Fundamentals of Private Equity and Venture Capital - PEI Media

GETTING THE MOST OUT OF THIS MODULE
Welcome to Module 9 in the Fundamentals of private equity series. This module
focuses on private equity secondaries and their alternatives. It is designed to
work both as a stand alone section and as part of the whole series. The module
necessarily draws upon topics reviewed in earlier modules, and seeks to avoid
repetition of their content. However, for the benefit of the stand alone reader,
a comprehensive glossary has been incorporated, which explains the background
and use of private equity terminology. All terms which may require
explanation or expansion are printed in bold, to indicate that there is a glossary
entry for them.
In any market, secondary activity is driven by
three major factors: volume in the primary market,
investment structure, and transparency.
Issues with all of these factors mitigated against
the development of a strong secondary market
in private equity until the last decade, when the
growth of straight secondary sales and the creation
of liquidity alternatives exploded. Even
though institutional private equity vehicles
have existed since the 1940s, the volume of
activity in the primary market did not warrant
an institutional approach to secondary activity
until the mid-1980s, and only in the late 1990s
did the primary market really begin to dramatically
expand.
What drives the need for liquidity?
Before delving more deeply into history, however,
it is useful to address participant motivations.
Exhibit 1 summarises briefly buyer and
seller motivations. While some circles may still
stigmatise fund managers whose fund has been
sold, most transactions are driven by the strategic
needs of the seller. In fact, in dollar terms,
most transactions have been driven by large
financial institutions – such as banks and insurance
companies – who have decided that private
equity is not a core business and who use
the secondary market to exit private equity
entirely, with the goal of redeploying capital
into core business lines. Recently, more activity
has been driven by institutional investors seeking
to rebalance their portfolios.
It is also important to note the buyer’s motivation.
Increasingly, investors with a long-term
commitment to private equity seek to purchase
positions in specific funds in order either to
develop a relationship with a fund manager
to gain access to future funds being raised,
or to strengthen a relationship with a the man-
Exhibit 1: Summary of buyer and seller motivations
Why do institutions sell existing
private equity positions?
Most often, sales of private equity funds are driven by
the internal motivations of the seller and not
performance issues. Reasons for selling include:
• Inability to fund future commitments
• Need for current cash
• Shift in institutional strategy away from private
equity or long-term assets in general
• Need to rebalance portfolio allocations between
private equity sub-sectors
• “House cleaning” of stub positions or problem
funds that will not be supported in the future in
order to decrease administrative burdens
Why do institutions buy secondary
private equity positions?
Institutions purchase secondary positions for a variety
of reasons given their strategic goals:
• To generate returns based upon the cash flow
potential of the portfolio
• To gain access to future funds to be raised by the
general partner of the fund being purchased
• To minimise the J-curve impacts on an
overall portfolio
• To rebalance portfolio allocations between private
equity sub-sectors
• To add vintage year or sector diversification to
a portfolio
COPYING WITHOUT PERMISSION IS UNLAWFUL
THE FUNDAMENTALS OF PRIVATE EQUITY 5