The CFO of a mid-market buyout fund recently told me how disillusioned he was with the secondary sale process. He had spent hours on diligence calls to help an investor sell his position in the fund, only to later discover that the sale had collapsed. He felt that he had wasted his time and was suffering from “secondary fatigue.”
My firm, VCFA Group, has been buying secondary interests in private equity funds for over thirty years. As the private equity market has matured and secondary funds have raised increasing amounts of capital, more and more general partners have become involved in secondary processes. In order to minimize secondary fatigue a GP must understand the three most common reasons why a secondary transaction might fail and how these risks can be mitigated.
1. Unmet price expectations
Unrealistic seller expectations are the most common reason for the failure of a secondary sale. Oftentimes a seller is fixated on a price that he or she might have heard about through the grapevine. These erroneous indications are usually based on different assets at different times. We try to address pricing expectations by offering a realistic range to the sellers from the outset. GPs looking to avoid secondary fatigue should ask whether the seller is happy with the range that the buyer has provided. If the buyer has not yet provided a range, there is a good chance that the seller will not be happy with the ultimate offer. If the seller’s expectations are above the buyer’s range, there will also likely not be a transaction. Buyers seldom raise prices above their range, even when a GP tells a compelling story about the portfolio. GPs can help to set realistic expectations for a price and avoid unnecessary and fruitless diligence.
2. A larger transaction fails to materialize
Most of the secondary sales we see today are part of a portfolio rebalancing whereby an institution or individual is seeking to reduce the number of investment managers in their portfolio. As a result, they are often selling multiple private equity limited partnership positions, sometimes including real estate, infrastructure and other less liquid assets. Even if a seller agrees with the buyer on one fund, the transaction can fail if other parts of the transaction are unsuccessful. Buyers often shun small transactions due to closing costs and internal issues. GPs should try to determine the relative importance of their fund in the portfolio sale. In some cases, a GP might wish to offer the interest to another investor if the larger transaction does not close.
3. Protracted legal negotiation
One of the most underappreciated aspects of a secondary sale is the negotiation of the purchase and sale agreements (PSAs) that govern the transfer of the assets. In the past year I have negotiated PSAs with over thirty sellers of LP positions in private equity funds. Some of these negotiations took as long as several months while others were signed with no negotiation. Although most PSA issues are eventually resolved, the delays introduced by these agreements can cause complications. Transactions frequently fall apart due to a subsequent event that may be known to the GP. For example, if a portfolio company is sold during the negotiation of the PSA, either the buyer or seller may reconsider their position. GPs should proactively notify both sellers and buyers of potential events in the portfolio. By increasing transparency, the GP can be assured that the transaction may close, even with delays.
While there is no sure way to avoid secondary fatigue, GPs can look for these three signs of a potentially failed secondary sale. Then a GP can then either take some simple steps to mitigate the risks or manage their time appropriately.
David B. Tom is a managing director at secondary buyer VCFA Group
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