Secondaries grow in stature

Following months of speculation and uncertainty, Deutsche Bank has finally announced the sale of part of its massive private equity portfolio. In two separate deals, the bank sold the more mature portion of Morgan Grenfell Private Equity's portfolio to Vision Capital for around $100m and, possibly more significantly, it completed a E1.5bn mega-deal to dispose of its late-stage direct private equity investments through a management buy-out vehicle called MidOcean Partners.

The MidOcean deal is significant partly because of its sheer size. Deutsche Bank claims that it is the largest ever secondary purchase of a private equity portfolio. It is difficult to verify this, as the vast majority of secondaries transactions happen away from public glare, but it is undoubtedly one of the largest seen in the private equity market. The vast majority of transactions tend to be at or below the $100m mark seen in the Vision Capital deal. In fact, most of the activity in recent years has been fuelled by sales of small portfolios by distressed high net worth individuals or small institutions. The MidOcean transaction is so large that one secondaries intermediary even expressed concern about it taking up a lot of the dry powder available for the market.

But, as with most things, size isn't everything. The deal's significance also lies in the way in which it has been conducted. In principle it is much the same as some of the large deals that have been completed in the past - using external capital to finance the spin-out of a management team from its parent. Coller Capital, for example, was behind the 2000 buy-out of NatWest Equity Partners from The Royal Bank of Scotland to create Bridgepoint Capital. And last year it financed New Venture Partners, the management team behind Lucent's corporate venturing activities, acquiring the telecom firm's portfolio of direct venturing investments. Once again, the DB direct portfolio sale amounted to a management buy-out facilitated by external capital.

But there was also an important difference from these transactions - MidOcean Partners was financed by a majority of primary capital and not predominantly by secondaries specialists. Indeed, much of the capital came from non-specialists in the secondaries market. In total, there were ten investors in the MidOcean transaction: NIB Capital Private Equity, Ontario Teachers' Pension Plan, CPP Investment Board, HarbourVest Partners, Paul Capital Partners, Coller Capital, Northwestern Mutual, The Yucaipa Companies and Presidential Life. Deutsche Bank retained a 20 per cent stake. Part of this reflects the desire of the management team to attract primary capital to build as diverse an investor base as possible from the outset of their independent existence. After all, they will probably want to raise external funds to finance future investments.

But an examination of the parties reveals another interesting development - the growing sophistication among private equity investors, secondary specialists and non-specialists alike. The lead players – NIB, Ontario and CPP in conjunction with Paul Capital Partners and HarbourVest - plus Deutsche, hold 90 per cent of the investment and these were the investors pushing the transaction forward, according to sources close to the deal. Of the these investors, Paul Capital is the only dedicated secondaries specialist, while HarbourVest and NIB have secondaries expertise. The other two, however, apparently had a heavy involvement in the due diligence and actively participated in the negotiations.

The fact that these main investors knew each other well would have helped smooth the process considerably. CPP has invested in both Paul Capital and NIB, for example, and Ontario and CPP are both based in Toronto and often share information. This joint approach is an indication of the way in which these large secondary transactions are likely to be carried out in future. With the prospect of other large secondaries deals on the horizon, it could well be that investors with existing relationships co-operate and take advantage of each other's resources, capital and knowledge bases to get the deal done.

In fact, the Deutsche deal is typical of the type of transaction that many in the industry are expecting to come to market in the near future for other reasons. Observers and participants in secondaries expect the majority of deal flow over coming months to emanate from sales by financial institutions. Many are affected by regulatory pressures, such as the Basel II Accord in Europe, which governs banks' minimum capital levels. And many are also facing pressure from shareholders. Banks and insurance companies have seen their profits fall over the last two years or so and several have announced losses. They are being forced to concentrate on core businesses - and for most that doesn't include volatile private equity investments.

The case for private equity has not been helped by the write-downs they have been forced to announce on their portfolios: the Financial Times recently estimated that banks had lost around $10bn on their private equity investments over the last three years, leading many to offload their portfolios on the secondary market. Some in the industry believe that further secondaries transactions will be announced on a quarter-by-quarter basis: financial institutions have a clear idea about how much they can afford to lose on their portfolios in each quarter. Many of them were apparently reluctant to sell before the end of the last financial year because a sale would have meant that they announced larger losses for 2002.

The MidOcean transaction is also indicative of the type of assets available on the market at the moment. Apart from a few notable exceptions, the secondaries market was reasonably subdued during 2001 and 2002. This is partly because a large proportion of the deals on the market involved portfolios of immature and often unfunded venture capital fund investments for which there were very few buyers. It was also because vendors' price expectations were simply too high, according to the secondaries players. But the attraction of the MidOcean portfolio was the fact that it contained late-stage investments rather than venture capital and that the companies were established and generating revenues. It includes a number of well known brands, such as Center Parcs and United Biscuits in Europe and Jostens and Jenny Craig in the US. Sales by financial institutions and other investors seeking to rebalance their overall allocations are bringing many more buy-out opportunities - in either direct or fund investments - to the market. AXA Private Equity's secondaries arm, for example, has just paid CDC Ixis Private Equity E170m for a portfolio of ten private equity partnership investments. The major draw for AXA was said to be the quality of the buy-out investments.

The AXA deal demonstrates that, while secondaries transactions are generally becoming more complex, there will always be a place for the plain vanilla exchange of interest in one or more private equity partnerships. And, in fact, these deals are likely to account for a large proportion of the market as a whole - although most of them will not make it into the headlines. But the direct or ‘synthetic' secondary transaction seen in the MidOcean deal is set to become an enduring feature of the market. There is no doubt that the supply of deals is there, after all. And both buyers and sellers appear to have become more sophisticated in their approach to secondary sales. The limiting factor is unlikely to be the supply of capital available for such transactions. The specialists have raised billions over the last few years for secondary investments and there are plenty of large institutions eager to co-invest alongside. The obstacle to delivering on their expectations is more likely to be reluctance on the part of vendors to adjust to realistic prices and concerns on the part of buyers about the quality of assets in an ever more uncertain economic and financial environment.

A new report on the dynamics and growing importance of direct secondaries transactions has been published by Columbia Strategy. For more information and purchase details, please click here

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