1. THE SECONDARY MARKET
- THE NEXT DEAL FRONTIER
C. Craig Lilly
600 Hansen Way
Palo Alto, California 94304-1043
650.843.3232
2. WHAT IS THE PE SECONDARY MARKET?
Primary transaction: investors in PE funds acquire
their LP interests directly from a fund
Secondary transaction: an existing investor in a fund
seeks to sell the LP interest to a buyer. This creates a
secondary market for that interest.
5. SECONDARY MARKET IS GROWING RAPIDLY
• Many institutions are rebalancing their private equity
(“PE”) investments to rebalance portfolio or reduce their
unfunded liabilities, or seeking cash to finance operations.
• “Denominator effect”: this is an asset-allocation problem
that is forcing the selloff of billions in PE and alternative
investments. As the public markets and the prices of liquid
assets have plummeted, the value of the overall portfolio, or
the denominator, has shrunk. Thus, some institutions have
an over-allocation in certain types of investments and must
sell those investments.
• Rising numbers of LPs in default of capital calls seeking
negotiated sale or exit.
• Because the sale of LP interests provide liquidity to sellers,
they are being discounted - some buyers are bidding as
little as 40 to 50 cents on the dollar.
6. 2009 SECONDARY MARKET STATISTICS
• Estimated $45 billion in secondary interests
expected to be offered for sale in 2009/ next 12
months
• Estimated 22 secondary funds to raise $32
billion in next 12 months
• Third most popular investment sector (source:
Probitas Partners 2009 Institutional Investors
Survey)
7. HISTORY / MILESTONES
• The Venture Capital Fund of America (founded by
Dayton Carr in 1982) was likely the first
investment firm to begin purchasing PE interests
• CalPERS agrees to the sale of $2.1 billion
portfolio of legacy PE funds to Oak Hill
Investment Management, Conversus Capital,
Lexington Partners, HarbourVest, Coller Capital
and Pantheon Ventures (2007)
8. HISTORY / MILESTONES (Continued)
• ABN AMRO sells a portfolio of PE interests in 32
European companies managed by AAC Capital
Partners to a consortium comprising Goldman
Sachs, AlpInvest Partners and CPP for $1.5
billion (2008)
• Goldman Sachs Group Inc. closes new $5.5
billion fund to buy PE investments on the
secondary market (GS Vintage Fund V) - this is
the largest secondary fund ever raised (2009)
9. TWO GENERAL STRUCTURES
1. Sale of Limited Partnership Interests:
The most common secondary transaction, this
category includes the sale of an investor's interest
in a PE fund or portfolio of interests in various
funds through the transfer of the investor's limited
partnership interest in the fund(s)
2. Sale of Direct Interests:
This type of sale refers to the sale of portfolios of
direct investments in operating companies, rather
than limited partnership interests in investment
funds
11. LEGAL ISSUES: LONG TERM COMMITMENT
• PE investments are illiquid - federal securities laws and
the fund's governing agreements impose significant
transfer restrictions
• The life of a fund is generally 10 years plus - investors
do not have redemption, withdrawal, or transfer rights
• Investors have long term capital commitment
obligations, and there are significant penalties for
default
• Secondary buyers, with the fund’s consent, offer
liquidity for investors looking to sell an individual
interest in a fund, or a portfolio of fund interests
12. PURCHASE BY SECONDARY BUYER
• Buyer assumes the obligations/ capital commitment
of the seller under the fund's governing document
• Buyer provides representations and warranties to
the fund similar to those that would be included in a
subscription agreement for a primary purchase of an
interest
• Buyer may seek to obtain the benefits of any side
letter or right to appoint an advisory committee member
• The purchase price paid for a LP interest is typically
based on the fund's net asset value (e.g., price could be
at a discount, premium or par to NAV)
13. KEY NEGOTIATING POINTS
1. Purchase price
2. Purchase and sale agreement
3. Transfer documentation - includes fund
manager; cooperation of fund manager/ GP is
critical
14. PURCHASE PRICE
• The purchase price is based on the value of the interests
being sold as of a set date - the cut-off date
• The cut-off date is tied to the date of the most recent NAV
calculations and the purchase price is driven by the NAV -
currently at discounts to NAV of 40% - 50% (note: FAS 157
implications)
• At the closing, the purchase price has a dollar-for-dollar
adjustment for capital contributions made by the seller
(increase in purchase price) and distributions received by
the seller (decrease in purchase price) since the cutoff date.
• Buyers prefer to receive a distributions shortly after
closing (vs. price reduction) - allows increase in IRR
computations
15. PURCHASE AND SALE AGREEMENT: KEY POINTS
LP CLAWBACK
• Seller indemnifies a buyer for any obligation (or a
“clawback”) to return distributions that were made
prior to the cutoff date
• Mechanism to calculate liability for clawbacks not
attributable to a particular distribution
• Liability will be shared pro rata based on the amount
of distributions each of the buyer and seller received
16. THRESHOLD FUNDS
• Portfolio sales - funds that the buyer will
require to be transferred to it before the buyer
will be required to close on any other funds in
the portfolio
• As sellers become more distressed, they may
structure transactions so that when a buyer
buys a fund managed by a top-tier manager,
the buyer also must purchase a less-desirable
fund
17. STAPLED TRANSACTIONS / “STAPLED
SECONDARIES”
• A “stapled” transaction means a secondary buyer
purchases an interest in an existing fund from a current
investor and makes a new commitment to the new fund
being raised by the GP. These transactions are often
initiated by PE firms during the fundraising process
(according to a recent market study, 74% of GPs/
sponsors are interested in a stapled transaction).
• The decision makers for a secondary purchase versus
primary purchase are frequently different
• Buyers will have more leverage to avoid this in 2009 -
managers will want to accommodate transfers to
reputable buyers, especially if there is a risk of default
by the seller
18. MATERIAL ADVERSE CHANGE (“MAC”)
CLAUSES
• A closing condition that no material adverse
change has occurred between signing and closing
• MAC clause appear to have broadened and are
heavily negotiated
• The buyer's ability to walk away from a recent,
major transaction due to an alleged MAC provides
another example of the increased negotiating
power of buyers in 2009
• No case law to report or interpret
19. TRANSFER PROCESS WITH FUND MANAGER
• The buyer needs to consider issues associated
with its investment in the underlying fund - the fund
needs to determine if admission of the buyer will
trigger regulatory or other issues (e.g., ERISA,
etc.)
• Generally requires Fund’s consent - may involve
waiver of ROFR, legal opinions, certifications,
timing restrictions, representations, etc. – review
governing documents
• Cherry - picking is difficult: generally, entire LP/
company portfolio is sold
20. TRANSFER PROCESS WITH FUND MANAGER
(Continued)
• Some funds only process transfers at end of
quarters
• Tax, ’40 Act, HSR and other considerations
• Assignment of any side letters rights or new side
letter
21. TRANSFER ISSUES THAT REQUIRE FUND’S
COMPLIANCE
– Investment Company Act of 1940
– Unrelated business taxable income and effectively
connected income
– ERISA - fund qualification as a venture capital
operating company or real estate operating
company
– Anti-money laundering regulations / OFAC
compliance
– Indemnities
– Reserves for capital commitment and back - stop by
seller
– Payment of expenses and legal fees
22. OTHER TYPES OF DIRECT PORTFOLIO SALES
• Secondary Direct – The sale of a captive portfolio of
direct investments to a secondary buyer that will either
manage the investments themselves or arrange for a
new manager for the investments
• Synthetic Secondary / Spinout - Under a synthetic
secondary transaction, secondary investors acquire an
interest in a new limited partnership that is formed
specifically to hold a portfolio of direct investments
• Tail-End – This category typically refers to the sale of
the remaining assets in a PE fund that is approaching,
or has exceeded, its anticipated life. A tail-end
transaction allows the manager of the fund to achieve
liquidity for the fund's investors.
23. CONCLUSION
• LP interests are selling at significant discounts due to
defaults or portfolio re-allocations
• Buyers have one of the best opportunities in the history
of this asset class to purchase at attractive prices
• Currently, many potential sales are failing as sellers are
unwilling to accept steep discounts - sellers’
expectations will moderate and the number of executed
transactions will increase in the second half of 2009 as
the pricing gap narrows
• Shared appreciation structures may be useful for sellers
experiencing “sticker shock”
24. C. Craig Lilly
600 Hansen Way
Palo Alto, California 94304-1043
650.843.3232
This presentation is intended only as a general
discussion and should not be regarded as legal
advice. For more information, please contact Craig
Lilly at 650.843.3232.
