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Sale of the century?

With the current downturn and Coller's recent Lucent acquisition, the secondaries market is something of a hot topic in private equity circles at the moment. And, as new research shows, this sub-set of the industry will become an increasingly important and innovative market as it starts shedding its shady image and enters the mainstream.

Prolonged market downturns, such as the one we're experiencing, always push investors into exploring the more esoteric corners of the investment firmament. In the private equity market, secondaries have been one of the principal beneficiaries of this search for shelter from the misery being experienced elsewhere. The counter-cyclical quality of this sub-set of the market has historically attracted enormous in-flow of capital into dedicated secondary funds.

Preliminary evidence suggests that the volume of funds raised for secondary investments in 2001 may have been almost on a par with the record year in 1999, when the entire private equity industry was undergoing an unprecedented boom and funds found it easier than ever to attract capital from investors. The last year has seen the emergence of the first billion-dollar secondary funds, elevating the sub-set into the major league.

More growth, more sophistication
The next few years are certain to see even more dramatic growth, if only because the potential supply of secondary transactions will flow from the massively inflated primary market of the late 1990s. Upcoming research from AltAssets predicts that there will be as much as $20bn of capital available for investment in secondaries by 2005 - roughly six times the figure in 2001.

But increased scale isn't the only characteristic of the market's next stage of evolution. Secondaries transactions will become increasingly complex and sophisticated. Plain vanilla primary fund sales will continue be the bread and butter of the market. But the type of deal supply will change in scope and direct investment sales will grow massively.

Traditionally, the bulk of secondary sales have been relatively mature buy-out funds, with an average age of between four and six years and generally more than 70 per cent invested. But given that the ultimate source of that supply is the broader primary market, it is only to be expected that a large chunk of future supply will be venture funds. After all, venture investments made up about half of the total market by the end of the 1990s.

Nothing could symbolise this shift more effectively than the first big deal of this year - the Coller Capital purchase of Lucent Technologies corporate venturing portfolio. Coller paid around $100m for an 80 per cent share of Lucent's New Venture Group portfolio, with the telecom firm retaining the balance.

The deal combined two key features of the future market - it involved a corporate venturing portfolio and it was mainly composed of direct investments. This type of deal presents a new challenge to the secondaries specialist. It requires them to analyse an unusually venture-heavy portfolio, and to manage direct rather than fund investments. The solution in this instance was to retain to the existing management team and set up a new vehicle called New Venture Partners II.

It's just the beginning
We can expect more of the same in the months ahead. Secondary specialists say there are dozens of venturing portfolios being marketed around by companies that have either been burnt by the collapse in public markets or lost all their original enthusiasm for venturing. Many of them will never find new homes because their mix of underlying investments, often put together for strategic rather than purely financial reasons, have little or no appeal to a secondary purchaser. But some of them, when appropriately discounted, will eventually appeal.

The end result of this change will be profound. Where secondaries have historically been considered a fairly esoteric corner of the market, they will emerge as something much more important. No longer the refuge of vultures picking at scraps at the bottom of the market, the secondaries market is becoming one of the most innovative corners of the private equity industry. The nature of present and future supply and the demands this places on established players is one important dynamic. But so is the increasing sophistication of the private equity industry itself.

Increased competition
More experienced practitioners nowadays are often happy to conduct secondary transactions themselves. This has upped the competition in the sector and inflated prices. There has been a massive influx of new players into the secondaries market from traditional funds of funds, working on the belief that their numerous fund investments have positioned them well to access deal flow. More and more are allocating significant portion of their capital to the secondaries market. The result is that the ‘plain vanilla' fund sales that used to make up the bulk of deal flow are more difficult to source.

The specialists' answer to this has to been to leverage their size and expertise. Size enables them to compete over the large institutional portfolios that can go for as much as $1bn. Their expertise allows them to work on investments that don't interest the generalists. The Lucent deal might be included in this, but so would so-called ‘tail-end' investments. These are generally funds nearing the end of their life that have eked out most of the value from the underlying investments. Secondaries specialists aim to buy them from general partners, impose a new incentive structure on the management team, and steer them towards exits. The attraction is that they are usually cheap but secure, with most of the investee companies mature and even cash-flow positive.

The most enterprising specialists are also looking with great enthusiasm at securitisation. It is still early days for the industry - an experimental phase - but securitisation of private equity investments looks certain to be one of the most explosive growth areas in the years ahead. US insurance group Aon Corporation marked the next step forward at the turn of the year by becoming the first institution to get a stand-alone credit rating from S&P for the securitisation of its limited partnership investments. None of the existing secondaries specialists want to be left out of this next phase.

In fact, Aon's securitisation and Coller's Lucent deal, both arriving at around the same time, have presented a symbolically important start to the year. They flag the future challenges for an industry that has finally established itself in the investment mainstream by virtue of its now significant size. All that remains for the secondaries market to cement its new prominence is its first big-time failure. Its brief history is so far unsullied by a crumbling fund or a whiff of panic. And no corner of the financial markets can truly claim to have reached adulthood until it has endured some form of adolescent crisis.

Chris Davison is head of research at AltAssets

The AltAssets report, The Advent of Liquidity: Private Equity Secondaries, is published on 11 February. For more information or to order a copy, please click here or telephone +44 (0) 20 7242 8852.