Three years ago, at 4am on the day after Thanksgiving, I rushed my pregnant wife to a Best Buy in Westchester, hunting for a laptop selling far below cost. Expecting to be among the very few crazy enough to shop on Black Friday before sunrise, I was shocked to see a line stretching around the block (including other pregnant women). By the time we were finally allowed into the store, all the best deals had all been snapped up, leaving laggards like us to scavenge through baskets of bargain-priced junk. Determined to have some sort of compensation for our lost hours of sleep, I purchased a deeply discounted DVD— the Arnold Schwarzenegger classic Total Recall. Since this event, I have taken to calling the purchase of a good or service to justify one’s effort “Black Friday Syndrome.”
Now, just a week after Black Friday 2009, I have been asked by several investors in private equity if Black Friday Syndrome might be entering the secondary market for private equity LP interests. Since late summer, we have seen prices increasing in the secondary market. This has been reported by numerous sources and nicely summarized at peHUB by Erin Griffith.
Are secondary investors starting to buy private equity LP interests to justify their fund-raising efforts or is there a more rational explanation? Will buyers be left with the private equity equivalents of Total Recall DVDs? At a secondaries conference I participated in several weeks ago, Dan Primack even speculated that secondary funds will be unable to find investable opportunities and return some of the capital they raised.
Those who believe that Black Friday Syndrome is invading the secondary market point to a need to deploy the large amount of secondary capital raised in 2009. According to Venture Economics, over $15 billion was committed to secondary funds during the first three quarters of 2009, more than double the total amount committed for all of 2008. These commitments also exclude funds-of-funds and other institutional investors who have opportunistically decided to purchase secondary interests in private equity.
Despite the large influx of capital into the secondary market, relatively few transactions closed in the first half of 2009. This disconnect between buyers and sellers of LP interests in private equity has been covered extensively, including in my previous post (The Human Gulf in Private Equity Secondaries).
However, upon closer inspection, the increase in prices in the secondary market is justifiable based on two factors. First, secondary purchases of private equity are typically measured as a discount from FMV— the value of a fund as reported by general partners to their investors. In many cases, FMV continued to decline throughout the early part of 2009. In almost all cases, private equity FMVs have declined on a relative basis when compared to the dramatic public market rally. Therefore, even if secondary funds have maintained a relatively consistent price, the decline of the denominator (FMV) has made the discount to appear to be less. The perceived increase in pricing is in many cases more a function of the declining valuations of private equity portfolios.
Secondly, the increasing stability in the overall economy has made valuations of the underlying portfolio companies easier to determine. As a secondary buyer, we struggled to value companies in private equity portfolios where revenues and profitability had dramatically declined in late 2008 and early 2009. For some companies, a poor Q1 and Q2 2009 reflected a delay of revenue that was subsequently realized later in the year. These stronger companies have often rebounded and are tracking towards growth for the year of 2009. Many other companies were unable to emerge from the financial meltdown. These weaker companies were often shut down or merged in a desperate effort to survive. The difficulty in separating the weak companies from the strong companies during the unprecedented chaos of early 2009 gave seasoned secondary buyers reason for extreme caution.
Despite the rational explanation for the increase in pricing in the secondary market, potential investors should be aware of Black Friday Syndrome when investing with secondary private equity funds. Many firms with limited experience in secondaries have recently raised substantial funds. It is possible that these investors will deploy capital at any cost in order to justify funds raised. As buyers in the secondary market, we have to be cautious of such investors driving prices to potentially inflated levels. Indeed, we have recently seen some portfolios priced as if the risks to the economy have subsided. The restructuring of Dubai World is a stark reminder that the ramifications of the credit crisis still reverberate throughout the world economy. Extreme vigilance is still necessary to avoid Black Friday Syndrome in the secondary market.