Secondary firms suddenly stalled

Business has stopped dead for secondary private equity managers, who were in the midst of their busiest season just three weeks ago.

Stock market volatility is making it impossible for managers to price the limited partnership interests and cast-off portfolio companies they want to buy. Indeed, some of the largest private equity managers moved to the sidelines despite a cornucopia of private equity interests up for sale.

“In the last couple of weeks we could not close one (deal) because of the (market) volatility,” said Byron T. Sheets, general partner at Paul Capital Partners, a San Francisco-based private equity secondary fund management firm.

Public companies are used as a proxy for private company values, but that can be challenging when the stock market has wide swings in a single day.

When the markets settle a bit, firms taking a long view of valuations expect to see bargains from the growing array of sellers offloading interests in private equity funds. Troubled banks like Citigroup Inc., Lehman Brothers Holdings Inc. and Wachovia Inc. and insurance companies such as American International Group Inc. — many either merging or being bailed out by governments around the world — are selling off their private equity portfolios to get liquidity.

Banks invested in private equity funds to get the lending business of their portfolio companies, Mr. Sheets said. “If you wanted to be on the call list of Blackstone, you had to make a pretty big commitment to its latest fund.”

Banks now are looking in every corner of their balance sheets for liquidity, he said. One side benefit for banks selling illiquid investments like private equity is that taking a loss does not count against them because Wall Street analysts do not include profit and loss of private equity activity, Mr. Sheets said. On the contrary, analysts view these sales as a positive move.

Banks are also spinning off their in-house private equity teams in sometimes-disguised management buyout deals. These deals have accounted for about 30% of the current deal flow in the secondary markets, Mr. Sheets said. Last year, Bank of America's venture capital team spun off to form Scale Venture Partners, removing the bank from the financial picture. Some deals are disguised so they don't look or feel like a distressed sale, Mr. Sheets said. Some transactions are being structured as joint ventures, where the seller gets a partial payment upfront in exchange for giving the buyer future distributions.

Another popular strategy used by Paul Capital is paying capital calls for an unfunded portion of the limited partners' commitments in exchange for an ownership interest in the entire portfolio. This eliminates selling the private equity stakes at a discount. The strategy has been popular with public pension funds wanting to reduce the risk from their 2006 and 2007 vintage buyout funds, Mr. Sheets said.

Historically, financial institutions have been consistent sellers, but since the first quarter, more pension plans, endowments and foundations are offering private equity interests for sale, said Bob Long, president and chief executive officer of private equity firm Conversus Asset Management LLC, Chicago. They are trying to prune their relationships, seek liquidity and change asset allocations.

In February, the $197.6 billion California Public Employees’ Retirement System, Sacramento, sold a $189 million private equity portfolio and about $25 million in unfunded commitments. It is continuing to sell off its legacy portfolio of about 40 partnership interests on the secondary market, and is cutting the number of funds in favor of a higher concentration of funds with top-tier firms.

Also this year, the $34.9 billion endowment of Harvard University, Cambridge, Mass., announced a $1 billion sale of private equity interests in the secondary markets to rebalance its private equity portfolio.

Many investors do not have capital to invest because the plummeting stock market has made them overallocated to private equity and real estate. But they need capital to invest in new private equity funds, distressed debt and mezzanine because they think they will reap large windfalls from the mayhem in the markets, said Dayton Carr, president and managing director at VCFA Group, New York, a private equity firm specializing in the secondary markets.

Rather than miss out on investment opportunities, these institutions would rather sell at a discount in the secondary market their interests in what they believe will be underperforming funds, he said.

“Some large institutions are bumping up against a liquidity cap,” he said. “Capital calls are continuing, but there are no distributions.”

Another issue is the consensus that venture capital and leveraged buyout returns will be down because of high prices paid for investments in companies made in the go-go days, Mr. Carr said.

In the first half of 2008, 22% of institutional investors indicated they sold private equity interests on the secondary markets, while 35% bought interests, according to the Global Private Equity Barometer, a semiannual survey of private equity limited partners by Coller Capital Ltd., London. Limited partners said two top reasons for selling stakes over the next couple of years are to refocus capital on best-performing private equity funds and to increase liquidity, according to the survey.

But investors will have to accept prices lower than they would have gotten a year ago.

“Discounts are generally the rule, as opposed to last year when the big funds were buying up,” Mr. Carr said. Secondary investors have to take into account that they will have to own private equity stakes longer, reducing returns. But investors won't be paying fees on capital their general partners have been unable to invest.

“I'm surprised that institutions have not been pressuring leveraged buyout (managers) to reduce fees,” Mr. Carr said.

Return expectations are low for multibillion-dollar funds raised during the heady private equity boom times. These days, stakes in megabuyout funds raised over the last two years are flowing into the secondary market.

“The market has frowned on 2006/2007 megabuyouts and there is a fair amount for sale,” said Mr. Long of Conversus.

But some secondary market fund managers see a buying opportunity. “Our belief is the market has undervalued the cheap and flexible debt packages those funds were able to access, which will be a significant benefit to the general partners going forward. There is enormous option value in a long-term capital structure unconstrained by covenants,” Mr. Long said. “We think the pricing is very interesting today and will get even more attractive in the first quarter.”

But secondary private equity investors differ whether the market is heading for a peak in the fourth quarter or if low volume and prices of private equity interests will continue to persist into the first quarter of 2009.

A number of large players have raised double-digit secondary funds and more managers are set to close megasecondary funds within the next couple of quarters, sources say. The gush of capital might adjust prices on the secondary markets upward.

“Supply has increased, and we believe it will further increase,” Mr. Long said. “We believe there will be more volume and more motivation by the sellers leading to better pricing.”

Contact Arleen Jacobius at [email protected]