondary buyers can recoup their investments faster than the fund's original limited partners because they invest later in the life of a fund, after the fund has made its portfolio investments.
Due to the potential complexity involved in a secondary transaction, including the need for thorough due diligence and valuations of underlying portfolio and cash requirements to fund the purchase price, buyers tend to be:
According to an industry source, around $26 billion was raised by secondary investors by December 2008, compared to around $14 billion in 2007.
Prominent players in the secondary market include the following:
The Financial Times article of May 10 2009 cited industry sources as follows:
As a result of recent market turmoil, 2009 may be a boom year for secondary transactions in private equity fund interests. This will depend on whether current investors and secondary purchasers can close the gap in their respective pricing expectations. Investors (eg, financial institutions, endowments and pension funds) will have increased needs for liquidity, to rebalance their portfolios and to reduce unfunded liabilities. These investors will seek to sell their private equity interests to a sophisticated set of financial buyers.
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Emanuel S Cherney