THE PRIVATE EQUITYSECONDARIES MARKET

A PRIVATE EQUITY INTERNATIONAL PUBLICATION

A complete guide to its structure, operation and performance

Edited by Campbell Lutyens

Prelims.Secondaries 23/1/08 11:05 am Page i

Published byPEI Media LtdSecond FloorSycamore HouseSycamore StreetLondon EC1Y 0SGUnited Kingdom

Telephone: +44 20 7566 5444

© 2008 PEI Media Ltd.

ISBN 978-1-904696-28-5

This publication is not included in the CLA Licence so you must not copy any portion of it without the per-mission of the publisher.

All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or transmit-ted, in any form or by any means, electronic, mechanical, photocopy, recording or otherwise, without theprior written permission of the publisher.

The views and opinions expressed in the book are solely those of the authors and need not reflect those oftheir employing institutions.

Although every reasonable effort has been made to ensure the accuracy of this publication, the publisheraccepts no responsibility for any errors or omissions within this publication or for any expense or other lossalleged to have arisen in any way in connection with a reader’s use of this publication.

Prelims.Secondaries 23/1/08 11:05 am Page ii

PART I INTRODUCTION AND CONTEMPORARY ANALYSIS OF THE SECONDARY MARKET 9Chapter 1 Introduction 11

Andrew Sealey, Campbell Lutyens Recent developments 11Chapters summary 13

Chapter 2 Different types of secondaries 15E. Livingstone and I. Richards, Pantheon VenturesPortfolio secondaries 15The emergence of “early secondaries” 15Secondary directs – “spin-outs” 16Secondary directs – “buy-ins” 17Stapled transactions 17Structuring 17Cash and paper deals 17Retaining upside potential 18Vendor financing 18Leverage and securitisation 19Transfer of economic interest 19The minimum requirements for a secondary transaction 19Secondary transactions versus direct investing 20The future of the secondary market 20

PART II LIQUIDITY IN THE MARKET FOR PORTFOLIO FUND TRANSACTIONS 21Chapter 3 Key issues in portfolio fund transactions 23

Michael Granoff, Mark Maruszewski and Tom Bradley, Pomona CapitalCompetitiveness 23Maturity of portfolio 23GP involvement 24GP consent 24Transfer restrictions 24Asset mix 25Leverage 25Information access 25Secondary fund lifecycle 26

Chapter 4 Trends towards active portfolio management in private equity 27Oliver Gardey and Jason Gull, Adams Street PartnersIntroduction 27A case study of portfolio management 27Larger private equity allocations drive increases in active portfolio management 29

Contents

iii

Prelims.Secondaries 23/1/08 11:05 am Page iii

Facilitating active portfolio management 30Key considerations in a secondary portfolio sale 31Conclusion 33

Chapter 5 Alternative routes to liquidity: securitising private equity 35Filip Henzler, Capital DynamicsIntroduction 35Rationale of securitising private equity 37The process of securitising private equity 39Market outlook 42

PART III THE MARKET FOR SECONDARY DIRECT TRANSACTIONS 43Chapter 6 The linkage between the primary and secondary markets 45

Wouter Moerel, AlpInvest PartnersIntroduction 45Market overview 46Conflicting interests and objectives 47Creating the win-win 49Case study: Lyceum Capital 50Conclusion 50

Chapter 7 The rise and rise of the secondary direct 53David Williamson, Nova Capital ManagementIntroduction 53Defining our space 53Fitting into the broader market 54What are secondary directs? 54Sellers and buyers 55What do the transactions involve? 56Key issues 57The future 58

Chapter 8 Investment considerations in direct secondary transactions 61David Atterbury, HarbourVest Partners (UK) LimitedEvolution of the secondary market: new sources of deal flow to manage 61The GP: relationships matter 62Appropriate due diligence: a balancing act 62Financing: creative approaches to maximise returns 63Structure and terms: a custom fit 64Post-completion: relationships remain key 64

Chapter 9 Legal and tax considerations to secondary and other sales 67Mark Mifsud, Kirkland & Ellis International LLP and David Schwartz, Debevoise & Plimpton LLPIntroduction 67Secondaries involving existing limited partnerships 67Secondaries involving direct private equity investments 75Conclusion 77

iv

CONTENTS

Prelims.Secondaries 23/1/08 11:05 am Page iv

PART IV INNOVATIONS AND NEW DEVELOPMENTS IN SECONDARY TRANSACTIONS 79Chapter 10 Private equity – fund leverage 81

Ian Shanks, Bank of ScotlandBackground 81When is unrated “senior debt” being used and why? 82How is senior debt typically deployed? 82Senior debt leverage characteristics 83Return benefit 85The future 86

Chapter 11 The use of insurance capital solutions in the secondary market 87Daniel Max, MarshIntroduction 87The relationship between risk and reward 87Portfolio fund transfers 88Insurance based solutions 88The insurance of unknown liabilities 88The insurance of known liabilities 89Conclusion 90

Chapter 12 Structured private equity vehicles and their demand for secondaries 91Sam Robinson, SVG AdvisersQuote unquote 91Too much cash is a drag 92Structured for enhanced returns 93Conclusion 94

Chapter 13 The role of the financial adviser in secondary transactions 95Immanuel Rubin, Campbell LutyensSale of a portfolio of fund interests: adviser acting for the vendor 95Advising on stapled transactions 98

Chapter 14 Opportunities in emerging markets 101Pablo Calo, Valerie Chen and Kennon Koay, AIG InvestmentsIntroduction 101Overview of private equity in emerging markets 101Size of the secondary market 102Supply side of secondary deal flow 102Pricing of secondary transactions 103Implications on exit risk 104Conclusions 105

Chapter 15 Property fund secondaries 107Gary P. Stevens and James J. Sunday, Landmark PartnersEvolution of the real estate secondary market 107Real estate secondary market dynamics 108Differences between real estate and private equity secondary markets 111Outlook 112Conclusions for the real estate secondary market 114

CONTENTS

v

Prelims.Secondaries 23/1/08 11:05 am Page v

PART V CONCLUSION 117Chapter 16 Conclusion 119

Andrew Sealey, Campbell LutyensOutlook for the secondaries market and future trends 121

APPENDIX I THE SURVEY 125Ben Pearce, Campbell LutyensThe private equity secondaries market survey 127Introduction 127Sell-side survey results 128Buy-side survey results 132Conclusions 137

APPENDIX II CASE STUDIES 139Case study 1 Secondaries – a tool for increasing efficiency in

fund of funds management 141Francesco di Valmarana, Unigestion

Case study 2 Opting for a hybrid direct–indirect secondary structure in Vivendi/Tempo deal 145Philippe Charquet, Tempo Capital Partners

Case study 3 Paul Capital’s Project Ritz: bringing in a “for hire” manager 149Elaine L. Small, Paul Capital Partners

Case study 4 Creating a win-win solution for an orphaned portfolio 151Sebastian Junoy and Laura Shen, Headway Capital Partners

Case study 5 Selling a portfolio of fund interests and of minority direct investments – Infineon Technologies 155André Aubert and Sascha Gruber, LGT Capital Partners

Case study 6 How to sell “non-core” divisions fast – the Northern Foods way 159Thierry de Panafieu, Vision Capital

Case study 7 Unlocking the portfolio of French Government development agency Oséo 161Benjamin Bréard, Dahlia Partners

Case study 8 Siemens – active portfolio management by a global corporate investor 165Tom S. Anthofer, Cipio Partners

Case study 9 Astrea – securitisation as a path to secondary liquidity 167Filip Henzler, Capital Dynamics and Manuel Etter

vi

CONTENTS

Prelims.Secondaries 23/1/08 11:05 am Page vi

APPENDIX III THE DIRECTORY 171Managers of secondary funds 173

APPENDIX IV IN THE NEWS 201News stories from PEI Media’s online news service, Private Equity Online(www.privateequityonline.com)

About PEI Media 212About Campbell Lutyens 212

CONTENTS

vii

Prelims.Secondaries 23/1/08 11:05 am Page vii

In many ways the evolution of the private equitysecondary market parallels the development of secondary liquidity of other asset classes. Over 300 years ago one of the first rudimentary financialsecondary markets started when shares and com-modities were traded in the coffee houses ofLondon. This early trading developed until, in 1761,a group of 150 brokers formed a club to buy and sellshares which later adopted the name “The StockExchange” and became what is now one of thelargest and most sophisticated secondary markets inthe world.

Other asset classes including commodities, property,debt and financial derivatives such as swaps startedinitially as primary markets only and, as theymatured, a secondary market developed alongsidethem; the secondary markets emerged to give initialinvestors or lenders liquidity without the require-ment to liquidate the underlying assets. They alsoserve to generate market pricing and facilitate fur-ther fundraising. The size of these markets has beendriven by the size and maturity of the respective pri-mary markets, the characteristics of the underlyingassets or financial instruments as well as the natureof the investors or lenders.

The growth of the private equity secondary markethas been driven in large part by the dynamic growthof the primary market over the last ten years and,while still termed an alternative asset class, hasbecome a very well established and significant com-ponent of institutional portfolios. With this growthin size and maturity, the range of investors partici-pating has also increased materially to now covermost types of investors across the world’s principalfinancial centres. There has also been a growingsophistication in the way that investors participatein the market which is by its nature a longer termand illiquid asset class.

As a consequence, the secondary market for privateequity assets has seen explosive growth, albeit trail-

ing primary market growth in private equity by afew years. The number of participants has grownfrom a small number of pioneering secondary fundsand transactions in the mid-nineties to today’s mar-ket an estimated $15 billion to $20 billion worth oftransactions per year. Notwithstanding this, themarket still remains relatively immature by com-parison with other secondary markets and still rep-resents a very small percentage of the primarymarket and is therefore likely to see further signifi-cant growth.

RECENT DEVELOPMENTS Even since the publication of this book’s predecessorRoutes to Liquidity in 2004, the private equity sec-ondary market has continued to experience very sig-nificant growth in terms of overall volume, numberof participants, complexity, range of transactionsand geographical activity. Capital raised for second-ary transactions is estimated to have reached $15billion in 2007, well over double the $6.4 billionraised during 2004. The rise is in part due to thedirect participation in the market of institutionalinvestors as well as the more recent infusion of non-traditional participants such as hedge funds, familyoffices and structured vehicles.

The entrance of new players has led to increasedspecialisation with buyers looking to find nichesbased around asset focus, maturity, geography orrole in capital structure. As well as the significantincrease in availability of capital to acquire second-ary private equity assets, there has also been a major

Introduction

By Andrew Sealey, Campbell Lutyens

Chapter 1

The growth of the private equity secondarymarket has been driven in large part by the

dynamic growth of the primary marketover the last ten years and has become a

very well established and significantcomponent of institutional portfolios.

11

Chapter 1.Secondaries 25/1/08 4:10 pm Page 11

development in the sophistication of players drivenby competition and a broadening of the experiencebase of the market.

Deeper liquidity levels in the market arising fromlarger pools of capital run by existing secondaryplayers has, together with new entrants to the sec-tor, led to a more competitive environment andtherefore better pricing. In addition, return expecta-tions of buyers have declined in line with the overallreduction in investment returns and have alsodeclined on a relative basis compared with primaryprivate equity as a better understanding has beenachieved of the comparative risk characteristics.

Pricing in the secondary market now more closelyreflects fair value which has stimulated new levels ofinterest from potential vendors. Many institutionswere historically put off from seeking early liquiditydue to the perception that they would only be able tosell at significant discounts. Now that the penaltycost of gaining early liquidity has largely evaporated,institutions can for the first time consider using thesecondary market for active portfolio management.Also, with the disappearance of much of the stigmaattached to the secondary market, owners of privateequity assets are more amenable to selling assets aspart of their normal course of business. The natureof the seller has therefore changed from one charac-terised by limited sophistication and sometimes dis-tress to one with high sophistication and discretionto sell or not to sell.

The historic ‘Fire-and-Forget’ strategy – where acommitment is made to a private equity fund withno further investment decisions coming due for tento twelve years – is no longer the only way forward.While, clearly, private equity is by its nature a longterm investment, it seems unrealistic to assume thatcircumstances do not change over a ten to twelveyear period; change will likely occur in the outlookfor the economy, geographic opportunities, growth

prospects of different sectors and, as has recentlybeen seen, in the leverage market.

In addition, the assessment of a particular managermay change as may an institution’s view of the man-ager’s ability, team members may leave or the teammay prove to be less competent than expected.Circumstances may change for institutions as well.For example, their assets under management maychange substantially, or there be a change in strate-gy or targeted risk profile.

Through secondary market liquidity and enhancedpricing, institutional investors can now rebalancetheir portfolios by absolute exposure or geographicor sector exposure, or by vintage year or managerexposure, or just as a housekeeping exercise. Thesecondary markets can be used by investors to dothis rebalancing, thereby improving overall portfolioreturns and risk characteristics.

Secondary markets have developed in a similar wayfor transactions involving portfolios of direct privateequity assets. While, historically, this has typicallyinvolved institutions exiting the asset class, we havemore recently seen the development of a number ofnew trends. The most notable has been what is oftenreferred to as a ‘stapled transaction’. Such deals linkthe raising of new capital to a secondary transaction.A more recent development has seen corporates’ useof the market to simultaneously dispose of multiple,sometimes unrelated, subsidiaries. Some privateequity funds themselves have come to see more andmore the merit of actively managing the tail-end oftheir portfolios through secondary markets sales.This more active management allows managers toreturn capital to their investors and wind up olderfunds. It also frees the manager to focus on newinvestments and, often, on the larger portfolio com-panies that have a greater impact on returns. Pricingin the secondary market has made all these realisticalternatives to selling companies or investments on adeal by deal basis.

Exit valuations can be potentially enhanced bygrouping a number of smaller exposures to create alarger transaction which can attract more competi-tion and better pricing. In addition considering anumber of companies in a single transaction diversi-fies and therefore decreases risk which arguablyshould increase valuations.

12

Now that the penalty cost of gaining early liquidity has largely

evaporated, institutions can for the first time consider using the

secondary market for active portfolio management.

INTRODUCTION AND CONTEMPORARY ANALYSIS OF THE SECONDARY MARKET

Chapter 1.Secondaries 25/1/08 4:10 pm Page 12

Transaction structureAnother important consideration when evaluatingportfolio rebalancing options is the structure of apotential transaction. The structure of any particulartransaction is completely dependent upon the objec-tives that a portfolio manager has in pursuing thetransaction. For example, a portfolio manager maywant to reduce its private equity exposure while opti-mising price in a sale. However, this institution maynot be as concerned about when it receives sales pro-ceeds. As such, the portfolio manager may offer toreceive deferred payments in order to reach a higherpurchase price. In another scenario, the portfoliomanager may want to reduce their overall privateequity exposure but want to maintain relationshipswith the GPs. As such, the portfolio manager mayoffer to sell a “strip” of their entire portfolio, forexample selling a 25 percent interest in a basket offund interests, thereby maintaining relationships andsub-class weightings, but reducing exposure overall.Alternatively, a portfolio manager may want to selldown their portfolio but is concerned about theheadline risk of a subsequent large winner in theportfolio that they did not know about. The transac-tion could be structured such that the buyer shares aportion of all proceeds after it has received back twotimes its invested capital. There are many ways atransaction can be structure to meet individual insti-tutional objectives beyond a straight sale of assets.

Transaction processAs important as the transaction structure is thetransaction process. Portfolio managers often havespecific needs or objectives when it comes to design-ing the right process. Some portfolio managers areseverely short-staffed and need to completely out-source the transaction process to an intermediary.Other portfolio managers may be quite familiar withthe secondary market and their own portfolio, socomfortable inviting a tight group of pre-qualifiedbidders. Some portfolio managers may need to doc-ument for specific internal purposes that they ran a

wide auction; others want to balance resources allo-cated to the sales process with very small incremen-tal gains in purchase price or terms. Some portfoliomanagers may be highly concerned with confiden-tiality while others are most concerned about theirreputation with the GPs of the funds sold. There isnot a correct or incorrect process; it depends uponthe facts and circumstances of the situation.

Specifically on the subject of auctions, the advan-tage of a large auction process is that in theory an auction is more competitive and should there-fore produce the highest possible bid. However, thedisadvantages of an auction are often a long drawn-out and unwieldy process with a large number of“thrown-in” bids and a complete loss of confiden-tiality. Furthermore, a carefully selected group ofbuyers can achieve the same pricing result with lesseffort and a more discreet process. Large auctionprocesses may actually discourage the buyers mostqualified to bid on assets due to low probability of closure in relation to the resources required tobid aggressively.

GP relationship managementThe management of the GP relationship is crucialduring a secondary sale since the LP is very depend-ent on the goodwill of the GP in order to achieve thebest outcome. The GP needs to give consent to mosttransfers and they have learned to use the secondarysale process as an opportunity to manage andimprove their investor base. Working with the GPs toidentify the best suited buyers for the assets is animportant part of an effective secondary saleprocess, preserving the relationship with the GPsand achieving a better price.

Additionally, the cooperation of the GPs during thesale process is crucial for the prospective buyers to obtain the best available information on a givenportfolio. In general, private company information issparse and therefore, secondary buyers rely heavilyon the information provided by the GPs. It is fair to assume that the more transparent the informa-tion, the better the price for the secondary transactionas buyers are not pricing in additional uncertainty.

Furthermore, the private equity industry is stillrestrictive in its access to the best funds. Selling aninterest in a private equity fund may mean that theLP loses access to future funds by that GP. Therefore,

32

Portfolio managers often have specificneeds or objectives when it comes to

designing the right process. Some portfoliomanagers are severely short-staffed and

need to completely outsource thetransaction process to an intermediary.

LIQUIDITY IN THE MARKET FOR PORTFOLIO FUND TRANSACTIONS

Chapter 4.Secondaries 21/1/08 4:45 pm Page 32

INTRODUCTIONApplying securitisation techniques to private equityhas opened up a range of new and valuable liquidityand financing alternatives to investors in the assetclass. With the success of the recent private equitysecuritisations, involved parties have gained experi-ence and third party investors have increasedappetite for these kinds of transactions, making theterms for securitising highly attractive. However, theadvantages and practices of securitising privateequity are still unfamiliar to a wide range of tradi-tional private equity market participants. This articleattempts to give an overview and some backgroundon this emerging financing option.

Background to the securitisation marketSecuritisation is a financing process in which aportfolio of financial assets is moved to a specialpurpose vehicle and refinanced through theissuance of various classes of notes. The history ofsecuritising assets started in the 1970s in the USmortgage markets, as means to increase fundingcapacity to meet the rising demand for housingcredits. Since then securitising assets has become astandardised commodity, with new yearlyissuances of several trillion dollars per year.1 Assetclasses where the benefits of securitisation tech-niques are commonly employed include mortgages,various forms of both performing and non-per-forming debts and loans, auto and aircraft leases,as well as credit card receivables. However, assetsas esoteric as champagne stock, music royalties,film libraries and future soccer spectator proceedshave also been securitised.

A significant advantage of securitisations is thatthey bring together a pool of financial assets thatotherwise could not be easily traded in their exist-ing form. By pooling together a large portfolio ofthese in isolation illiquid assets, they can be con-verted into instruments that may be offered andsold freely in the capital markets, thus allowing theowner of the assets to free up cash, to lower the cost

of financing, improve future liquidity opportunitiesand increase investment capacity. Securitisationsare also used to achieve regulatory relief and off-balance sheet financing.

Given the very specific characteristics of the privateequity market, and especially due to the volatilenature of the cash flow streams of private equitypartnership investments, private equity was longperceived as an asset class that could not be securi-tised. While it is indeed challenging and complex, anumber of attractive private equity securitisationshave been closed over recent years, demonstratingnot only the feasibility of such transactions, but alsothe great benefits that can be achieved.

Examples of private equity securitisationsThe following examples illustrate how securitisationtechniques can be applied to different situations andachieve various objectives. The flexibility of thisfinancing method can of course also be useful inother situations and to achieve other goals, asdescribed further below in this article.

Astrea2 is a securitisation of a diversified portfolio oflimited partnership interests in 46 different privateequity funds with a total exposure (reported valueplus open commitments) of $810 million that closedin 2006. As a consideration the owner of the portfo-lio received cash on a non-recourse basis equallingapproximately the portfolio’s reported value andabout half of the junior securities issued. The seniordebt was structured into two classes of notes thatwere rated AAA and AA respectively and sold to cap-

Alternative routes to liquidity: securitising private equity

By Filip Henzler, Capital Dynamics

Chapter 5

Asset classes where the benefits ofsecuritisation techniques are commonly

employed include mortgages, various formsof both performing and non-performing

debts and loans, auto and aircraft leases,as well as credit card receivables.

35

Chapter 5.Secondaries 25/1/08 4:30 pm Page 35

ital market investors. A novelty with this transactionwas the cash efficiency of the structure as well ashalf of the junior securities being sold to third par-ties. The rationale of the owner, an experiencedinstitutional investor with several billion US dollarsin historic private equity commitments, was to freeup cash to increase its investment capacity and tomore efficiently finance its private equity holdingsto maximise its return on investment.3

Pine Street4 is a securitisation of a diversified port-folio of interests in 64 different private equity fundswith a total exposure of $1.0 billion that closed in2002. Similar to Astrea, the rationale of the ownerwas to free up cash for new investment opportuni-ties and to reduce the cost of financing. Six classesof notes with various levels of seniority were issued,but only the most senior Class A notes with a princi-pal amount of $250 million and an AAA rating weresold to third parties. As a consideration the sellersof the portfolio received cash on a non-recoursebasis equalling approximately 40 percent of thereported value of the portfolio and all junior securi-ties (Class B through F notes) to retain the upsidepotential of the portfolio. It was the first time anAAA rating was achieved for notes backed by pri-vate equity.

While Pine Street and Astrea are examples of refi-nancings of fixed, pre-defined portfolios (suchtransactions are called portfolio securitisations orclosed-pool securitisations),5 securitisations havealso been undertaken where the issuance proceedsare partly or completely used to purchase unidenti-fied assets post closing. Such transactions arecalled managed securitisations or blind-pool secu-ritisations.

Examples of such managed securitisations are thethree Diamond transactions6 with closings in 2004,2006, and 2007, the Tenzing CFO7 with a closing in2004, as well as Prime Edge Capital8 with a closing

in 2001. In these cases the portfolio that was securi-tised consisted of only partly existing investments,along with investment capacity reserved for newinvestments and reinvestments to be determinedafter closing. These transactions thus require largerliquidity reserves, and the investors have to take intoaccount the additional risk that no good investmentopportunities will arise in the future. The reason forthese transactions is primarily to optimise return oninvested capital for the equity investors and toincrease investment capacity.

A number of non-public loan financings of privateequity portfolios have also been undertaken, struc-tured similar to a securitisation but with a singlebank as the lender. The advantage of using a bankloan instead of issuing securities is that it mayenable you to negotiate more elaborate terms to fitcertain portfolio anomalies and that it is feasible forsmaller transaction sizes as well.

Differentiating securitisation from secondarysales and structured salesPrivate equity securitisations are often compared tosecondary sales. While it is true that a securitisationis an attractive alternative to a secondary sale, asecuritisation is more flexible and is mainly under-taken in situations where the owner wants to gener-ate an early cash payment, but does not want to exitfrom its private equity investments as it believes inthe future profit potential of the assets.

If the objective is to generate early liquidity, a secu-ritisation can help the owner achieve an initial, non-recourse cash payment of up to an amount equallingapproximately the reported NAV of the portfolio andat the same time participate in the future up-sidepotential of the portfolio through the retention ofthe junior securities.

Further, it is important to differentiate between asecuritisation and a structured sale. A structuredsale is basically a secondary sale with additionalconditions, such as seller financing, deferred pur-chase price payments, splitting of future distribu-tions and/or draw-downs, earn out clauses, etc. It ispossible to structure these conditions to accomplishsimilar benefits to a securitisation. Securitisationsare not suitable for small portfolios with insufficientdiversification and a structured sale is the only func-tional alternative.

36

The advantage of using a bank loaninstead of issuing securities is that it may

enable you to negotiate more elaborateterms to fit certain portfolio anomalies

and that it is feasible for smallertransaction sizes as well.

LIQUIDITY IN THE MARKET FOR PORTFOLIO FUND TRANSACTIONS

Chapter 5.Secondaries 25/1/08 4:30 pm Page 36

INTRODUCTIONIn the past few years, the primary and secondary pri-vate equity markets have started to convergethrough “stapled” transactions. In a stapled transac-tion, an investor: (i) acquires an interest in an exist-ing fund in combination with (ii) a blind-poolcommitment to a fund managed by the same gener-al partner (GP) that is aimed at making new invest-ments. Alternatively, in a spin-out situation thestapled transaction can comprise the combination ofa secondary acquisition of a pool of direct privateequity assets, in combination with a commitment tofund new investments.

In a stapled transaction, both the secondary acquisi-tion and the primary commitment are part of onetransaction and most often the secondary sale andthe new commitment are completed at the sametime. Through a stapled transaction the secondaryinvestor becomes a limited partner (LP) in an exist-ing pool of assets (Fund I) as well as an investor in anew fund (Fund II). Stapled transactions are oftencompleted shortly before or during the raising ofFund II and can be instigated by either the GP or theexisting investor (Old LP) who wants to reduce itsexposure to Fund I.

The rise of stapled transaction has its roots in the fol-lowing developments:

• Generally, GPs have become more active in man-aging their investor base as they recognise thataccess to capital and long-term relations withinvestors are crucial for the continued success oftheir business.

• Multiple funds have large or even cornerstone LPswho are unwilling or unable to commit to succes-sor funds for strategic or other reasons.

• There continue to be GPs who spin out from theircurrent, captive environments to increase theirindependence and broaden their investor base,e.g. spin-outs from financial institutions such asbanks and family offices.

• GPs look to replace existing LPs, which are unwill-ing or unable to make new commitments, withnew investors who are able to support the GPsbusiness through new commitments.

• Certain GPs face challenges in fundraising, e.g.resulting from a combination of unclear pastinvestment track records or highly unrealisedexisting investment portfolios.

Recognising these market dynamics, GPs can enticenew investors into making a commitment to theirnew fund (Fund II) by brokering an opportunity toacquire a position in their existing fund (Fund I) andthus results a stapled transaction.

Under-taking a stapled transaction requires a combi-nation of secondary, primary and complex transac-tion execution skills. The acquirer (New LP) needs tobe able to: (i) offer an acceptable price for the FundI assets; (ii) provide a Fund II commitment which isrelevant to the GP and supports further fundraising;(iii) offer the GP the perspective of a long-term rela-tionship (i.e. beyond Fund II if the GP is successful);and (iv) manage and negotiate a complex transac-tion that comprises a “deal” between three differentparticipants who have different objectives.

The remainder of this article will be dedicated to: (i)how the stapled market has evolved to what it istoday; (ii) the conflicting interests and objectives ofthe three parties involved in a stapled transaction(the GP, the Old LP and the New LP); (iii) how tocreate a win-win transaction between all three par-ties involved; (iv) the example of the Lyceum Capital

The linkage between the primary and secondary markets

By Wouter Moerel, AlpInvest Partners

Chapter 6

In a stapled transaction, both thesecondary acquisition and the primary

commitment are part of one transactionand most often the secondary sale andthe new commitment are completed at

the same time.

45

Chapter 6.Secondaries 21/1/08 4:48 pm Page 45

stapled transaction; and (v) lessons learned fromAlpInvest’s involvement in stapled transactions.

MARKET OVERVIEWThe market for stapled transactions has grown inthree years to approximately €2 billion in 2006. Weestimate that this constitutes approximately 20 per-cent of the total secondary market in 2006, as meas-ured by transaction volume. Stapled transactions havebeen completed in the buyout, venture capital andmezzanine segments of the market, and have beenexecuted in Europe, the US and Asia. Specifically in2006, stapled transactions have seen a phenomenalgrowth and we expect this trend to continue.

Stapled transactions can be found in many shapes andforms, but will always contain a secondary element(acquisition of an existing pool of private equityassets, most often a commitment to Fund I) and a pri-mary element (new capital commitment to Fund II).We identify four main types of stapled transactionsbased on the core motives behind the transaction:

• Spin-out from captive. The GP wishes to becomeindependent from the organisation that it is cur-rently exclusively investing for, and the Old LP iswilling to seek an exit from a direct private equityinvestment activity, which it no longer considersas a core business. Generally, a New LP will: (i)acquire (a portion of) the direct private equityassets from the Old LP; (ii) provide the GP with amanagement company structure (by setting up anew management company or by supporting thebuyout of an existing management company)owned by the GP and independent from any LPs;and (iii) make a new commitment to Fund II.

• Replacement of Old LP. The GP has identified one ormore Old LPs in Fund I, which have indicated thatthey will not commit to Fund II. In such case, GPsapproach New LPs with the opportunity to make acommitment to Fund II, while at the same time

offering the ability to acquire exposure in Fund I byacquiring the Old LP’s interests. GPs often use thistransaction type to attract investors with both sec-ondary and primary capabilities, but who mightnot be willing to invest in Fund II on a stand-alonebasis. The asset visibility from Fund I, as well as thealignment of economic interest with the GP (theNew LPs benefit from value creation in both Fund Iand Fund II) make this an attractive transaction formany secondary and primary investors.

• Replacement of cornerstone LP. In certain funds, LPshave taken large positions to help the GP raise a firstfund, or to allow the Old LP to sell ancillary servic-es to the GP. An example could be an investmentbank sponsoring a first time manager, such as in thecase of Lyceum Capital (see below). When theobjectives of the Old LP change (the investment isno longer strategic), the position in Fund I becomesnon-core and a commitment to Fund II will not bepursued. The Old LP looks for a New LP, which iswilling to commit long-term to the GP, via at least acommitment to Fund II and the acquisition of theOld LP’s Fund I commitment. This can be in combi-nation with the buyout of the management compa-ny and Fund I carried interest, in case the Old LPhad an economic interest in either of these.

• Fundraising-driven stapled. Some GPs, in exchangefor providing consent to a transfer of a LP interestin Fund I, have demanded a commitment to FundII from New LPs. As such, they are using their rightto withhold transfer consent to attract new LPs to Fund II, while such a primary commitment was originally not part of the secondary transac-tion. Such conduct is perceived as highly contro-versial, and has been most practiced by GPs who had great difficulties in raising Fund II, hold-ing a pure secondary transaction hostage to a pri-mary commitment.

We have illustrated the difference between a “spin-out from a captive” and a “replacement of an Old LP”in Exhibit 6.1.

Stapled transactions come in different shapes andforms, with the transactions’ ultimate structureguided by which of the different actors’ (GP or OldLP) interests are dominant. Every stapled transac-tion, however, is dependent on the New LP’s abilityand willingness to provide a commitment to Fund II,and preferably (from the GP’s perspective) start along-term relationship that can result in commit-

46

The market for stapled transactions hasgrown in three years to approximately

€2 billion in 2006. We estimate that thisconstitutes approximately 20 percent of the

total secondary market in 2006, asmeasured by transaction volume.

THE MARKET FOR SECONDARY DIRECT TRANSACTIONS

Chapter 6.Secondaries 21/1/08 4:48 pm Page 46

INTRODUCTIONSecondary directs are the “new boys on the block” ofthe secondaries market. Given that this was, untilrecently, the way in which the whole secondariesmarket was regarded in the context of the broaderprivate equity industry, it is clear that we are talkingabout the “niche within the niche”. Or, as practition-ers of secondary directs would have it, the cuttingedge of the cutting edge.

This chapter addresses that sharp edge that is sec-ondary directs. It attempts to answer these questionsabout secondary directs:

• What are they?• Who are the sellers and buyers and why does the

market exist?• What do secondary directs involve and how are

they executed?• What are the key issues that arise?• What is the future for this market?

Before addressing these questions, however, weneed to start with some definitions and also to placesecondary directs in the context of the overall sec-ondaries market.

DEFINING OUR SPACEIn new markets and products, terminology can takesome time to establish itself. Remember the confu-sion in the early years of private equity between ven-ture capital, development capital, buyouts, buy-ins(and even BIMBOs) before private equity emergedas the defining term.

Well, secondary directs suffers from the same defi-nition problem. A common term for them threeyears ago was “synthetic secondaries”. Thankfully,this term has not caught on! The term we will usethroughout this chapter, and one that we hope willestablish itself for the long run, is secondarydirects. We use secondary directs to describe a type

of transaction where, typically, there is a transfer ofownership of interests held in a portfolio of privateequity companies. The crucial distinction with themain secondaries market is that, in secondarydirects, interests transferred are held directly inunderlying portfolio companies, whereas in thetraditional secondaries market, the interests aregenerally in limited partnerships which themselveshold interests in the underlying portfolio compa-nies, i.e. secondary indirects!

We believe that this definition accurately describes atypical secondary direct transaction. “Typical” is animportant word here however. As we will see later,as this market continues its rapid evolution andinnovation, transactions are already occurringwhich test this definition, particularly in the acquisi-tion of portfolios of subsidiaries from corporate sell-ers. Direct transactions, of course. But secondary?

The point is that definitions don’t matter, as long aswe all know what we mean and what we are talkingabout. “Secondary directs” it will be, to includethese corporate portfolio acquisitions and anythingelse similar which comes along.

Before moving on, we need to deal with one otherpoint. Anyone reading this who comes from the pri-mary private equity marketplace, would have acompletely different perspective and interpretationof secondary transactions. When they “do a sec-ondary”, they mean (most of the time) buying orselling a single private equity backed companywhere seller and buyer are both private equity

The rise and rise of the secondary direct

By David Williamson, Nova Capital Management

Chapter 7

As we will see later, as this marketcontinues its rapid evolution and

innovation, transactions are alreadyoccurring which test this definition

particularly in the acquisition of portfoliosof subsidiaries from corporate sellers.

53

Chapter 7.Secondaries 21/1/08 4:49 pm Page 53

INTRODUCTION As discussed extensively within the contributions to this publication, the private equity secondaries markethas seen an explosion in growth in recent years. Such growth can be readily quantified using an abundanceof widely available statistics. What is not so easily quantified is the corresponding changes in the perceptionsof those acting within the market; the results of this survey elucidate the views of an often opaque industrywhilst providing invaluable insight into the future movements of a rapidly evolving market.

This survey of industry professionals was compiled through an online questionnaire with 93 participantsresponding between July and September 2007. Each respondent, depending on the nature of their business,was asked to complete a sell- or a buy-side questionnaire and the ensuing narrative is structured around theresponses of these two predominant sets of market participants. The themes addressed are:

The breakdown of respondents by organisation type in Exhibit 1 shows two types dominating and togetheraccounting for 49 percent of all respondents: fund-of-funds (31 percent) and pension funds (18 percent).Given that many organisations active in the market potentially act on both the sell- and buy-side, this break-down does not allow a split to be made between sell- and buy-side respondents. However, as is laterrevealed, 51 percent of the respondents consider themselves buyers of secondary interests.

The private equity secondaries market survey

By Ben Pearce, Campbell Lutyens

Exhibit 1: Respondent classiTcation

GP (PE/VC)

Fund of funds

Government/state authority

Insurance fund

Pension fund

Secondary investor

Specialist secondary fund

Asset manager

Endowment fund

Corporate investor

Family ofTce

Bank or other Tnancial institution

30%10% 20% 40% 60% 70%50% 80% 90% 100%0%

Q. Which of the following best describes the nature of your organisation? Please select one.

8%

5%

2%

5%

3%

31%

5%

8%

18%

6%

5%

2%

Sell-side • Recent market activity• Future market expectations• Vendor motivations

Buy-side • Buyer characteristics• Current trends• Perceived pricing levels

127

Survey.Secondaries 25/1/08 4:16 pm Page 127

Illiquidity is one of the hallmarks of private equity,and it is in part this very lack of liquidity which helpsfund managers to generate exceptional returns.Investing in illiquid private companies is a barrier toentry, albeit a relative one. The closed nature of pri-vate equity funds supports demand, as investors canonly gain access at certain times. And the illiquidity offund commitments guarantees to managers that themoney will be there when they need it, as well as pro-tecting them against having to sell at the wrong timeto meet redemptions. But there are times when thelack of liquidity and the corresponding lack of effi-ciency can work against the interests of investors. Thisis particularly relevant when funds of funds enter latematurity – their own “tail-end” period. The underly-ing funds are themselves nearing the end of their con-tractual lives, the assets in these funds are often“living dead” with limited upside, and the investmentteams are focused on new funds, yet reportingrequirements do not diminish and investors’ capital isstill tied up. The most natural course of action, andthat in the best interests of investors, would be to liq-uidate the assets and return the capital to investorsbefore time and fees reduce their returns, yet fund offunds managers’ ability to do so has traditionally beenrestricted by the lack of a liquid market.

However, recent developments in the secondarymarket have changed all of that. The purchase andsale of private equity limited partnership (LP) inter-ests has matured from a niche in the private equityindustry to an accepted investment strategy. Thisdevelopment has widened the market, increased thenumber of buyers and sellers, and inevitably result-ed in increased pricing efficiency. No longer forcedto sell at a loss, fund of funds managers can now usesecondary transactions to accelerate cash flows toinvestors, to lock in returns, and to manage theirportfolios more efficiently.

As an active investor in both the primary and second-ary markets, Unigestion decided in late 2005 to reviewa mature fund of funds that it managed for institution-al investors, and to consider the option of selling theremaining portfolio into the secondary market to max-imise returns. The 1997 fund of funds was comprisedof 17 LP interests and several co-investments that pro-vided exposure to some 150 companies and featuredsome of the leading buyout funds in Europe and theUS (see Exhibit 1).

The key factor in evaluating the sale of the portfoliowas that, although the fund would continue to make

Secondaries – a tool for increasing efficiency in fund offunds management

By Francesco di Valmarana, Unigestion

Case study 1

Exhibit 1: Fund of funds composition

Source: Unigestion.

By strategy By geographyCo-invest

(2%)Other(6%)

Venture(12%)

Mid-marketbuyout(26%)

Large-capbuyout(54%)

Rest of world(6%)

US(43%)

Europe(51%)

141

Chapter 18.Secondaries 21/1/08 5:11 pm Page 141

APPENDIX III

The directory*

MANAGERS OF SECONDARY FUNDS

* The directory is a limited extract from Private Equity Connect, PEI Media’s authoritative, live, online databasetracking investors in private equity and venture capital funds globally (www.privateequityconnect.com)

Appendix 3 PT.Secondaries 21/1/08 5:20 pm Page 171

Managers of secondary fundsThis directory is a limited extract from Private Equity Connect, PEI Media’s authoritative, live, online database tracking investors in private equity and venture capital funds globally (www.privateequityconnect.com)

BACKGROUNDAdams Street Partners is an independent private equity fund of fundsmanager. One of the largest and most established fund of funds man-agers in the world, Adams Street Partners has been investing in privateequity partnerships since 1979. It was formerly the private equityinvestment division of the financial services firm Brinson Partners.

Adams Street Partners was a pioneer in the development of the privateequity secondary market. Secondaries is the second of the three legs ofits business, the third being direct investments. It started investing insecondaries in 1986, raising its first dedicated secondary fund in 1988.

PRIVATE EQUITY INVESTMENT ALLOCATION BREAKDOWNProvides a breakdown in percentage terms of the institution’s alloca-tion to private equity, in terms of geography, fund type and invest-ment opportunities.

PRIVATE EQUITY INVESTMENT APPETITEProvides an indication either of the company’s current appetite for different types of private equity invest-ment opportunities, or that the institution has invested in such vehicles/opportunities in the past.

NorthAmerica

WesternEurope

Central & EasternEurope

Middle East/Africa

Asia Pacific

LatinAmerica

Buyout/later stage • • •Venture • • •Mezzanine/subordinated debt • • •Turnaround • • •

North America 65% Western Europe 20% Asia Pacific 15%

ADAMS STREET PARTNERS www.adamsstreetpartners.com

Assets/funds under management (as of 31/12/2005) $12.13 billion

Allocation to private equity 100%

Year first invested in private equity 1972

Number of private equity funds committed to 400+

One North Wacker DriveSuite 2200Chicago IL 60606-2807United States

Tel: +1 312 553 7890Fax: +1 312 553 7891

BRANCH OFFICESLondon, Menlo Park, Singapore

KEY CONTACTSMr T. Bondurant French CEO & CIOTel: +1 312 553 8480bfrench@adamsstreetpartners.comChicago

Mr Oliver Gardey Partnerogardey@adamsstreetpartners.comLondon

173

Directory.Secondaries 23/1/08 11:34 am Page 173

THE DIRECTORY

174

BACKGROUNDAIG Investments (not to be confused with the Swiss firm AIG PrivateEquity) is made up of a group of international investment adviser com-panies, which provide advice, investment products and asset manage-ment services to clients around the world. It has a total of 44 officesworldwide.

The group’s activities range across equities, fixed income, hedge funds,private equity and real estate. Its roots in the private equity industry dateback to the 1960s, before private equity was recognised as an asset class,when it provided capital and investment advice to family-owned busi-nesses in Asia. It remains very active in south east Asia, and in 1988,expanded its private equity activity there, principally through HongKong. By 1994, AIG’s Asia team had strong deal flow in the local marketsand thus decided to launch a series of private equity Asia funds of funds.

AIG Investments has executed secondary market transactions totalling$2.6 billion since 2002.

PRIVATE EQUITY INVESTMENT ALLOCATION BREAKDOWNProvides a breakdown in percentage terms of the company’s regional allocation to private equity.

PRIVATE EQUITY INVESTMENT APPETITEProvides an indication either of the company’s current appetite for different types of private equity invest-ment opportunities, or that the institution has invested in such vehicles/opportunities in the past.

NorthAmerica

WesternEurope

Central & EasternEurope

Middle East/Africa

Asia Pacific

LatinAmerica

Generalist • • • • •Buyout/later stage • • • • • •Venture • •Mezzanine/subordinated debt • • •Turnaround • • • • • •

North America 50% Central & Eastern Europe 2% Asia Pacific 2%

Western Europe 40% Middle East/Africa 2% Latin America 2%

Other 2%

AIG INVESTMENTS www.aiginvestments.com

Assets/funds under management (as of 30/09/2008) $744 billion

Allocation to private equity 3.7%

Year first invested in private equity 1980

70 Pine StreetNew YorkNY 10270United States

Tel: +1 212 770 7000Fax: +1 212 770 9491

BRANCH OFFICESLondon, Hong Kong, Tokyo

KEY CONTACTSMr Pablo CaloGlobal SecondariesLondon

Ms Valerie ChenGlobal SecondariesHong Kong

Mr Kennon KoayGlobal SecondariesHong Kong

Directory.Secondaries 23/1/08 11:34 am Page 174

About PEI MediaIn November 2001, a management team bought out their business from major financial publishing group,Euromoney Institutional Investor PLC. This business was centered on private equity and venture capital, andincluded the website PrivateEquityOnline.com – already one of the most heavily used private equity newssites around – as well as plans for a major new magazine dedicated to the asset class. That magazine waslaunched in December 2001 and is called Private Equity International.

Since then, that same group of managers plus a growing team of seasoned journalists and other publishingprofessionals have been busy developing a range of publications and other media centered on private equi-ty, venture capital and real estate. The company now has offices in London, New York and Singapore and isable to track all aspects of these two key alternative asset classes across all time zones. We are genuinelyglobal in our approach to what are truly global markets.

PEI Media have four magazines, run 20 plus annual conferences globally, publish a library of books, marketreports and directories and have a fast-growing online data business.

About Campbell LutyensPrimary fund placement and secondary transactionsCampbell Lutyens is an independent private equity advisory firm founded in 1988 focused on private equi-ty fund placements and specialist private equity fund and portfolio secondary transactions. The firm hasoffices in London and New York and comprises a team of 40 international executives, advisors and staff withglobal and broad-ranging expertise in the private equity sector.

Campbell Lutyens provides specialist advice to institutions, general partners and other organisations on allaspects of the private equity sector, including the sale and restructuring of portfolios of private equity fundinterests and portfolios of direct private equity investments. Advisory transaction mandates typically rangein size from $30 million to $3 billion. The firm’s recent track record includes advising on over $4 billion ofprivate equity secondary transactions and restructurings of private equity assets.

Campbell Lutyens also assists private equity managers in raising funds and advises on all stages and aspectsof the fundraising process including strategy, documentation and structuring. The firm acts for European,US and Asian managers raising funds of typically between $200 million and $2 billion from institutionalinvestors globally. It has raised venture capital, development capital, buyout, distressed debt, special situa-tion, mezzanine and infrastructure funds.

About.Secondaries 25/1/08 4:07 pm Page 212