Secondaries: GPs for hire

Duke Street's announcement in February that it had abandoned plans to raise a EUR850 million buyout fund came as little surprise. The UK-based private equity firm had targeted a first close by Christmas but ended up postponing it to the first quarter of the year, before finally accepting that the European fundraising environment wasn't about the improve.

Duke Street instead plans to seek capital on a deal-by-deal basis. It already has a strong track record and the idea is that this can be burnished through savvy investments. Once LPs regain their appetite for the asset class, the firm might have something to shout about when it returns to the fundraising trail.

Industry participants expect a wave of restructuring and consolidation in Europe and the US as fund managers - typically mid-market operators - struggle to raise new vehicles and are forced to look at their options. Asia could see a similar scenario as GPs that emerged four or five years ago, but have since underperformed find LPs aren't willing to back a second fund.

For secondary investors, it has become a target-rich environment. They are scouring the region for managers that want to service their existing funds, either by selling off assets or receiving top-up capital, or even getting out of the business altogether.

"You have guys who are good managers but they are struggling with fundraising and plan on getting back into it once things look less ugly," says Tim Flower, a principal at HarbourVest Partners in Hong Kong. "We come in and replace LPs that don't have the stomachs to continue, buy the portfolio, spin out the GP and give them some money for the portfolio as well as for new deals."

Several secondaries players add that a few GPs are also following Duke Street's lead, modifying their approach to focus on single-asset deals and inviting LPs to co-invest.

After the blowout

These models are by no means widely proven, but the scale of the perceived opportunity rests on the fact that more capital has been deployed with Asian managers than the region can bear at this point in its development.

According to AVCJ Research, $166.9 billion was raised between 2006 and 2008, three times the total for the three previous years combined. There were 2,900 private equity firms operating in the region at the end of 2011, compared to just over 1,600 six years ago.

Fundraising last year may have reached a peak not see since 2008 but no one expects the next couple of years to be easy.

"A very large number of Asian firms raised funds of $200-500 million in 2006-2007, when people were throwing money at all kinds of things without conducting proper due diligence," says Doug Coulter, head of Asia Pacific private equity for LGT Capital Partners. "Some of these firms haven't seen a single exit and it will be extraordinarily difficult to raise new funds. I can't think of more than a handful of India fund managers who are likely to achieve a final close this year."

India and Australia are identified as the most promising markets for secondary investors.

Indian GPs attracted more than $23 billion in commitments between 2006 and 2008 but less than half that in the three subsequent years. Market sources predict that total fundraising won't reach $3 billion in 2012, compared to $3.5 billion the previous year. Australian fund managers, meanwhile, are adjusting to reduced commitments from domestic investors. The logical response is to target international LPs but it remains to be seen how effectively the smaller players can do this - for reasons of scale, not quality. It is suggested that US pension funds would only be interested in fund managers with the capacity to handle a $100 million-plus commitment.

"We've had several conversations with managers in India and Australia that are struggling to raise new funds and are trying to turn themselves into portfolio managers," says HarbourVest's Flower. "I never thought I would be as busy as I am in India. There are massive opportunities on the secondary side because the country hasn't delivered as of yet and a lot of portfolios are unrealized."

Enter and control

The key issues for secondary investors examining a portfolio of assets are the willingness of the GP and the existing investors to cede control and who will manage the assets in the event of a transaction.

NewQuest Capital Partners stands out as Asia's only real secondary spinout. Last year, HarbourVest, LGT, Paul Capital and Axiom Asia put up $400 million to acquire Bank of America Merrill Lynch's (BoAML) private equity business, taking the existing management with them.
NewQuest now has a brief to cultivate the existing portfolio and buy assets from other GPs that need to return money to investors but are unable to secure a quick exit via the capital markets or through a trade sale.

Direct secondary acquisitions are complicated because they typically require more information than the purchase of a package of LP interests in private equity funds. It is necessary to conduct due diligence on each portfolio company and terms must be negotiated with the existing manager as well as all the investors.

With NewQuest, there was only one investor - BoAML, which had to scale back its alternatives exposure for regulatory reasons - and a GP keen on the transaction because it promised a longer-term future for the franchise. This is not always the case.

European mid-market buyout firm Cognetas became a target for secondary investors in the second half of last year due to the difficult macroeconomic environment and the departure of its managing partner triggering a key-man event and an investment freeze. An offer for the portfolio from the private equity firm's second fund was turned down by the advisory board, which opted for a plan put forward by the existing management team to downsize operations and - presumably - reduce fees and carried interest.

The challenge for any investor looking to resuscitate a deal is winning support from management, which would likely be conditional on retaining them, or signing up three quarters of the LP base to a proposal to replace the GP. "In our experience, not many GPs have sold portfolio companies to secondary buyers," says Conrad Yan, head of Asia for Campbell Lutyens. "There is often reluctance on the part of certain GPs to let the assets go. It doesn't help the economics."

Yan sees no reason why Asia wouldn't follow a similar pattern to the rest of the world. Across the industry, it is accepted that the region will see its fare share of zombie funds as managers let their franchises die away, content to live on the management fees for a few years.

Divorces between investors and fund managers are difficult. If the LP base is sufficiently narrow that a consensus can be achieved, the documentation involved isn't ideal and tends to make for a protracted process.
And then there is the challenge of finding someone to manage the assets. The proliferation of one-fund-only GPs in Asia may largely be a product of a crazy fundraising environment, but it is also a reminder that experienced managers are in the minority.

Working in tandem

While selling assets without a manager isn't impossible - Thomas Liaudet, a partner in secondary advisory team at Campbell Lutyens, recalls advising Goldman Sachs on a portfolio of asset sale last year to a GP backed by a syndicate of secondary investors - there are easier ways to do business. A consensual restructure that sees some or all of the incumbent team remain in place is generally preferable.

One option is to set up an annex vehicle whereby a GP that is unable to raise a new fund instead taps new and existing investors for capital to service existing portfolio companies (see "Annex funds: Compromise approach"). For secondary investors, however, the ideal scenario in terms of economics and control tends to be when LPs sell their positions and the GP is charged with operating the assets on the secondary player's behalf.

Fund managers who are willing to accept these situations are likely to have one eye on retaining their team - which requires consistent fees and carried interest - and raising a new fund in due course. It is a calculated gamble: There is no guarantee they will attract commitments for a second vehicle three years down the line, but proving an ability to develop the current portfolio and exit at a profit does no harm to their prospects.

Working with a secondary investor that also has a primary business can help in this respect. "I was looking at a small portfolio recently and the opening remark from the GP was that it would be nice to have HarbourVest as an LP," says Flower. "Doing a secondary deal puts a fund manager into our landscape. Familiarity breeds interest."

Furthermore, it is not unknown for fund managers in Europe and the US to sell off all the assets in one fund to a secondary investor so they can return money to LPs. The hope is that some of this capital will come back into the private equity firm's successor vehicle.

Whatever the approach, effective deal sourcing relies on understanding the individual managers just as much as knowing who might be having trouble raising a new fund.

For secondary players targeting LP interests, leveraging relationships with GPs that might be wary of being sold down through an auction is always helpful. For direct secondary investors who focus on restructuring portfolios on the ground, being able to second-guess GPs' responses is essential.

"Knowing GPs and appreciating how they think about portfolios is very important," says Jason Sambanju, managing director with Paul Capital in Hong Kong. "Either you are a very experienced Asia LP who understands the mentality of GPs or you are an ex-GP yourself."

Annex funds: Compromise approach

Annex funds are familiar to US investors who have seen difficult times. Venture capital firms used them to support portfolio companies after the dotcom bubble burst in 2000 and some private equity houses took similar steps following the global financial crisis.

Arguably the standout example is MatlinPatterson's $165 million annex fund, launched in 2009. The US-based distressed asset investor had run into trouble with its second buyout fund and asked investors in the $1.6 billion vehicle to put up more capital. When they refused, the firm turned to the secondary market.

"They got two secondary funds to supply capital and it was looking like such a good deal that they went back to the LPs and some of them came in through the annex as well," says one secondary investor familiar with the transaction.

It was structured so that participants in the annex received a share of the profits first and LPs in the original fund only got their cut once a certain threshold was reached.

Jason Sambanju, managing director with Paul Capital in Hong Kong, sees scope for similar vehicles in Asia. He notes that a GP might have fully deployed its first fund yet not recorded any exits due to the weak IPO market. In the absence of follow-on capital, a secondary investor could come in via an annex and re-energize the portfolio.

Although the economics will be inferior to those in the original fund - well below 2% and 20% for the fees and carried interest, respectively - the possibility of retaining part of the original LP base rather than becoming a hired hand answering to a single investor that owns the assets might be incentive enough for a GP.

"We have seen a few of these opportunities already in Asia and the need will increase over time," Sambanju says. "It is growth equity for growth equity investors."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Secondaries
• GPs
• Fundraising
• Secondaries
• GPs
• Fundraising
• NewQuest Capital Partners
• Bank of America Merrill Lynch
• Cognetas
• Campbell Lutyens
• Paul Capital Partners