Secondary Transactions in Private Equity Interests: Market Report - International Law Office

Introduction
Current Market Environment
Why Sell Limited Partner Interests?
Why Buy Limited Partner Interests?
Who Are Secondary Buyers?
Market Status
Comment

Introduction

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.

Current Market Environment

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:

• AP Alternative Assets, a publicly traded fund that invests alongside Apollo Management, recently reported a 60% decline in the value of its assets in 2008, resulting in $1.2 billion in write-downs across its portfolio.
• On February 4 2009 MetLife announced that it may write down some investments in large private equity funds during the first half of 2009.
• In January 2009 it was reported that the investments of private equity firm Thomas H Lee in certain companies have declined by $524 million.
• The Blackstone Group LP marked down its portfolio by $827 million in the fourth quarter of 2008 as the value of its private equity, hedge fund and real estate investments deteriorated.
• Shares of KKR Private Equity Investors, LP, a publicly traded fund that invests in Kohlberg Kravis Roberts & Co's various portfolio companies and funds, fell 32.2% in the fourth quarter of 2008 as it confronted losses of $1.2 billion.

Examples of losses among university endowments include the following:

• Harvard University's endowment, the largest in the United States, decreased by 22% from its value of $36.9 billion on June 30 2008 to approximately $29 billion at the end of October 2008. This may have put the fund on course for its worst performance in at least four decades. Harvard was reportedly in talks to sell about 38% of its $1.5 billion private equity portfolio and was reportedly operating under the assumption that its investment portfolio would be down by 30% for the quarter.
• The University of Virginia's endowment declined by about 20% to $4.2 billion in the four months ending in October 2008. It has stated that it may sell some of the $1.6 billion that it has invested in buy-out funds, noting that proceeds "may be far below face value". The university's endowment was valued at approximately $3.8 billion in March 2009, following almost $400 million of losses since November 2008.
• Yale University's endowment fund reportedly declined by 13.4% from June 30 2008 to the end of October 2008, and by about 25% from June 30 2008 to the end of December 2008.

Why Sell Limited Partner Interests?

Fund investors increasingly view secondary funds as an alternative means to gain liquidity and rebalance their portfolios.

Lower returns
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.

Liquidity issues
Private equity fund interests are illiquid:

• The governing documents of private equity funds commonly impose significant restrictions on transfer.
• The life of a fund is typically 10 years or more, during which investors do not usually have redemption, withdrawal or other rights to cash out.
• Investors must fund capital calls upon request during the life of the fund.

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.

Rebalancing portfolios
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.

Reducing commitments
Limited partners also seek to sell private equity interests to reduce balance-sheet liabilities associated with unfunded capital commitments.

Why Buy Limited Partner Interests?

Discounted price
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.

Who Are Secondary Buyers?

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:

• dedicated secondary investment funds;
• funds of funds; or
• institutions that specialize in buying limited partnership interests from original investors.

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:

• Goldman Sachs - in April 2009 Goldman Sachs Group Inc raised its fifth dedicated private equity secondary fund, GS Vintage Fund V, with around $5.5 billion in capital commitments.
• Paul Capital Partners - in May 2008 Paul Capital Partners closed its ninth private equity secondary fund, Paul Capital Partners IX, with $1.65 billion in capital commitments. According to reports in May 2008, the firm manages $4.2 billion in capital for the secondary market.
• Coller Capital - in April 2007 Coller International Partners V closed with $4.8 billion. It is the world's largest secondary fund. Coller plans to launch a sixth fund in the coming months in response to the increased availability of distressed private equity fund interests.
• Lexington Partners - in 2006 Lexington Capital Partners VI raised $3.8 billion. The firm has reported $10.2 billion in assets under management and is currently raising capital for a seventh fund. With a $5 billion target, this fund would surpass Coller International Partners V as the world's largest secondary fund.
• Pantheon Ventures - in December 2006 Pantheon Global Secondary Fund III closed with $2 billion. Pantheon had $23 billion under management as of September 2008.

Market Status

The Financial Times article of May 10 2009 cited industry sources as follows:

• Between $100 and $130 billion of the $2.2 trillion committed to private equity is expected to be offered for sale in the next two years.
• The volume of secondary sales slumped to $2 billion in the first quarter of 2009.
• Prices have been struck at an average of 37% of face value.
• There is a large gap between the pricing expectations of buyers and sellers.

Comment

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.

For further information on this topic please contact Emanuel Cherney at Kaye Scholer LLP by telephone (+1 212 836 8000) or by fax (+1 212 836 8689) or by email (echerney@kayescholer.com).