Q&A: Paul Capital's Bryon Sheets

Q: What is the state of secondaries market globally?

A: It's been as robust in the last 12 months as we have ever seen in terms of our deal flow - perhaps 1.5 times what we were working on even two years ago. A lot of it is driven by financial institutions disposing of their alternative investment programs in order to comply with Dodd-Frank legislation: a bank-like entity can't sponsor more than 3% of the capital of a captive private equity program and it can't have more than 3% of tier-one capital in any form of alternative asset pool. Looking at the tier-one capital of the largest banks in the US, 3% of that is $2-5 billion.

Q: How much deal flow is coming from the banks versus pension fund churn, and how does it compare to 10 years ago?

A: A little over half of our deal flow is coming from banks and significantly more than half in terms of dollars. Banks have always been an important part of our business, but a decade ago it was more about Basel II implementation and consolidation. We met with the head of PE at leading US bank just after it had acquired a smaller competitor and brought with us a complete database of what that competitor owned; it was the first time he had seen a consolidated picture. In the chaos of these transactions, if you could offer some intelligence it led to interesting discussions as to what role you could play in their programming.

Q: What challenges do you face in spinning out captive teams from banks?

A: You have multiple stakeholders and the management team is in charge of who they want to do business with. It's more about choosing a sponsor that can executed the transaction and support the business going forward than maximizing the price for the bank. These teams have spent 10 years building up portfolios and then the bank gives them three years to divest the assets. They get interested when we offer to transition them out into an independent platform and use that as a bridge to raise third-party capital.

Q: We've only seen one such transaction in Asia with the spinout of NewQuest Capital Partners. Do you expect more?

A: When the NewQuest deal closed it resulted in a lot of inbound inquiries to us and there are a number of deals now being worked on. These kinds of transactions are always bespoke. When we started talking to the NewQuest team they wanted to transition from a single captive LP to a diversified pool and so we brought in some other parties. In other cases this isn't so important, for example if the bank has a very narrow window in which to get the transaction done because it wants drive the impact into quarterly earnings.

Q: What is your long-term plan for the likes of NewQuest given that GPs often want to diversify the LP base further in subsequent funds?

A: A spinout GP will never do another fund unless the track record on the secondary deal is good. We help them set up the transaction so there is a high probability of success. This means picking assets that can deliver a quick return on capital, robust IRR out of the box, and early distributions so you can show clear mitigation of the J-curve. These are emerging managers in disguise. They've been buried inside organizations and never had the chance to raise third-party capital but they've built up really interesting portfolios. We put them in a position to do a successful fund I - backed by us - so they can approach institutional investors and raise fund II.

Q: Do you purse GP-for-hire transactions as well?

A: It's enormously powerful when you bring out an incumbent management team because they have been living and breathing the portfolio for years, they know where the value is and there is continuity of the relationships with underlying companies. And when we do these transactions we want the team to write a big check alongside our investors, budget management fees to reflect actual costs and make most of their money from successful transactions. Negotiating GP-for-hire deals is tougher because they are building a business around fee generation rather than profit participation.

Q: A number firms offer secondaries alongside fund-of-funds, arguing that an ability to make primary commitments leads to more secondary opportunities. What is your view on this?

A: We are hardly ever denied consent on secondary transfers even though our fund-of-funds business has been spun out. Also, if you rely on a primary commitment to a GP as a way to get a secondary deal done there is a conflict of interest because these are two different programs within your firm and they have different investors and different economics. You have to be careful navigating that.

Q: What are the prospects for secondaries in Asia?

A: Asia is a frontier market for secondary participants -pricing is still pretty inefficient and there is a lack of certainty around the information you get on portfolios - but we see huge growth opportunities out here, especially in areas like renminbi funds. There are structural issues in doing this but we are actively working on a solution and I think we could be the first bone fide institutional buyer at some point.

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