Lexington eyes bumper deal flow

Q: At $7 billion, Lexington Capital Partners VII is 80% larger than its predecessor. What does this say about the secondary investment market?

A: When we started in this business in the early 1990s the whole market's annual turnover was $200 million. Last year, secondary market volume was $21 billion and it's going to be $25 billion this year. Our database tells us that through June 30 it was already $14 billion. We need a big fund to accommodate that amount of selling volume. Even with a $7 billion pool of capital to invest over a 3-4 year period, say we do $2 billion in deals per year, that's only 10% of the total buying opportunity. Having said that, I don't think there will be a lot of $7 billion funds. There were unique characteristics in terms of what we were trying to establish, the timing, and some of the investors in our fund. It's not the new normal.

Q: Did the fact that many international banks are obliged to reduce their exposure to alternative investments - and divest assets, potentially to secondary investors - have any bearing on the size of the fund?

A: We became experts in Dodd-Frank, Basel III and Solvency II by necessity. We have been all over the bank counterparty market. We did some arithmetic coming out of 2008 and it showed us there was $100 billion in alternatives held by the leading banks - $75 billion of which might trade. This really began to happen in 2010 and it continues today because of price increases in the secondary market. If you see a fall in prices, banks will slow down sales because they don't have to come into compliance with the new regulations until around 2013.

Q: So these divestments don't account for a large amount of your deal flow?

A: We have done 20 deals so far in the new fund and more than half have been non-financial institutions. There have been a few large financial transactions but a larger number of pension funds that are either in the process of selling part of their portfolios, or have announced their intention to do so, either informally or by picking an agent. These guys are not liquidating, they are reallocating. There is $1.6 trillion in private equity inventory - most of it with fiduciaries like pension funds - and that is going to be our bread and butter once the bank deals are completed.

Q: Your latest fund includes separate accounts for two particular investors. Why did you opt for this approach?

A: These accounts gave us very important firepower while we were putting the fund together. The Citigroup deal [Lexington last year co-led the purchase of $1.1 billion in private equity assets from the bank] would have been difficult to do without these accounts. Now that the fund is closed everything is normalized. We have two of the largest investors in the world as a magnet for larger transactions. We view their participation as creative in every way - in terms of capital, deal flow, and the economics for everyone else in the fund.

Q: How do you deal with potential conflict of interest issues?

A: We have experience running separate accounts - they exist in our global co-investment funds, with most of the money coming from two large US pension funds. You will see more separate account activity across the board in private equity. How do you align that with a co-mingled fund? Thoughtfully and carefully. Not everyone can show up in the offering period of a fund so if you want to bring in strategic capital you can set up a separate account either while fundraising or between funds. It's not a general goal for us, but it was helpful because fundraising took a little longer coming out of 2008-2009.

Q: A number of buyout firms are said to have mega-funds in the pipeline. What does this mean for Lexington?

A: Last year, a total of $120 billion was raised by private equity funds globally and in the first half of this year it was $45 billion. There are more than a dozen mega-funds that we believe will launch before the end of the year, seeking up to $150 billion - it's going to be a real food fight out there. We look on this favorably since one of the things that drives our business is LPs that want to participate in new funds but first have to reduce exposure to existing funds. They can either sell down or else GPs may want to facilitate a swap to free up capital for commitments to their new funds by introducing the LP to some source of liquidity.

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