Secondary Pricing Analysis Interim Update, Summer 2009

Cogent Closes Over $2.5B in Transactions – Less Than 20% Purchased by Secondary Funds

By Colin McGrady, CFABrad Heffern

Secondary Pricing Analysis Interim Update, Summer 2009 1

Executive Summary

The secondary market for private equity has played a key role in providing liquidity to institutional investors, allowing them to rebalance asset allocations and acting as a source of liquidity. Pricing of private equity in the secondary market fell in concert with other asset classes in 2008, but did it recover along with the public equity markets in the first half of 2009? A review of the pricing and trends in the secondary sales Cogent represented in the first half of 2009 revealed the following findings:

1. Pricing for all funds was 45.1% of the 12/31/08 NAV.

2. Pricing strengthened over the half-year, with bids based off of 12/31/08 NAVs coming in higher than would be justified by write-downs when compared to 9/30/08 bids.

3. Large amounts of unfunded capital had a substantial effect on pricing, though the direction of the impact was opposite for buyout and venture funds.

4. 2006 and 2008 vintage funds received surprisingly good pricing, while 2007 funds received much worse pricing than any other vintage.

5. Over half of the high bids were received from non-traditional secondary buyers, who are approaching the secondary market in an opportunistic manner as a way to improve the return profiles of their primary portfolios.

6. The non-traditional buyers were diverse, with pensions, insurance companies, family offices, endowments, foundations and general partners all participating in transactions.

7. Over 50% by value of the funds transferred in the first half of 2009 went to first-time buyers.

8. Market knowledge is more valuable than ever in achieving the optimal valuation and meeting timing constraints in secondary transactions.

Data Sample and Methodology

This study analyzes the bids that Cogent Partners received on a diverse group of more than 200 partnership interests marketed from January through June 2009, representing more than $2.5B in transaction value. The funds marketed represent a diverse range in fund types (61% buyout funds, 22% venture funds, and 17% other funds). As always, the bids represent first-round bids. Consistent with the methodology used in previous pricing studies, in cases where bidders submitted a pricing range in lieu of specific numbers, the midpoint of the range was used in the analysis. Continuing the trend noted in the second half of 2008, many binding first-round bids were requested for portfolios or fund assets marketed in the first half of 2009, whereas first-round bids had been almost exclusively non-binding prior to 2008.

One positive side effect of increased media coverage is an increased interest in buy-side participation in the secondary market. As such, bidders during this period were diverse. While the bidder profile in the data set differs from that in past studies, Cogent remains confident that the bids are indicative of the price that could be achieved for the funds. This confidence stems both from the historic performance of first round bids and ultimate transaction values from buyers in Cogent-led transactions, and because this data set contains more binding first round bids and bids from single-stage processes than any previous data set.

Secondary Pricing Analysis Interim Update, Summer 2009 Cogent Closes Over $2.5B in Transactions – Less Than 20% Purchased by Secondary Funds

By Colin McGrady, CFABrad Heffern

Secondary Pricing Analysis Interim Update, Summer 20092

Secondary Market Prices Continue 2008 Trend

As the effects of the weakening economy cascaded through the financials of private equity portfolio companies, pricing for the funds continued to weaken as a percentage of the stale reported NAVs. For the first half of the 2009, the average high bid (the simple average of the highest individual bid received for each asset) across all assets in the sample was 39.6% of the NAV of the funds’ most recent financial statements, with an average median bid of 35.7% of NAV and an average low bid of 31.6% of NAV (Figure 1). This pricing level represents a continuation of the pricing decline for secondary transactions observed in 2008, when pricing fell from above NAV in 2007 to 61.0% in the second half of 2008. Prices have fallen to the lowest levels seen since the publication of this analysis (Figure 2).

The decline in pricing is not specific to fund types, though venture funds did achieve slightly higher

pricing than buyout funds in this sample with an average high bid of 39.4% of NAV, an average median bid of 37.7% of NAV and an average low bid of 33.9% of NAV. The average high, median and low bids for buyout funds were 37.7% of NAV, 33.0% of NAV, and 28.8% of NAV, respectively.

Pricing as a Percentage of the Year-End Valuation

While the above analysis is consistent with the methodology used in previous first-half pricing analyses, the volume of prices received early in the year (prior to the availability of the general partner year-end valuations) and the level of markdowns taken at the end of 2008 versus previous years skews the pricing considerably. This effect can be seen by disaggregating the pricing by the quarterly statements the funds were priced against. Funds priced off of the year-end numbers achieved an average high bid of 52.4% of NAV, while funds priced prior to the release of the year-end financials had

BB

B

B

All Buyout Venture Other20%

25%

30%

35%

40%

45%

50%

55%

60%

% N

AV

Private Equity Categories

Average High

Average Median

Average Low

Fig. 1 Secondary Bid Spreads (H1 2009)

0% Bids High Bids <20% High Bids >60% Highest Bid % of Funds

All 7% 17% 13% 102.0%

Buyout 8 20 12 100.0

Venture 4 17 13 102.0

Other 5 5 21 86.0

Table 1 Pricing Dispersion H1 2009

Secondary Pricing Analysis Interim Update, Summer 2009 3

an average high bid of 38.1% of the 9/30/08 reported NAVs. When those NAVs are adjusted for the write downs taken at year end, the pricing improves to 44.1% of the subsequently released year-end financials. The delta between the bids based off of 12/31 NAVs and the bids originally based off of 9/30 NAVs and rolled forward to 12/31 may indicate that secondary pricing had actually improved by the time 12/31 financial statements began becoming widely available. Further bids received after the first half of 2009 also suggest that secondary pricing is improving.

Pricing is Asset Specific

While overall pricing levels certainly declined in the first quarter, pricing for funds continues to be primarily driven by the underlying assets in the portfolio, not typical trading ranges for particular GPs. Table 1 details the pricing level dispersion

for the funds in the survey. Even amidst the broad decline in pricing, the highest value received for a buyout fund was 100.0% of NAV, while the most highly valued venture fund was priced at 102.0% of NAV. However, only 12% of the buyout funds and 13% of the venture funds priced above 60% of NAV.

At the other extreme, 17% of the funds received a high bid of 20% or less of NAV. In these instances, it was not that the underlying investments were deemed to be nearly worthless, but that the bidders required a discount of nearly the full NAV to assume large unfunded commitments associated with the funds. Unfunded Capital Has a Dramatic Effect on Pricing

Given the liquidity squeeze that has been affecting nearly every institution since the beginning of the downturn, more highly unfunded partnerships were

B

B

B

BB

B

B

B

2003 2004 2005 2006 2007 H1 2008 H2 2008 H1 2009 H1 2009As a % of12/31 NAV

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

% N

AV

Bid Spreads By Year

Average High

Average Median

Average Low

Fig. 2 Secondary Bid Spreads Over Time (H1 2009)

Table 2 Unfunded Impact on Pricing

Average High Bid (% of NAV)

<50% Funded >50% Funded

Buyout 27.2% 42.7%

Venture 51.7% 36.0%

Secondary Pricing Analysis Interim Update, Summer 20094

marketed in the first half of 2009 than in any other time in recent memory. While it can be argued that, with highly unfunded partnerships, pricing as a percentage of NAV is less meaningful, the perceived liability of unfunded commitments has caused buyers to place, and sellers to accept, lower bids as a percentage of NAV.

For buyout funds, Cogent found a discrepancy of more than 50% between funds less than 50% called and those more than 50% called. These funds had an average high bid of 27.2% and 42.7% of NAV, respectively. However, venture funds that were less than 50% funded actually had significantly higher pricing than funds greater than 50% funded, at 51.7% and 36.0% of NAV, respectively. This additional discount applied to mature venture funds is likely explained by concerns that the funds will not have enough capital to protect positions in the anticipated future financing rounds of the portfolio companies. Therefore, the general partners will either invest in those companies in subsequent funds, or need to raise annex funds to protect their position.

Vintage Year Matters

While pricing was relatively consistent in the mid-40% range for funds with vintage years of 2005 and earlier (representing nearly 50% of the sample),

pricing for 2006-2008 funds was more interesting. Pricing for 2006 and 2008 funds, at 39.7% and 41.3% of NAV respectively, was actually significantly higher than might be expected. However, pricing for 2007 funds was abysmal at 26.1% of NAV, approximately 40% lower than the pricing for 2005 and earlier vintages. This may be explained by the fact that, while 2006 funds may have made bad investments and 2008 funds have large amounts of unfunded capital, 2007 is the only vintage which has both issues.

Achieving the Best Price – Know the Market!

The most striking data from the pricing analysis comes from a review of the profile of the winning bids for the funds marketed. As losses have rolled through private equity funds, many of the traditional secondary buyers, both dedicated secondary buyers and active fund-of-funds buyers, have changed their behavior considerably. These buyers, who have traditionally represented the bulk of buyers in the secondary market, have become much less aggressive with pricing and much more selective in the funds they are willing to price at reasonable levels. At the same time, a large number of non-traditional buyers have ventured out of their core competency of primary investing, and are purchasing secondary fund interests. Cogent maintains ongoing dialogues and

Fig. 3 Vintage Year Pricing

2008

2007

2006

2005 and Earlier

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Average High Bid (% of NAV)

Secondary Pricing Analysis Interim Update, Summer 2009 5

secondary interest lists with institutional investors, and was able to achieve the best pricing from these institutions in 43% of the funds sold during the first half of the year. This effort was broad, with only one non-traditional buyer purchasing funds in more that one transaction, and over 20 buyers purchasing only one fund interest during the first half of the year.

The non-traditional buyers that Cogent was able to enlist in its transactions were diverse, with pension funds purchasing approximately 37% of the funds, and insurance companies, family offices, endowments and foundations all purchasing a double-digit percentage of the funds sold to non-traditional buyers.

This ability to achieve the best pricing for our clients demonstrates clearly the added value of the approach Cogent Partners has taken to developing the secondary market. By performing the underwriting, understanding the assets, and being able to drive interest with non-traditional secondary buyers, our clients have achieved far better pricing than they would have received simply marketing to the large secondary buyers. Further, Cogent’s expertise in driving the closing process is even more beneficial when both the purchaser and seller are unaccustomed to the transfer process.

Transaction Trends

In this fluid financial environment, the nature of marketed transactions has changed. One significant change is the nature of assets buyers are willing, or unwilling, to bid on. Potential buyers are much more selective in the assets they are willing to price, or price reasonably. This has led to an increase in the number of buyers involved in transactions, or put a different way, a decrease in the number of funds a bidder purchases in each transaction. In 2007, a buyer of a market portfolio purchased 6.1 fund interests on average, while for the first half of 2009, the average number of funds purchased by a successful bidder fell to 2.2. While this adds complexity to the sale process from marketing to closing, it indisputably creates value for the seller. In previous years the demonstrated benefit of selling to multiple bidders rather than the highest single bidder in a transaction was an incremental 10%. The 177% increase in the average number of buyers for a similarly sized transaction over the past two years has dramatically increased the value of selling to multiple buyers over the previous incremental uplift in value.

Fig. 4 Transaction Value by Buyer Type

Dedicated Secondary (17.2%)

Fund-of-funds (39.7%)

Non traditional (43.1%)

Secondary Pricing Analysis Interim Update, Summer 20096

The Value of Deep Market Knowledge

It can be unequivocally stated that the economic rationale for institutions seeking liquidity in the secondary market to use an informed advisor has never been more compelling. Institutions that negotiate either with only one or a small number of potential buyers and thus receive large portfolio bids are leaving money, terms, and transaction timing on the table. This point is made by the secondary buyers themselves, which in their fund marketing materials universally point to proprietary deal flow as a signal of superior returns. This fact is emphasized by the data in this study as well, in which dedicated secondary buyers were the high bid on only 17% of the funds, and no single dedicated secondary buyer was the high bid on more than 4% of the funds.

The increased complexity needed to maximize pricing magnifies the importance of market knowledge and proper transaction management in a successful secondary sale. Bringing a portfolio to market by approaching two or three large bidders, hoping their competition will drive the best price, leaves significant value on the table. Further, when timing is of concern, recent detailed knowledge of which buyers, and specifically which non-traditional buyers, are pricing certain assets aggressively is of great value. Unrepresented sellers in exclusive or limited conversations have seen buyers delay transaction timing, while any pressure from the

seller to close is viewed as a sign of weakness that only further erodes pricing. The current environment has increased the importance of knowledge of buyer preferences, bidding history and transaction strategy in executing a successful secondary sale.

Considering these market facts, it is not surprising that the most sophisticated market participants are seeking the market expertise and assistance of intermediaries. With the pricing insight, market knowledge, and process and negotiation expertise an experienced advisor can provide, institutional investors can intelligently look to the secondary market to help achieve liquidity and rebalancing needs in their portfolio.

Fig. 5 Non-Traditional Buyer Types

Pension (36.8%)

Insurance (17.5%)

Family Office (15.8%)

Endowment (11%)

Foundation (11%)

GP (9%)

Colin McGrady, CFA

Mr. McGrady is Managing Director in the firm’s Dallas office, and is a co-founder of Cogent Partners. Colin has advised clients on large asset sales, structured transactions, and recapitalization of securitized private equity vehicles. In addition to client engagements, Colin developed and oversees Cogent Partners’ annual pricing analyses.

Prior to co-founding Cogent Partners, Colin worked at The Crossroads Group, a $2B private equity fund of funds. He began his career at Bain & Company, working in the private equity practice in both Dallas and Tokyo. Colin earned an MBA from Harvard Business School, a BA in economics with a Japanese minor from Brigham Young University, and is a CFA charterholder.

Brad Heffern

Mr. Heffern is an associate in the firm’s Dallas office and works in Cogent Partners’ Research Business Unit, performing portfolio analysis and valuations, and assisting in client engagements. He joined Cogent Partners in 2005.

Mr. Heffern holds an AB in mathematics and economics from the University of Chicago, and has passed all three levels of the CFA program, with a charter pending necessary work experience.

Cogent Partners has advised institutional investors on over $30 billion of private equity secondary transactions since the firm’s founding. Through its research-driven, analytical approach to the secondaries market, Cogent Partners assists the most sophisticated institutional investors in achieving their objectives and fulfilling their fiduciary duties.

If you are interested in a confidential discussion of your alternative asset portfolio paths to liquidity, with detailed insight into pricing for assets you would consider selling, or other avenues to generate liquidity, please don’t hesitate to contact us. All conversations are held in the strictest confidence.

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