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.