A Secondary Market for Private Equity Is Born

Aug 28 2001

What happens when investors in venture funds want to sell?

It's a question that is increasingly being asked. Unlike stocks, bonds, mutual funds, hedge funds, cars, houses, boats, baseball cards or more less any other asset class, there's never been much of a resale market for venture capital. Indeed, venture capital funds aren't designed to be resold in the "secondary market" like other financial assets. The theory is that you plunk down your money, and then go away for a few years while the VCs do their voodoo. Down the road, you take delivery on a bucketful of shares of the next Cisco, yours to keep or sell.

Those rules were designed for the old pre-bubble era, though. The huge expansion of the venture capital market in recent years, combined with the subsequent tech stock bust, has created some new pressures on the institutions, companies and wealthy individuals who make up the bulk of venture investors. The upshot is, a growing number of investors are looking for ways to unload their venture fund holdings. The result: a quiet surge in the secondary market in venture capital partnership interests.

"Private equity is a trillion-dollar market, it's now an institutional class asset," says Kathleen Powers Dunlap, CEO of PrivateTrade, a startup trying to create an online secondary market in private fund interests. "In private equity, the absence of a secondary market is striking. It's been done in a one-off fashion."

Certainly, the dramatic expansion of the size and scope of the venture capital market in the last few years has created rising demand for a more active secondary market. That's a fundamental change, made possible largely by savvy investors who see a chance to generate fat returns.

Overall investing in venture capital surged in the late 1990s. Far more money is invested in private companies now than ever before. Morgan Stanley calculates that total venture dollars invested in 1999 and 2000 made up more than two-thirds of total funding of the last 25 years. That boom, of course, set the stage for a dramatic tech bust that has slammed institutions and individuals alike. And that's led a variety of investors in venture funds to start eyeing the exits.

Historically, about 3.2 percent of venture investments are resold, according to Nick Harris, a partner with Lexington Partners, one of the largest investors in the venture capital secondary market. Even if that figure stays constant, he says, the size of the market should expand rapidly because of the huge increase in VC funding in recent years. From 1995 to 1999, he notes, about $400 billion was invested in VC funds, compared to $100 billion the previous five years. "If this 3.2 percent rate holds, business could quadruple," he says. Harris says that rate could rise to between 4 percent and 5 percent, thanks to the uncertainty of venture returns in the next few years and the choppy market for public offerings.

Lexington is gearing up to meet the higher volume: Having raised a combined $2.5 billion in their first four funds, the firm is now raising a new $2.5 billion fund to invest in venture funds and other private investment portfolios. "The early interest is very high," he says. "The stars are aligned for secondaries now." One lure is the potential for strong returns. Secondary investors think they can generate annual gains of 25 percent to 35 percent after fees.

While the market may be growing, it is doing so quietly. With a few notable exceptions, transactions in the secondary market happen out of public view – press releases or tombstone ads are rare, and there are no required public financial filings. Usually, one or more of the parties – the seller, the buyer, or even the general partner of the subject fund – prefer to keep the deals quiet.

Sellers, whether individuals or institutions, may not want to tip off their need to raise cash. Funds prefer not to offer public information on the market value of their portfolios as implied by a transaction. While it is not news that the value of venture portfolios has been damaged in the tech bust, the VC funds see no need to provide specific data on the subject that might confirm investors' worst fears. And buyers see no need to cross up the other parties in the transaction, and may not want to tip their hands on pricing or strategy.

The VC bubble of 1999 and 2000 brought with it a wave of nouveaux zillionaires eager to stash some of their fortune in venture funds. Now, with many stock portfolios in enfeebled condition, some of those people are seeking a way out, facing debts run up in the good old days. "You have high-net-worth individuals once worth $100 million, now worth less than their debt is worth," says Merrill Lynch investment banker Jack Weingart. But it's no easier to identify them. "It tends to be a very private market, and not a lot gets disclosed," Weingart says.

Even so, most of the dollar volume in the VC secondary market comes from institutional sales. Weingart says that in some cases, institutions that expanded aggressively into venture capital now want to sell some of their positions. Francisco Borges, CEO of Landmark Partners, says some institutions want to redeploy capital from mature or troubled funds to invest in newer funds – sometimes run by the same general partners of the funds they want to sell.

Many large institutional portfolios suffered from an unexpected spike in a portfolio’s commitment to one asset class when the value of their tech holdings collapsed. Suppose a pension fund decided to invest 10 percent of its $100 million in assets in venture funds, with the rest in growth stocks. As a result of the recent stock slide, the other 90 percent of the portfolio could be down dramatically – say, 40 percent or more. Suddenly, the $90 million stock portion of the portfolio is worth $54 million – and the $10 million venture investment has grown to be more than 15 percent of the portfolio. Solving that problem requires unwinding some venture investments.

Depsite the hush-hush nature of most of these transactions, details on a few large transactions have leaked out. In the largest-ever liquidation of private partnership interests, J. P. Morgan Chase raised a reported $1 billion in the secondary market, with Lexington acquiring about 51 percent of the total and a variety of investors taking the rest. Chase, which sees its venture investing at least partly as a way to find new banking customers, said they wanted to free capital to invest in new deals, and eliminate duplication, where they had investments in multiple funds from the same venture capital firms. Lucent is reportedly now in the market to sell positions in about 50 venture and private-equity funds. Other big sellers in recent years have included Raytheon , St. Paul Cos., NatWest and Bank of America .

The J.P. Morgan Chase deal highlights some of the complexities of this odd market. Consider the issue of how to price the transactions. Dale Meyer, head of private equity fund raising and secondary sales for the bank, says Chase sold interests in 123 funds, with "gross commitments" of $1.5 billion, about 70 percent of which had already been invested. If you assume that each fund had at least 10 investments – a highly conservative estimate – then figuring out what the whole was worth required estimating the value and exit strategies of well over 1,000 companies, most of them still private. As part of the due diligence process for the sale, Morgan provided potential investors with more than 300,000 pages of material on the funds and their constituent parts. The process of selling the investments, which started last summer, took almost a year to complete.

In the secondary market, due diligence is crucial to making educated bids. Secondary specialists like Lexington and Landmark maintain detailed databases of thousands of deals to simplify the process.

Moreover, sellers in this market also need the consent of the general partners of each individual fund involved. Although it happens only rarely, the general partners of many funds retain the right to veto the transfer of a limited partnership interest in the fund.

Despite the complications, the appeal is clear: a chance to invest on the cheap in a venture fund where the portfolio is already defined. "A primary venture fund investment is blind pool investment, on faith," says PrivateTrade's Wisdom. "Secondary trades allow investment later on in the life of a fund, when you have a window into the strategy. Lots of sophisticated portfolio managers are going to opportunistically buy in."

Even with the expansion of the secondary market, there is no guarantee that there will be buyers for investments in the most troubled funds. David H. De Weese, partner with Paul Capital Partners, notes that the funds created at the height of the Internet bubble will not be very appetizing to many buyers. "We’re loath to bid on 1999 and 2000 vintage portfolios," says DeWeese. "There still might be a lot of pain in them."

At the same time, De Weese contends the pressure on some investors to rejigger their portfolios will create highly motivated sellers – and some potential bargains for firms interested in investing in well-established venture funds. "Opportunities in the secondary markets for people in funds like ours are as good as they've been at any time in the last decade," he says.