Pricing private equity secondary transactions

What is being sold?

When advisors consult with clients regarding their pricing expectations for a fund or portfolio, many cite a discount at which they are comfortable transacting. The next question is, discount to what? Prospective sellers think about discounts different ways. Some believe the capital they have paid in to the funds is the benchmark, while others view the actual book value (or net asset value) of the portfolio as the relevant baseline for considering discounts. It is best to advise clients to view the asset being sold as the sum of the current net asset value and the future commitments to be assumed by the buyer. The reason is simple: that is how the buyer views the assets. The seller must realise they are selling more than just the assets currently in the portfolio; they are also transferring the legal obligation to make all future capital calls.

What is the fair market value of the portfolio?

The buyer next determines the fair market value of the two components of the sale: the current portfolio and the unfunded commitments. Funds differ in their propensity to write portfolio investments up or down to reflect the realities of the market environment. Many funds change the valuation of an investment only when an outside financing event occurs. Therefore, most investments are held at the value as of the last financing, irrespective of changes in the broader market for comparable public companies. Making positive or negative value adjustments for each portfolio company is an important aspect of pricing a secondary for a buyer.

For portfolio companies in buyout funds, this can be relatively straight-forward. Each portfolio company may be valued at the price to earnings ratio it was purchased at (if it is still applicable) times the trailing twelve months of earnings, less the outstanding debt. Venture capital portfolio valuations are more subjective. The buyers must consider what value each firm would warrant in the current fundraising environment, the likelihood it will need to seek additional financing, and the number and strength of each firm's competitors. Essentially, the buyer must reassess the investment as a venture capitalist would: how attractive is the business model, how strong is the management, what progress has been made and what future dilution can I expect to encounter.

As a rough proxy for the fair market value, a seller can consider the performance of a basket of public market comparables for each portfolio investment. The gain or decline in that basket from the date of the last valuation is an indication of how the market pricing for each investment may have changed. As with any comparable analysis, care must be taken to consider the appropriate comparables, and adjust for any unique circumstances.

The buyer must then assess the value he places on the unfunded portion of the commitment. To gauge the reaction to the unfunded portion, a seller may consider the ease with which the general partnership could raise another fund in the current market. For many general partners, a long track record and history of superior returns would likely result in an easy fund-raise. Newer fund groups with a shorter track record would have difficulty in the current fundraising environment. The more difficult the fund raise would be, the higher the discount is needed to place the unfunded commitment.

Cash flow modeling

To model returns, secondary buyers must estimate the exit value of an investment and the timing until liquidity for each investment. Many secondary purchasers have databases with historic cash-flow characteristics of a large number of funds. Because estimating liquidity for any private investment is problematic, buyers also generally model the presumed cash flows using conservative assumptions based on these historic statistics and the funds characteristics. The firm may assume an aggressive capital call schedule, and conservative distribution cycle, and solve for the discount that is necessary to achieve their target return on any investment. The buyer will also consider where each fund is in the distribution cycle. Firms that have just or are about to return invested capital will have a disproportionate percentage of the near-term distributions going to the general partnership as they ‘catch-up' on their carry. Any perceived delay to the cash flows will affect the pricing of the portfolio.

Other factors

Several other factors affect the pricing of the portfolio. Chief among them is the size of the portfolio. Smaller portfolios are priced at a discount to larger portfolios with the same investments. A buyer must do the same work to assess a $1M commitment to a fund as they do to assess a $10M commitment to the same fund. The opportunity cost of working on the smaller commitment results in a larger discount.

The motivation level of the seller is also a factor in pricing. If the seller has two weeks to make a capital call, the buyer knows the seller is highly motivated and less price sensitive. The buyer also may not have sufficient time to examine the portfolio and model the returns in depth, and will likely place a larger discount on the portfolio as a result. If you are thinking about selling, do not wait until the capital call comes to explore your options!

What is the discount?

Consider the pricing of the sale of two venture fund investments. Each investment is a $10M commitment in similar calibre funds. The younger fund has called 40 per cent of the capital, while the more seasoned investment has called 80 per cent of the capital. Each fund's current net asset value as a percentage of paid-in-capital is 80 per cent. In the case of the younger fund, this is likely due to the management fees paid and investment write-offs (remembering that lemons often ripen early). The older fund is most likely valued under paid-in-capital because successful investments have been realized and the investor has received distributions. After analysing each fund, the buyer feels the fair market value of each fund is a ten-percent discount to the current book value, and feels a similar discount is warranted on the uncalled capital.

The younger fund has a net asset value of $4.0M x 80 per cent= $3.2M, and an uncalled commitment of $6.0M, for a total transaction value of $9.2M.

The more mature fund has a net asset value of $8.0M x 80 per cent = $6.4M, and an uncalled commitment of $2.0M, for a total transaction of $8.4M.

To purchase the younger fund, the buyer requires a $320K discount for the current investments and $600K for the future commitments, for a total of a $920K. Because the discount the buyer requires must be taken out of the current porfolio value, the net payment to the seller will be $3.2M-$920K = $2.28M.

To purchase the more mature fund, the buyer requires a $640K discount on the current portfolio and a $200K discount on the unfunded commitment. The net payment to the seller will be $6.4M - $840K = $5.56m.

Even though each seller received the same discount on the total assets being sold, the younger fund was sold for a larger discount to net asset value, 28.8 per cent versus 13.1 per cent. This larger discount is an accounting illusion, as the uncalled capital commitment does not appear on the balance sheet as a liability. However, this uncalled commitment is an important aspect of the transaction, and its transfer may be a primary motivator of the seller.

Conclusion

$17bn has been raised over the last five years solely to purchase secondary interests in private equity limited partnerships. Billions more is available from sophisticated private equity investors seeking to add to their portfolios by purchasing secondary interests. Despite the large amount of competition from secondary buyers, sellers are sometimes surprised by the pricing they are quoted for their portfolios. This is often a result of misunderstanding the methodology used by the professional secondary buyers.

In a secondary transaction, the buyer must pay for the current assets, and must assume the liability of the unfunded capital commitments. The amount being sold should be thought of as the current net asset value plus the uncalled capital commitment. Evaluating a discount based on only the current net asset value ignores an important component of the transaction. Often, a steep discount to net asset value is very attractive pricing when the seller considers all the assets that are being sold.

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Cogent Partners is a private equity-focused investment bank dedicated to serving the needs of the private equity community. Cogent Partners represents sellers in traditional and securitised secondary transactions, conducts detailed portfolio assessment and pricing analysis, and provides fairness assessments for secondary buyers and sellers. For more information on Cogent Partners or the private equity secondary market, please visit the firm's website at www.cogent-partners.com.