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Skip Navigation LinksHome :: Back Issues :: Finding love the second time around

July 2001

Finding love the second time around





       
Carol Kennedy
A private equity investment is for life, or at least until an IPO or trade sale comes along - right? Not necessarily. With IPOs and trade sales proving tricky to pull off today, selling to another private equity firm is becoming more common.
This type of pass-the-parcel deal often takes place just before a firm goes out fund raising. Investors want to see at least some of their capital back before they commit any more money to a fund. So, there's pressure on general partners to find an alternative means of crystallising profits and generating returns, even in an unreceptive market. Transferring assets to another fund is a quick and easy way to do this.
Last year, for example, BC Partners bought private hospital provider General Healthcare from Cinven for e2.1 billion. Cinven had acquired the UK and French healthcare divisions of Compagnie Generale des Eaux (now Vivendi) in 1997. It merged the UK business with Amicus, another healthcare company, before selling it. A firm that has also used this strategy in the past is Doughty Hanson. It is currently in talks with Charterhouse over the sale of Dunlop Standard Aerospace for a reported £900 million. Doughty Hanson bought Dunlop, which has its headquarters in Canada, from BTR of the UK in 1998.
Selling assets to a fellow private equity firm is unlikely to generate as much profit as an IPO or trade sale, so general partners are wise to avoid resorting to this strategy too often if they want to keep investors happy.
However, for a growing number of companies, the public markets are not an option, nor are they going to be at any time in the forseeable future, either because they are too small - equity investors aren't particularly interested in owning anything with a market cap of less than £100 million - or because they happen to be in an unfashionable sector. If, as some experts are predicting, private equity steps into this void and becomes more of a permanent home than a go-between, how to value these unloved companies will be a fundamental challenge for the industry.
"[Secondary buyouts] aren't necessarily a problem for investors as long as we're seeing some cash at some point, and as long as the way that the industry is being valued is appropriate," says Carol Kennedy, director of strategy at Pantheon, a UK fund of funds. Just because a business has already been in private hands doesn't mean that another private owner cannot add value. "Where we would worry is when the valuation in a private portfolio is higher than it would be in the public arena," she continues.
Another trend which has emerged since the market turndown is an increase in secondary investing. General partners can try as they might to bolster returns via sales to competitors, releveraging companies or perhaps securitizing a firm's cashflow, but some investors will be unhappy with how their funds are performing.
The prospect of limited partners reneging on commitments worries fund managers a great deal. When times are tough, the last thing they want to happen is for investors to pull back. This is where secondary investment comes into play. Funds that buy these assets from investors who no longer want to have such a large position in private equity, perform a crucial role in underpinning the liquidity of the whole business.
So far there are around six major players in this game worldwide. Among them is Coller Capital, a UK firm founded in 1997 which last year closed its third fund dedicated to secondaries. A number of smaller players also now have funds which specialise in secondary investing.
"We believe this market will continue to grow strongly," says Timothy Jones, investment director at Coller. Currently between 0.5% and 3%, or $4 and $20 billion, of the total capital committed to private equity is recycled through the secondary market each year, according to Jones. "We're also aware of a further $10 billion in funds where people are thinking about getting out," he adds.
Common reasons for wanting to reduce exposure are that an institution has been over-exuberant in making private equity investments, either because the fund manager didn't expect all of the commitments to be drawn down or because he was counting on higher returns. A number of banks that made large commitments to venture capital firms in order to generate deals on the debt side feel that, once the fund is fully invested, they have no real reason to hold onto the assets any longer.
An organisation might also want to tidy up its portfolio following a merger. For example, in May 2000, Coller led a syndicate of investors to purchase the portfolio of NatWest Equity partners following the Royal Bank of Scotland's acquisition of NatWest Bank. At $1 billion, it was the largest secondary buyout completed to date demonstrating that, despite its small size, the secondary market has a lot of capacity.
"In the bull market, there were lots of commitments made. Now there's a lot more uncertainty and people are worried and they're wanting to reduce their exposure," explains Jones. "For people like us, that means an explosion in deal flow."






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