Secondary considerations: an introduction to secondary funds

In the past, secondary funds may have been viewed by some as merely the purchasers of last resort for those desperate to exit the private equity market. Today, however, secondary funds have become an innovative investment strategy in their own right. Limited partnership interests are an illiquid asset class, and investors have typically relied upon distributions from funds to provide them with liquidity. However, in an economic environment where traditional liquidity events are few and far between, investors are increasingly viewing secondary funds as an alternative pathway to liquidity. According to industry sources, sales on the secondary market totalled approximately $2.1 billion in 2000, $1.6 billion in 2001, and an estimated $900 million through May 15 of 2002; and some believe that the size of the secondary market over the next five years will aggregate $13 billion.

Who sells and why? Sellers on the secondary market include financial institutions, insurance companies, pension plans, endowments, corporations, private equity fund-of-funds and high net worth individuals. Investors sell their private equity holdings for a variety of reasons, including:

• Changes in asset allocation - As the value of investors' public equity holdings decline in the recent public market collapse, they may find themselves exceeding their permitted private equity allocation levels. Likewise, corporate consolidations may leave the combined entity over-allocated in alternative assets. As a result, investors may need to divest some of their fund holdings.
  
  
• Regulatory changes - Some investors may need to sell in order to comply with governmental regulations. For example, banks are now required to set aside a certain percentage of their capital to protect against possible private equity losses and, as a consequence, may prefer to divest certain private equity holdings.
  
  
• Strategic positioning - Investors may wish to prune certain non-strategic relationships from their portfolios and re-invest their capital in entities that are more likely to bring them business in return.
  
  
• Management of financial results - Companies may divest some of their fund holdings in order to increase their earnings, improve short-term operating results and reduce their future capital call obligations.
  
  
• Cash flow needs - The individual needs of investors change over the 10+ year life of a fund. Investors may find that they are unable to make a particular capital call or must obtain liquidity for some other reason.
  
  
• Reducing administrative burden - Because monitoring and managing sizeable portfolios is time-consuming, periodic reductions in some portfolio interests may permit the seller to focus on a smaller number of key relationships.
  
  
• Dissatisfaction - Occasionally, a limited partner may become dissatisfied with the performance of a fund's existing management team or with the overall performance of the fund, and may wish to redeploy its capital into a more attractive opportunity.

Because the reasons that investors sell their private equity holdings are so varied, buyers cannot assume that a seller is desperate, nor can buyers expect that they will necessarily be able to dictate the terms of the purchase.

Who buys and why? Because of the complexity involved in any secondary transaction, including the need for exhaustive due diligence, complicated valuations of the underlying portfolio, and the requirement of large amounts of cash on hand, secondary buyers tend to be large, experienced secondary funds and like-minded institutions. Investors buy private equity interests on the secondary market for a variety of reasons, including:

• Quicker returns on investment - Typically, secondary buyers recoup their investment faster than a fund's original limited partners because they invest later in the life of the fund, after the fund has made investments that may now be producing returns to the fund.
  
  
• No “blind pools” - In a sense, secondary buyers have the benefit of perfect hindsight because they can observe the actual performance of a particular private equity fund portfolio before taking the plunge.
  
  
• Access to selective funds - Because many general partners do not admit limited partners unless they have a pre-existing relationship with the fund, a secondary purchase may give an investor an entrée into a previously inaccessible fund and its successors.
  
  
• Discounted price - Secondary purchases are typically made at a 20% to 50% discount to the original purchase price. As a result, investors have the opportunity to purchase an interest in the underlying assets at prices well below the valuations that may have been paid at the height of the market, and earn rates of return higher than those achieved by the fund's original investors.
  
  
• Diversification - Secondary purchasers may wish to diversify their portfolio holdings across industries, investment strategies, fund managers, fund sizes or geographic location. Buyers can also select the vintage year of the fund, thereby back-filling a particular void in their portfolio.

For these reasons, buyers typically purchase a partnership interest later in the life of a fund when a significant portion of the fund's total capital has been called down and invested.

Transactional issues. Any secondary sale involves a number of important transactional issues:

• Due diligence - Unlike the initial investors in a fund, secondary buyers are investing not just in the management team, but also in the portfolio investments of the fund. This process requires careful analysis of each portfolio company of the fund and its performance and prospects. In addition, buyers must also analyze the fund's agreements and its annual reports and financial statements.
  
  
• Valuation - It is difficult to value the underlying portfolio investments of the fund because the relevant information is generally not public. General partners are, for obvious reasons, reluctant to share that information, and much of the analysis of privately held companies is subjective.
  
  
• Confidentiality - General partners tend to view the sale of an interest in their fund as a negative event which might give others the impression of investor dissatisfaction. Sellers, likewise, often wish to keep both the fact and terms of a sale confidential.
  
  
• Accounting - In the year of the sale, the parties must keep track of the allocation between the buyer and the seller of partnership gains and losses, capital accounts, expenses, and distributions.
  
  
• Compliance - All transfers must comply with the requirements of the existing partnership agreement of the fund including the consent of the general partner, and, in some instances, the right of refusal held by other limited partners.
  
  
• Timing - The transfer process, including due diligence, negotiation of transfer agreements and closing, typically takes from three to six months.

Legal and other issues. In addition to transactional issues, there are many legal, tax and other regulatory issues to consider when engaging in a secondary purchase that may constrain the sale of an interest:

• Legal - The sale of a partnership interest is a sale of a security that must qualify for an exemption from registration under the Securities Act of 1933. As such, the buyer must be an accredited investor and no public advertising can be used in soliciting potential purchasers. In addition, the transfer cannot result in the fund losing its exemption from registration under the Investment Company Act. This means that either the transferee must be a “qualified purchaser” or the transfer cannot result in the fund having more than 100 partners. As with any sale of a security, sellers and general partners must keep in mind that the information they provide in connection with a transaction can be the subject of a fraud claim under applicable securities laws.
  
  
• Tax - To avoid having the partnership classified as a publicly traded partnership (and subject to taxation as a corporation), interests in the partnership cannot be considered to be readily tradable on a secondary market. Ordinarily, purchases of partnership interests by secondary funds will qualify for “safe harbors” under the tax regulations and, thus, will not cause the interest to be readily tradable on a secondary market.
  
  
• Regulatory - The general partner must understand the profile of the new buyer. If the transferee is an ERISA-regulated entity or a subsidiary of a bank holding company, for example, the fund must comply with the applicable provisions of ERISA or the Bank Holding Company Act, as if the transferee were an original investor in the fund.

Conclusion. While the public markets and other avenues to liquidity have slowed over the last two years, the need for liquidity has not. More and more, investors are accessing the secondary fund market in order to manage their private equity holdings. The secondary market has traditionally lagged behind the primary private equity market by about five years. Due to the surge of primary investment activity in the late 1990s and 2000, secondary funds are likely to present opportunities for limited and general partners alike for years to come, and these funds will continue to have a far-reaching impact on the private equity industry.

Copyright © 2002 Testa, Hurwitz & Thibeault, LLP. All Rights Reserved

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