Fundamentals of Private Equity and Venture Capital - PEI Media

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difficult to track, as the exact sub-allocations to secondaries within fund-of-funds, or allocations within institutional investors’ alternative programs are not widely advertised and can also be flexibly adjusted. In total, however, the amount of money focused on secondary market investing is in the range of two to three times the amount raised for specialised secondary funds. Secondary sales and purchases: practical issues Difficulties in execution Though secondary sales have been around for a long time, there are a number of issues that make the execution of secondary transactions difficult. Problems with the traditional sales process include the following: • The potential for deep discounts. Secondary purchases are usually executed at a discount to the fund manager’s carrying value though the level of discount fluctuates with market forces. (A more detailed primer on secondary pricing dynamics is included in Appendix 3 on pages 25–26.) Throughout the 1990s, the increasing number of funds focused on secondary investing resulted in pressure on these discounts, resulting in transactions being executed at prices in the range of 75 percent to 85 percent of reported NAV. With the bursting of the internet bubble these discounts increased, resulting in transaction values of zero percent to 50 percent of reported NAV for venture capital funds, and to 40 percent to 70 percent of NAV for buyout funds. Over the last three years the market has rebounded significantly, to the point that high quality buyout funds often trade at a premium to NAV. • Long time required to execute. The process of selling a partnership position takes a long time. The due diligence process by a potential buyer to establish a final price – especially when a portfolio of a number of partnerships is involved – can take weeks to accomplish. Once the due diligence process is completed, the final sale, or legal transfer of rights and obligations from one party to another, must be approved by the fund manager in a process that can also take weeks or months as the fund manager often has little motivation to help the process and respond quickly. • Right of first refusal. A significant number of funds contain “right of first refusal” clauses which mandate that, before a position can be transferred to another investor, current LPs in the fund have the right to match the price. This clause can add to the complexity of the sales process and affect details of the bidding process. • Due diligence can be intensive and disruptive. The due diligence process that a buyer necessarily performs in order to develop a firm bid, especially in situations where the buyer is not intimately familiar with the partnerships being sold, is usually intensive and can be disruptive for both parties. This can result in damaged relationships with the fund manager – an important consideration for a buyer whose interest in purchasing a position may be driven by a desire to gain access to future funds to be raised by that same GP. • May impact the relationship with a fund manager and access to future funds. Selling a partnership, especially if it is part of a targeted portfolio rebalancing effort as opposed to a wholesale portfolio sale, may communicate the message to a fund manager that its efforts and the relationship are not valued. Just as the purchaser of a partnership interest seeks to establish a relationship, selling a position communicates the opposite. A seller seeking to maintain a relationship and future access to a fund being sold needs to proceed carefully. Motivations of institutional investors: portfolio management Over the last few years, more institutional investors (as opposed to specialised secondary fund managers or fund-of-funds managers) have begun to consider both purchasing and selling positions in the secondary market for portfolio management purposes. The motivations for these investors include the following: • To provide flexibility in rebalancing a portfolio. A portfolio manager may decide to rebalance a portfolio in order to reduce overall exposure and maintain it within allocations, or to decrease or increase exposure to specific market or industry sectors. The sale of positions in the portfolio or the purchase of positions on the open market can be effective tools to reach those goals. • To change portfolio cash flow dynamic. In situations where a portfolio manager needs to generate cash, the sale of private equity positions can both generate immediate cash and at the 10 THE FUNDAMENTALS OF PRIVATE EQUITY COPYING WITHOUT PERMISSION IS UNLAWFUL
Exhibit 7: Secondary private equity ABS structure Portfolio being securitised Undrawn commitments Investments outstanding Financing structure Liquidity facility “AA” tranche “A” tranche “BBB” tranche “BB” tranche “B” tranche Equity tranche Bank or insurance company Structured bond buyers Purchasers of residual risk Note: The difference in size between the facilities is driven by the discount and the need to over collateralise the top rated tranches. Securitised vehicles To date, most of the effort in producing structured vehicles has been in the primary market as structured fund-of-funds, but the technology developed in this area is now being applied in the secondary market. The primary goal of these structures as applied to private equity portfolios is to decrease the discount to NAV on secondary positions and to make the portfolio more marketable through the use of financial structuring. There is no common nomenclature yet for these structures, though “collateralised fund obligations” and “private fund obligations” have been used frequently. They are based on standard asset backed security (ABS) financial technologies that have been used for years to create securities backed by mortgages, credit card receivables, auto loans, commercial bank loans and corporate bonds. The goal of most ABS structures is to create a more efficient financing vehicle for assets by taking a large portfolio and stripping the cash flow generated by the underlying securities into different obligations. Each “strip” or tranche has different cash flow characteristics and has a credit rating that declines with each descending strip depending upon the collateral or cash flow priority held in support of that particular security. The last strip in the structure is the unrated “equity” strip, which retains all of the residual return and risk. Each strip is then sold to different types of investors on the basis of their respective risk/return appetite. A sample structure is shown in Exhibit 7. The structure outlined in Exhibit 7 differs from a typical ABS structure by the inclusion of a liquidity facility. Private equity portfolios are different from most ABS situations in that, even with a seasoned portfolio, new funding is required as commitments are drawn down. Though the early return of capital on certain investments provides a means of funding future draw-downs, it is prudent to arrange a liquidity facility or line of credit with a bank to ensure that future commitments will be met in a timely manner regardless of the realisation experience of the portfolio. Another way of looking at the structure is as a leveraged investment in private equity for those willing to invest in the equity tranche. The various tranches senior to the equity tranche effectively provide debt financing to purchase the portfolio, while the residual risks – and residual benefits – accrue to the holder of the equity tranche. To date, relatively few private equity transactions – either in the primary fund-of-funds market or in the secondary market – have been rated by the credit rating agencies. However, Standard and Poor’s, Moody’s, and Fitch’s have all established rating policies for securities collateralised by portfolios of private equity partnerships. At a summary level, the policies of all three require similar elements in order to achieve specified rating levels. These elements include, for example, professional portfolio oversight, specified levels of portfolio diversification, differing levels of overcollateralisation or cash flow preference, and equity protection provided by the unrated tranche. Issues with the ABS structure Fundamental issues with the ABS structure have kept it from being widely used as a means 14 THE FUNDAMENTALS OF PRIVATE EQUITY COPYING WITHOUT PERMISSION IS UNLAWFUL
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THE FUNDAMENTALS OF PRIVATE EQUITY
Page 3 and 4: Contents About the author iv Gettin
Page 5 and 6: GETTING THE MOST OUT OF THIS MODULE
Page 7 and 8: Module 2: Private equity as an asse
Page 9 and 10: About the author Garry Sharp - inde
Page 11 and 12: Exhibit 3: Distribution when one fu
Page 13 and 14: Module 3: Structuring and raising a
Page 19 and 20: Module 4: Venture and development c
Page 25 and 26: Module 5: Management and leveraged
Page 31 and 32: Module 6: Private equity real estat
Page 35 and 36: preceded the private equity hotel c
Page 37 and 38: Module 7: Due diligence COPYING WIT
Page 43 and 44: Module 8: Aftercare and exits COPYI
Page 49 and 50: Module 9: Secondaries and their alt
Page 53: GETTING THE MOST OUT OF THIS MODULE
Page 57 and 58: Published in September 2007 by: PEI
Page 59 and 60: About the author David Huckfield -
Page 61 and 62: of members including representative
Page 63 and 64: Published in September 2007 by: PEI
Page 65: The Fundamentals of Private Equity
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