Private Equity Secondaries in China

So a number of folks have asked me questions. And these are great questions: “NiuShi, isn’t the IPO pipeline backed up in China? Won’t all these PE firms need to exit by M&A opportunities to (generally) strategic buyers? Aren’t these LPs pissed the GP is holding onto their stakes past the originally agreed upon investment window? How’s this going to shake out?”

While I’ve seen this topic mentioned briefly elsewhere in the forums but I wanted to touch on it a bit particularly in relation to China: Private Equity Secondaries.

Imagine if you are the Teacher’s Pension Fund of Somewhere, with a total of $5B invested in PE. This represents 5% of your overall $100B to invest. But the summer comes and along with it a huge heat wave and resulting power outage. The NASDAQ tumbles, somehow crippling your overall investment pool to $75B. Now, all of a sudden your PE stake went from 5% to 6.67% of your overall investment pool, which is just too damn high, according to your financial advisor. What do you do?

One option is to sell some of your PE holdings on the Secondary Market, thereby providing yourself with liquidity and re-balancing/re-allocating your portfolio according to your original investment strategy.

Private Equity Secondaries provide liquidity to an otherwise illiquid asset class – this generally means buying an LP’s stake in a fund, which includes the responsibility to participate in future capital calls/drawdowns. That’s the long and the short of it.

[note: this post does not speak about ‘direct secondary sales,’ in which one PE firm might buy a portfolio company from another]

While the industry was in its infancy (a mere 15 years ago), buying Secondaries was frowned upon and many people treated the process as if you were handling damaged goods.

Why else would an LP want to sell their stake in a fund, right? Well, it actually turns out there are a few other reasons to sell, including:

- Re-allocation of funds from PE to another alternative investment
- Realization that higher returns can be generated elsewhere
- Change in investment strategy (by sector or geography, for example)
- And then…maybe the fund is actually a damaged good, the investments actually are performing terribly, and the LP just wants out.

From the buyer’s perspective, here’s a way for new LPs to invest in funds that have already been running for a few years. Their goal is to enter the investment later in the life cycle (holding the investment for just a few years) and cash out with perhaps a smaller multiple but with a shorter investment period.

Interest in this asset class is growing, and over the last few years, there have been a number of secondary-focused fund-of-funds that have completed a successful fundraise, such as HarbourVest Partners, Paul Capital, and the Goldman Sachs Private Equity Group.

Even as the market and interest in Secondaries is increasing on a worldwide scale, in China there seems to be a special amount of interest due to the limit exit opportunities PE firms have at the moment.

Just last month, it was announced that Shanghai (which already has a major, though rather battered, stock exchange) would establish a publicly traded market for Secondaries. As the demand for liquidity goes up in the PE industry, more Secondaries are likely to be swapping hands, or so the thinking goes. The goal is to have the exchange up and running by the end of 2014.

And the powers-that-be are getting involved too: the Chinese government bought out a number of stakes held by Carlyle and Blackstone last summer.

So what do you guys think? Are Secondaries good for the PE industry? Will LPs remain committed to their GPs over the long haul? Will there remain a strong degree of trust between the parties, or will LPs begin to run at the first sign of too steep a downward J-curve? Does it even matter? What other sort of tangential business models could you see arising from an increased Secondary market?

Also, post any questions you have about the market for Secondaries. It’s a growing sub-industry and all of us (someday) PE monkeys should be in tune with what’s going on. If we have some greyed and grizzled monkeys out there with other insights, please chime in!

 
Best Response

I agree, the market for LP secondaries has certainly been growing. One of the more interesting trades right now is in venture secondaries - a lot of institutional investors have been reducing their exposure to venture, and selling off their positions in managers that they have no intention of re-upping with. This has created a pretty good buying opportunity for secondary shops, as you are seeing a lot of funds in older vintages (i.e. 2000-2007) finally getting close to achieving significant liquidity being put out on the market. To give a brief case study, I have seen some variant of this scenario play out quite a bit in the past year or so:

Seller: Bumblefuck University Endowment with $3 billion+ AUM is frustrated with the performance of their venture portfolio, and decides to decrease their venture allocation from 5% to 2.5%. They draw up a list of 6 firms that they will go forward with - the rest are culled. The problem is, they still have 15 venture manager relationships, but only 5 people on their investment team. Those are a lot of annual meetings to fly around too, and after thinking about, they decide it is best to sell of all their fund positions in managers that they aren't going to be re-upping with on the secondary market. All of the managers that they are firing have tarnished brands and are going to have difficulty fundraising whenever they hit the trail (which in the mind of their LPs is preferably never). They package all these assets, hire a banker, and hope that they can offload these at reasonable discounts (15-40%).

Buyer: As a secondary buyer, you have a much different underwriting profile than what the endowment originally had when they made their primary commitment. You don't necessarily need "good" funds - you are looking for funds that have a great return profile given the expected discount and the reduced time to liquidity. You look over the list of funds that are being sold - most are dogs, just as bad as you would have expected. That said, because this isn't your firm's first rodeo and they have evaluated these type of transactions before, you have a decent database of information on the underlying assets in these funds that would otherwise be difficult to obtain. You see a series of what, in retrospect, were extremely ill-timed commitments by Bumblefuck Endowment: CRAPPY VC Fund IV, CRAPPY VC Fund V, and CRAPPY VC Fund VI. CRAPPY VC IV & VI are truly bad funds, and will be lucky to return capital when it is all said and done. CRAPPY VC V is a little more interesting, but will not light the world on fire, projected between a 1.3 - 1.7x. This particular fund is around 7-8 years into its term, and around 85% called. Very little liquidity so far, and the fund's IRR potential is probably shot. Not exciting on the surface, at least on a primary basis. That said, you know a lot of the underlying portfolio companies, have exit projections, financial data, etc. just from other transactions you have worked on. There are 12 remaining portfolio companies, two of which are trendy SaaS companies that are set to IPO within the next year. There is also a late-stage biopharma company that has burned through 3 times more capital than anyone could have initially envisioned, but that finally received FDA approval and is set to ramp up commercially in the U.S. You can see this business as a potential IPO or M&A candidate within the next two years. These three companies combined compose 80% of the funds current NAV, although you recognize that depending on how the SaaS business trade in the public markets, they are really driving almost all the upside potential in the portfolio. From a secondary buyers' perspective, you have an extremely compelling investment. With the three companies above, the investment has a strong near-term liquidity profile, and depending on the ultimate discount you are able to obtain on the secondary transaction, you could conservatively project to recoup your deal cost within a year on the SaaS companies alone. This will boost the IRR, and you still have the upside for 2x+ on the multiple. The J-curve is significantly mitigated, since you are buying a fund that is 8 years into its life. Realistically, the fund will go to all the way year 15 (since all venture funds seem to do that these days), but most of the value drivers will be realized within the next three or four.

 
joeiz:

..because this isn't your firm's first rodeo and they have evaluated these type of transactions before, you have a decent database of information on the underlying assets in these funds that would otherwise be difficult to obtain... Not exciting on the surface, at least on a primary basis. That said, you know a lot of the underlying portfolio companies, have exit projections, financial data, etc. just from other transactions you have worked on.

One man's trash is another man's treasure, indeed. SB for you, good sir.

 
NiuShi:
joeiz:

..because this isn't your firm's first rodeo and they have evaluated these type of transactions before, you have a decent database of information on the underlying assets in these funds that would otherwise be difficult to obtain... Not exciting on the surface, at least on a primary basis. That said, you know a lot of the underlying portfolio companies, have exit projections, financial data, etc. just from other transactions you have worked on.

One man's trash is another man's treasure, indeed. SB for you, good sir.

Well especially when said trash is sold at fire sale discount price.

Joeiz, thank you for providing a great writeup that clearly lays out the investment process of a PE secondary firm . Do you happen to work in that industry?

Too late for second-guessing Too late to go back to sleep.
 

Good write-up. Venture secondaries are interesting, and there are a lot of them out there right now. My 2 cents; "dead" GPs are a tricky animal, with no prospect of raising another fund, there isn't really an incentive for them to exit companies sooner rather than later, and they likely won't hit the carry either. For those 1 or 2 good remaining companies, they'll likely want to hold onto them as long as possible to generate a home run in an attempt to salvage the fund. Also, once companies are sold, they lose the management fee, so their income stream dries up. Lastly, there is a reason that some of these companies have been in the portfolio for 7 to 8 years, there aren't any buyers or exit options for them.

I'd expect that since the seller wants to trim relationships, that you'd probably have to take all 3 funds, rather than just the best one, since sticking them with the worse of the 2 doesn't really solve their problem.

But overall I agree, being able to find value in some of these funds is a good play right now. Just need to tread carefully, and I think it's more of a discount play than anything, if you can find a seller willing to swallow that discount.

 
m8:

Good write-up. Venture secondaries are interesting, and there are a lot of them out there right now. My 2 cents; "dead" GPs are a tricky animal, with no prospect of raising another fund, there isn't really an incentive for them to exit companies sooner rather than later, and they likely won't hit the carry either. For those 1 or 2 good remaining companies, they'll likely want to hold onto them as long as possible to generate a home run in an attempt to salvage the fund. Also, once companies are sold, they lose the management fee, so their income stream dries up. Lastly, there is a reason that some of these companies have been in the portfolio for 7 to 8 years, there aren't any buyers or exit options for them.

I'd expect that since the seller wants to trim relationships, that you'd probably have to take all 3 funds, rather than just the best one, since sticking them with the worse of the 2 doesn't really solve their problem.

But overall I agree, being able to find value in some of these funds is a good play right now. Just need to tread carefully, and I think it's more of a discount play than anything, if you can find a seller willing to swallow that discount.

Excellent points. You are right, in most instances, the seller would not be willing to strip out just the single fund, unless you place an aggressive bid that is significantly below everyone else. The nice thing about the seller being an endowment though instead of a distressed seller is that they can be less sensitive about the timing of the transaction. All positions don't have to be sold as soon as it hits the market. They can be more picky about their pricing, and if someone comes in with a solid bid on just one or two of their funds, they may be willing move it.

Also, the thing about the GP incentives is key. There is an ongoing conflict between institutional investors and venture firms over this, as most institutional investors are compensated based off some IRR benchmark (l think this is typically the Russell 3000 + 300 basis points), whereas the venture capitalists get into the carry off a multiple. This can create a lot of problems when it comes to portfolio management, and the situation you described where, much to the chagrin of the LPs, the VC holds onto companies far too long in hopes of squeezing every last dollar from their investments. Ultimately, this hits on a point that is important for secondary buyers to consider - much of the risk in even a mature portfolio is not just tied up in the underlying assets, but in the manager as well.

 

NiuShi, thanks for another good post. That Shanghai is building a secondaries exchange is a news to me. I know Qianhai (shenzhen) has already set up a pe stake exchange and it's been very hot (given the good venture environment in shenzhen). So, adding to your questions, how would a company choose which exchange it wants to be listed on? How would a fund/LP determine which exchange to go to look for their next project? Is it possible to arbitrage between the two markets? And since the constraints on insurance companies investing in pe/vc are going to be loosened, will this help or depress the development of the secondaries? I would guess it will depress somewhat, as those insurance money can be more patient than wealthy LPs'.

 
brandon st randy:

Great article from Pension&Investments on this topic:
http://www.pionline.com/article/20130610/PRINTSUB/...

You can try to get as creative as you want with restructuring these end of life funds, resetting the GP carry, etc. but when it comes down to it, you can't put whip cream on bullshit and that's what the remaining assets in the majority of these funds are. I have a hard time seeing these type of solutions squeezing tangible returns out of these things. Also, the majority of LPs are IRR-driven investors (compensated on an IRR, not a multiple), and throwing back distributions in year 10 or 11 (15 or 16 for VCs) of a fund's life simply isn't going to do much for your IRR.

 

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