Investors who dabble in the secondary market for private equity often compare it to “betting on a horse that is already halfway around the track.” Indeed, secondary stakes in private equity funds do offer advantages for both parties. Buyers enjoy returns that consistently outshine other asset classes (because they sell at a discount, the all-in returns may outpace even those reaped by the original investors in the private equity vehicles in question). Sellers pressed for cash can unburden themselves of illiquid assets. This has spurred significant growth in activity among those buying and selling stakes in funds specializing in secondary private equity investments (see “Secondary Funds”). The Camelot Group International, a secondary market advisor in New York, reports that the total volume of capital committed annually to these funds reached $18.5 billion in 2004, up from about $14.3 billion in 2003, and $7.3 billion in 2002.

The secondary private equity market allows investors to buy, sell, loan or even swap their investments in private equity funds. Many of these transactions occur when the funds’ original investors find themselves in financial trouble, and need to liquidate their holdings. Laurence Allen, CEO of the New York Private Placement Exchange (NYPPE), a secondary private equity exchange in Greenwich, Conn., estimates that 20 percent of all limited partners in private equity—including private clients, corporations and banks—will face a potential default scenario this year. Under such dire circumstances, many do try to sell their equity stakes on the secondary market, often at considerable discounts.

Motivated Sellers
However, financial distress does not drive all sales. “The sophisticated investor increasingly seeks to sell because he wants to change allocation percentages within an alternative asset portfolio, be it for a hedge fund, a leveraged buy out, venture capital or some other form of private equity,” Allen notes.

Changing investor priorities may also prompt a limited partner to seek to offload his stake. “I continue to see [secondary] real estate deals, and to a lesser extent, oil and gas deals, driven not by a burned-out tax shelter, but by an estate that wants out; that’s a very active market now,” says Morgan White, a managing director of Woodside Asset Management, a subsidiary of Silicon Valley Bank in Menlo Park, Calif.

Increasing demand means sellers no longer have to take a massive loss to offload their interests. According to Allen, returns from secondary investments in private equity currently range from 15 to 20 percent, a level that currently outpaces venture capital investments. This kind of performance has recently attracted large, institutional players, as well as smaller, nontraditional investors. “Unlike the large targeted funds, there are pension funds, endowment funds and family offices that are buying for both financial and strategic reasons,” says Brian Mooney, the vice president and cofounder of Cogent Partners, a secondary market advisor in New York. “Because the [latter] groups have a lower cost of capital and often are willing to pay for diversification or access to some general partner, they may pay a higher price for a lower return. That’s where the opportunity is for the high-net-worth seller.”

TOP VIEW The secondary market for private equity interests allows investors to sell unwanted assets and buyers to snap up private equity positions at a discount. Specialized advisors now work with both parties on a variety of transactions that range from simple buy-sell agreements to collateralized loans and swaps. While experts expect returns in this market to remain consistent for the next few years, they caution that currently attractive sale discounts are narrowing.

Specialized advisors often match buyers and sellers in a variety of auctions and other increasingly sophisticated deal mechanisms that require market expertise. “The importance of advice in this market is very high,” says Rajesh Nakadi, the chief investment officer for the private banking and investment group at Merrill Lynch in New York. “The secondary private equity market is still a very, very inefficient market because of all the negotiated deals. The investor base and the market itself are very fragmented,” he says. “So our recommendation is to go with a diversified manager.”

These advisors help both buyers and sellers in the most critical aspect of a secondary equity sale: determining the fair market value of the asset in question. “Secondary transactions in private equity can be complex, and you have to accurately value the assets, which can be very hard to do on your own,” says Lawrence Penn, managing director at The Camelot Group International. “We have found that we typically get a seller a price 20 percent or higher than what he or she might have managed on their own,” he adds.

Fees for a secondary market deal can be high, ranging from 3 to 5 percent of the total transaction value for smaller deals, depending on their complexity. Advisors often do deals worth less than $10 million, and some handle deals under $100,000. For smaller transactions, a firm may levy a flat advisory fee of $5,000, one advisor says. Fees for deals involving structures other than a direct purchase or sale can vary, depending on the components. In the case of a loan against assets, Allen says NYPPE recently lent at 5.11 percent—or 3 percentage points over one-month Libor (London Interbank Offered Rate)—plus a 1 percent fee.

Finally, because much private equity is governed by limited partnership agreements, sellers must obtain permission from general partners who, in the past, have balked at a partner’s request to pull out of an investment. The momentum of the secondary market has changed things, Allen says. “Today, unlike two years ago, most general partners will permit a secondary transfer of the asset ownership when requested.”

Value Proposition
Secondary equity’s appeal is multifaceted, encompassing favorable risks, returns and discounts, among other factors. For instance, risks in this market are lower than those found in direct private equity investments, hence the “horse halfway around the track” comparisons. By the time a partnership interest appears on the secondary market, the private equity fund has usually completed its fund-raising and may have invested the money in portfolio companies. If it has not, or is running into trouble finding attractive investments, the secondary private equity buyer can offer less for the interest. “The big benefit to secondary market investing is definitely in pricing power,” Mooney says. “An individual can look at an opportunity and say ‘I’d invest at this price.’ But in the primary market, it’s ‘Take it or leave it.’”

From Your Side of the Table

Essential questions to ask your financial advisor about the secondary private equity market:

1. How will the investment affect my portfolio diversification in terms of maturities, industry and geography? 2. How has the private equity fund performed? Will this deal provide me better access to other companies or funds run by these managers? 3. What is the discount to net asset value? 4. What factors affect the value of the asset, and how objective is the valuation? 5. What is the expected schedule for returns? 6. What is the cost of the independent valuation and advice, and what is the transaction fee?

Another advantage of the secondary market is that the wait for initial returns may be shorter than in the primary market. “The weighted average life of an investment in the primary market may be as high as seven to nine years. For secondaries, depending on maturity, we see deals with a three- to five-year life span,” Mooney says. “Most money in the secondary market is drawn down in three to four years, and the remainder is returned in the three to four years after that,” agrees Michael J. Brandmeyer, managing director of Goldman Sachs’ private equity group.

Yet the secondary market may now be becoming less attractive. Sellers still offer discounts to fair market value, but they are diminishing. “Two years ago, if you were selling venture capital assets, you would probably average only 20 cents on the dollar; now you should get 70 cents, and some groups are getting 100 cents, if not a premium,” says Kelly DePonte, a partner at Probitas Partners, secondary advisors in San Francisco. Typically, though, a purchase on the secondary market today still will involve a net asset value discount averaging 40 percent.

Brandmeyer expects returns to remain high for a few more years, while the current cycle of primary private equity investments is completed. “The secondary private equity market lags the primary market by three to five years,” he says. “Since the primary market grew so dramatically through 2002, this is a good time for returns in the secondary market.”

Secondary Funds
Secondary private equity funds offer investors another option for entering the market. “With secondary funds, you can analyze what you are investing in, get quarterly statements and perform an analysis of the portfolio of companies,” says Lawrence Penn, managing director at The Camelot Group International.

There are at least half a dozen secondary funds that will accept small minimum investments. Among the managers offering these vehicles are New York-based Lexington Partners, which manages five secondary funds and comanages six others, and Goldman Sachs, which offers investors access to a series of vehicles called GS Vintage Funds.

As with direct secondary investments, larger investors dominate the list of participants in many secondary equity funds. However, these funds also attract individuals, says Brian Mooney, vice president and cofounder of Cogent Partners. “There are a lot of secondary fund groups willing to let in smaller investors, and I don’t think they’d turn away $1 million.”