Textbooks teach us that private equity is marked to models. Discounting forecasts of cash flows, benchmarking against comparable quoted companies, applying multiples to any earnings, or estimating the value of any net assets are widely used methods mentioned in the international guidelines on private equity valuation, available here.
These recommendations were endorsed by 35 associations in countries ranging from Tunisia to Slovakia and Latvia. However the cited guidelines have not been updated since 2006, and nor have those from the European Venture Capital Association located here. Could both sets of rules benefit from paying more attention to secondary transactions?
As long ago as 2005, research such as this talked about secondary markets creating “a new liquidity paradigm” for private equity. Such transactions need not to be priced against models because supply and demand set the market price. Sufficiently buoyant markets could even remove the need for guidelines that nearly always counsel a marketability or liquidity discount being applied relative to publicly listed equities. After all, buyout specialists almost invariably take over public companies above recent prices, and unquoted assets sometimes change hands at big premiums to listed comparables – that is, where any comparables exist.
The uniqueness of private assets, especially early stage ones, encourages more and more investors to base their strategy on real prices rather than plugging figures into models and some $75 billion is now dedicated purely to investing in “secondaries”. The annual amount raised for such funds has multiplied more than eleven-fold since the year 2000, as the chart below shows, adapted from this report by Preqin Research.
Amount Raised for Funds of Secondary Private Equity
Yet these dedicated, pure play, funds of secondary market stakes are far from the only players. This research from the ICADE School of Business in Spain also identified nearly half of buyers came under neither of the two obvious categories: funds of private equity funds (which invest in both primary and secondary interests), and funds of secondary private equity stakes. These new kids on the block are called “non traditional” buyers, and include larger pension funds who make direct investments into private equity, as well as family offices, foundations, endowments, and insurance companies.
Secondary PE Investor Breakdown
If demand has clearly grown exponentially, the supply of limited partnership interests could explode over the coming years. What seems at first ironic about Goldman buying a stake in Facebook is new Volker/Dodd/Frank laws for US-based banks, combined with higher Basel three capital requirements everywhere, are generally (absent the advisory loophole Goldman is exploiting) expected to force most banks to do just the opposite, and divest or spin off proprietary activities, according to this report. The rules apply to US-based subsidiaries of overseas banks, but no concessions are offered to overseas subsidiaries of US banks (assuming they aren’t scuppered by the new Republican Congress), so only banks wholly operating outside the US will entirely escape the exodus from private equity.
These enforced sales by banks are set to power the next wave of expansion in secondary markets, which could unmask the buyouts, private equity and venture capital industries because US listed banks are held to some of the most onerous disclosure requirements in the world. Continued proliferation of secondary markets could foster transparency in other ways too, such as a Securities and Exchange Commission rule that demands more disclosure from firms with more than five hundred investors – whether they are private or public firms. Over time, opening up these private markets should make it easier for investors to compare pricing between deals and over time, and therefore more difficult for intermediaries to profit from the informational asymmetries highlighted in this AAA story a year ago.
The aforementioned ICADE study complains that pricing remains “inherently inefficient with pricing varying widely between bidders”. Banks needing to maximise realisations from their sales may also insist on illuminating this growing marketplace, and regulators anxious to bolster the banks’ balance sheets should be only too happy to help them in this endeavour. The report says that secondary transactions (peaking at $16bn in a year) represent less than 1% of the overall size of the private equity industry ($2.5tn) – so there is clearly massive growth potential. The report estimates that 2010 will have set a new record of $27bn for assets raised for funds of secondary private equity.