Q&A: Jeffrey Akers, Partner at Adams Street Partners, on the Secondary Market

August 7, 2009

CHICAGO - “ Secondary market activities, which have grown from a relatively small fund in the 1980s to $6 billion in annual transaction volume, has Adams Street Partners as one of its primary movers. Partner Jeffrey Akers is an expert in secondary markets and explains the appeal in an interview with the IVCA.

IVCA: How do you succinctly define the secondary market?
Jeffrey Akers: The private equity secondary market generally refers to the purchase and sale of investment commitments to private equity funds often in the form of limited partnership interests.

Since most secondary transactions take place after some passage of time following initial primary investment commitments to funds from sellers, buyers are typically purchasing portfolios of existing funded assets in funds while also assuming any remaining unfunded commitments to the same funds.

IVCA: The secondary market for venture capital and private equity funds has been growing over the last few years. To what do you attribute its growth?
JA: The secondary market has exhibited strong long-term growth trends. Sophisticated limited partners are increasingly viewing private equity as an asset class upon which they can pursue active portfolio management strategies.

To manage vintage, sector, manager, geographic and subclass concentrations, many limited partners have pursued secondary sales as a portfolio balancing tool. The overall growth in private equity fundraising over the last 5 years has also dramatically increased the pool of potentially tradable private equity limited partnership interests.

Over the last year, many private equity limited partners have faced acute liquidity needs as a result of falling asset values throughout their broader investment portfolios. Several limited partners intended to fund future commitments to private equity funds with distributions from their existing funded private equity portfolios.

With stagnant capital markets, the pace of distributions from these funds has slowed dramatically. Many limited partners have felt under-reserved to meet their future capital commitments.

Since private equity is a generally illiquid asset class, the only means for these limited partners to monetize their illiquid private equity investments has been through secondary market sales. As a result, the fourth quarter of 2008 was a busy time for many secondary buyers.

IVCA: Please describe recent activity in the secondary market.
JA: Very recently, the pace of secondary activity has slowed due to widening bid-ask spreads between buyers and sellers and a normal seasonal slowdown during the second and third quarter of the calendar year. Sellers are often focused on achieving an attractive price relative to a fund's reported capital account value.

Given the uncertainty in today's market, underwriting cases for secondary buyers are often underpinned by extended hold periods, selected portfolio company write-offs due to excessive balance sheet or financing risk, tempered portfolio company growth rates and more moderate valuation multiples than were seen between 2005 and 2007.

As a result, buyers are generally seeking to pay substantial discounts to reported capital account values for private equity fund interests. These discounts coupled with the need by sellers to trade at a value close to their capital account value have resulted in greater inactivity.

This is further exacerbated by first-quarter 2009 reports and an early read of second-quarter 2009 reports, which are showing flat to positive valuation movements. This is widening rather than narrowing the bid-ask spread. Intermediaries that are typically active in the market seem to be slow at the moment.

The transactions that are currently getting completed tend to fall into two categories. First, there have been a number of transactions with sellers that are looking to alleviate unfunded exposure through the sale of largely unfunded interests for free.

Second, there have been several transactions with sellers that have rationally reviewed the opportunity cost of capital required to retain fund interests until a liquidity date and see the current discounts offered by buyers as an attractive option.

At Adams Street Partners, we have been more active recently in purchasing defensive- and growth-oriented private equity assets where we believe balance sheet or financing risk is mitigated and valuation multiples have been more stable. This has allowed us to offer pricing to sellers with more moderate discounts.

IVCA: Who are the typical buyers and sellers in the secondary market?
JA: There are three different kinds of private equity secondary buyers: secondary-only firms (which make up the majority of secondary teams), firms such as ours that have the advantage of an integrated platform and some larger sophisticated institutional investors.

Secondary-only firms are dedicated to the sourcing and execution of secondary interests. Firms with an integrated platform leverage a broader private equity strategy (often including primary and direct investment capabilities) to capture competitive advantage.

From time to time, larger limited partners will participate in the secondary market to increase exposures or make certain tactical bets. This has historically been a relatively small portion of the market.

Sellers of private equity interests span the full spectrum of institutional investors including endowments, foundations, financial institutions, family offices, pension funds, insurance companies and investment management firms. Endowments and foundations have recently been particularly active sellers of private equity interests given their over-commitment strategies and associated liquidity needs.

IVCA: What types of private equity funds are available for sale on the secondary market?
JA: There is relatively consistent deal flow of limited partnership interests across all subclasses of private equity including venture capital, growth equity, leveraged buyout, mezzanine debt, distressed debt and real estate.

Given the recent market environment and a desire by sellers to alleviate the pressure of future capital calls, we have seen a fairly dramatic increase in the number of funds in the secondary market with high proportions of unfunded commitments remaining. Private equity portfolios for sale often possess funds of varying quality.

With recent market stress, secondary buyers have been more focused on funds managed by the highest quality managers. Many fund portfolios brought to market (which would have historically been sold as a full portfolio of funds) have recently been cherry-picked solely for the best funds.

IVCA: How is the secondary market priced?
JA: While our pricing methodology is rather simple, the details and assumptions that go into the analysis can be very complex. Generally speaking, we forecast an exit value and exit timing for each company in a portfolio with particular emphasis on the larger portfolio company exposures in the fund.

We rely on strong relationships with the general partner of the fund we are pricing as a key source of information and insight. Following this analysis, we discount those expected cash flows from the fund at a required return commensurate with their underlying risk to arrive at a price or a present value of the portfolio.

It's very difficult to provide guidance on pricing because it totally depends on the particular characteristics of the funds and the underlying assets. In general, secondary buyers are bidding at discounts of greater than 50 percent of capital account value (often well in excess of 50-percent discounts) for highly leveraged mega-buyout funds and early stage venture capital funds.

Bidding on high-quality and defensive assets with little or modest leverage can fetch 30 percent to 40 percent discounts only if the underlying general partner uses conservative measures when marking their portfolio.

IVCA: What does the sale of an interest mean to the general partner? What are some best practices for how general partners manage the process?
JA: General partners are necessarily quite involved in the secondary process. They are often the only source of good information on the portfolio companies. They are spending an increasing amount of their time helping buyers better understand their portfolio (whether those buyers are existing or prospective limited partners).

They are concerned about confidential information leaking beyond their existing limited partner base. They are therefore increasingly restrictive about ensuring only the most reputable parties receive it to perform due diligence. Further, most limited partnership agreements require the general partner to provide consent to any transfers in the funds.

As such, many general partners are getting more involved in the transfer process and are using the secondary market to help strategically replace or - œupgrade-  their limited partner base. General partners want to increase the likelihood that replacement limited partners will desire a long-term relationship and have capital to invest in their next fund.

IVCA: What are the best practices for buyers and sellers in the secondary process?
JA: As a buyer, we are focused on understanding the specific needs of each seller we are working with early in the sales process. In many ways, we view a secondary transaction as a partnership where we are trying to create a win-win-win scenario for the seller, the underlying general partner and ourselves.

With strong insight into a seller's objectives and issues, we are much more likely to develop an acceptable customized solution for all parties.

We find that sellers that are well prepared at the outset of a transaction are most likely to have a favorable outcome. Most important, sellers should notify general partners in advance of marketing a potential transfer in their funds and understand their own reservation price before any bids are submitted.

IVCA: What are the advantages and inherent risks associated with investing in a secondary fund?
JA: Secondary investments generally have complementary cash flow characteristics to traditional private equity fund commitments. Since the funds we purchase are further along in their matriculation than a primary blind pool commitment, we are able to purchase attractive assets closer to their date of liquidity for our clients.

This often means we have good visibility into ultimate company outcomes. We avoid paying management and performance fees for a large portion of the fund investment periods. Over multiple cycles, this has generally resulted in high-risk adjusted returns, low loss rates, faster return of capital, dampened j-curve impact and enhanced vintage diversification.

Secondary investments do possess many of the same risks inherent in other subclasses of private equity including financing, technology, clinical trial and execution risk. The performance of secondary investments depends on the incremental performance of the underlying portfolio companies after purchase.

Given the shorter duration of most secondary investments, extended hold periods longer than underwriting expectations can negatively impact rates of return on transactions more than the typical case for a traditional private equity investment.

IVCA: As a pioneer in this type of investing, how did Adams Street evolve the process? How do you provide access to potential buyers?
JA: Adams Street Partners has been making private equity secondary investments for 23 years. The firm completed some of the earliest secondary investments in the private equity industry. We have maintained a consistent secondary investment approach and process for more than two decades.

We seek to leverage the breadth and depth of our integrated platform. This includes primary, secondary and direct investing. Our firm has $20 billion in assets under management. Across the platform, we have 235 direct venture investments and more than 500 primary fund investments. We have completed more than 100 secondary transactions.

Our investment teams sit on more than 100 advisory boards. Despite this, we believe our particular strength is not in the platform itself but in how we use it. Our primary and secondary teams participate in a weekly video conference call to review all of our new investment opportunities. Members of our direct team also regularly attend.

We have offices in Chicago, Menlo Park, London and Singapore. Every office participates actively in the global meetings. During these meetings, we discuss what we're working on and where we can share ideas and contacts.

The use of our platform gives us a sharp edge in sourcing the highest quality deals and conducting due diligence. Over time, we strongly believe this strategy has provided appealing liquidity options for sellers while also generating attractive returns for our clients.

Our clients access our secondary investments in two ways. First, investors in our firm's core annual subscriptions get access to primary, secondary and direct investments. For any subscription, we target a percentage of committed dollars to be invested in secondary transactions.

The current target is approximately 20 percent for the global subscription. We also recently closed our Adams Street Global Opportunities Secondary Fund II with $730 million of commitments. This invests alongside our core annual subscriptions. In total, Adams Street Partners has $3.4 billion of secondary assets under management.

IVCA: How did you personally evolve into an expert on this end of the business? What in your background led you toward this type of investing?
JA: I began my career as an investment banking analyst most recently with William Blair & Company here in Chicago. This provided me with a foundation of corporate finance skills that I still use today in valuing companies in the portfolios we are buying.

Following three years of investment banking, I joined William Blair Capital Partners (now known as Chicago Growth Partners) as an investment associate. During this period of time, I was able to begin developing investment judgment as a principal investor.

Following two years of business school at Kellogg, I joined a strategy consulting firm called LEK Consulting. There, I focused primarily on performing commercial due diligence for top-tier private equity firms as they pursued new investment opportunities. In this role, I learned how to evaluate new investments with clear logic flow and data analysis.

While all of these skills have proven useful on the secondary investment team at Adams Street Partners, the secondary business is fundamentally an apprenticeship. Most of my development as a secondary investor has been through experience working on transactions and alongside colleagues at Adams Street Partners who have decades of experience in the industry.

IVCA: How do you see the secondary market impacting fundraising?
JA: Many limited partners (particularly those who have historically not been secondary buyers) are purchasing secondary interests in high-quality funds that are only 10 percent to 20 percent funded for a purchase price of zero. They often view these purchases as primary commitments that have the benefit of several existing assets at no cost to the buyer.

As such, limited partners view these opportunities favorably to a fresh commitment in a new fund. This dynamic is absorbing some proportion of capital otherwise available for new private equity fund commitments.

In addition, there have been several secondary funds themselves in the market fundraising. For the reasons I mentioned earlier, many limited partners have viewed secondary funds as an attractive alternative to traditional fund commitments. As such, they are attracting capital that might otherwise be directed toward traditional buyout or venture funds.

IVCA: What are your predictions for growth in the secondary market? Will there be significant shifts in the next 6 months to a year or will it evolve more slowly?
JA: As an institution, we are very enthusiastic about future growth in the secondary market. In the near term, we expect liquidity needs to drive increased deal flow. Once the economy begins to rebound, we anticipate limited partners will need to honor capital calls from general partners long before meaningful distributions resume from which to fund the capital calls.

This dynamic (whether it occurs in 6 months or 18 months) is likely to spur another round of heavy secondary selling. Longer term, active risk management through the sale of private equity interests is of increasing importance to limited partners.

Since private equity funds are blind pool instruments at the time of initial commitment with varying active lives, limited partners in private equity can't be certain of the ultimate composition of their portfolios from any dimension including sector, portfolio company vintage, subclass, geography or leverage.

As a result and over time, the profile of private equity portfolios can be vastly different than their initial intention at the time of commitment. This makes risk management very difficult. The secondary market is at the forefront of alleviating this tension between a need for active risk management and the illiquid nature of private equity.