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Finance & Investment: Shelter for Investors

Daniel Gross

In March 2000, a consultant invested in a Silicon Valley Internet venture fund, lured by the potentially lucrative perk of becoming a limited partner. The consultant, who prefers not to be identified, eagerly anted up a six-figure sum and made a commitment to contribute $1 million more each time the fund required additional capital.

The plum quickly turned bitter. Soon after his arrival, many of the fund’s high-profile Internet start-ups started to tank as the dot-com meltdown began in earnest. The value of his equity in the private venture fund was quickly declining, but worse, he was consigned to invest even more money over the next several years. “I was willing to hold on, but I didn’t want to keep writing checks for investments,” he says. “It went from a privilege to a liability.”

Rather than allow this investment to ruin his portfolio, he sought out other investors who also wanted to extricate themselves from the fund. Together, they contacted Landmark Partners, a Simsbury, Conn., outfit that purchases private equity interests—investments in venture capital funds, real estate funds, and leveraged buyout funds. The catchall term private equity also refers to restricted stock in public companies and stock in privately held companies. In August 2001, Landmark offered to buy the investors’ share for about 60 percent of its then-current value and agreed to assume future liabilities. “I did an Irish jig. I couldn’t have been happier,” says the investor. He and the other investors accepted a short-term loss, but they gained liquidity and unburdened themselves of risky obligations.

Companies that buy shareholders out of such investments are becoming more common in the United States, where a secondary market for private equity has been developing since savings and loans, among other financial institutions, began selling assets during the early 1990s. Now, about 2 percent of secondary assets changes hands each year. Industry experts say the development of secondary markets was inevitable, given the value of stock in privately held companies and the substantial expansion in venture capital in the late 1990s. Venture capital funds raised $30.8 billion in 1998, $59.1 billion in 1999, and a stunning $105.2 billion in 2000, according to Venture Economics, a division of Thomson Financial.

As with the stock market, many investors bought into VC funds and acquired private stock at or near the top of the market in 1999 and 2000. Now, many of those same investors—companies, institutions, and individuals—are seeking graceful exits, because most funds have a life of at least five years and limited partners are often expected to invest additional money throughout the life of the fund. One exit option is to default on future investments; however, the trade-off would be the forfeiture of your stake in the fund.

If you want to sell private equity, the first step is to contact one of the dozen-odd outfits that specialize in purchasing investors’ stakes. These include Landmark, Pomona Capital, HarbourVest Partners, Lexington Partners, and San Francisco–based Venture Capital Fund of America. Several of the large investment banks—Goldman Sachs and Deutsche Bank, to name two—have divisions that purchase limited partner interests. Buyers tend to look for pieces of brand-name funds, such as Kleiner, Perkins, or Benchmark Capital, while shunning the smaller venture funds created at the end of the dot-com boom. Because these buyers plan to hold the investment for the long term and are sometimes obligated to reinvest, they want to be as certain as possible that they are joining funds with solid track records.

“We do our own analysis from the bottom up and try to evaluate the prospects of every company in a fund’s portfolio,” says Michael Granoff, chief executive officer of Po-mona Capital. “When we bid, we have to make conclusions about, say, 100 companies in two weeks.”

Once potential buyers become interested in acquiring private equity, they will make offers at sharp discounts, which can range from 30 percent to 60 percent for venture capital funds, and 20 percent to 40 percent for leveraged buyout funds. For example, an original investment of
$2 million in a VC fund that is now worth $1.5 million could generate
an offer of $1.1 million from a potential buyer.


The secondary market value of private equity is often tied to the climate in the public markets. A fund specializing in fiber-optic companies, in which the value of publicly held stocks has fallen 90 percent in the past few years, is unlikely to draw attractive offers from secondary buyers. “Because of the valuation risk built into many of these investments, a buyer is going to be conservative and look for some sort of substantial discount,” says Brett Gordon, vice president at HarbourVest Partners in Boston.

Once a price is agreed upon, the seller and the secondary buyer must obtain the blessing of the fund’s general partner, and that’s not al-ways assured. “General partners often look for limited partners to provide more than just money,” says Jeanne Metzger, vice president of the National Venture Capital Association. “They want them to serve as advisers, to bring their own network of contacts, and commit to being long-term supportive partners.” Occasionally, general partners block the sale of a stake, and the seller ends up back at square one.

To be sure, buying and selling private equity isn’t akin to trading 1,000 shares of IBM on the New York Stock Exchange in about
30 seconds. In fact, it usually takes several weeks to several months for the seller, the buyer, and the general partner to negotiate a deal and conclude the transaction.

Because of the size and complexity of the transactions, purchasing secondary interests in private equity has generally been confined to institutional investors who can bear the price and the long-term costs. But it is possible for individuals to invest in funds that purchase private equity investments—essentially mutual funds for private equity. The minimum required in-vestment in a secondary fund varies widely. The entry point for Landmark Partners’ fund is $5 million, but the requirement is sometimes reduced for individuals with valuable business ties or financial knowledge. At Venture Capital Fund of America (VCFA), which raised about 30 percent of its most recent fund from individuals, the minimum is $1 million.


As opposed to venture investing, a speculative play in which investors hope some minor-leaguers will grow into major-league home-run hitters and compensate for those that strike out, secondary investing is tantamount to assembling a team of veteran singles hitters. When purchasing stakes in an existing venture capital fund, secondary fund owners already have some indication of the managers’ track records. “You’re in effect betting on the horse when it’s halfway around the track,” says Larry Allen, a former managing director at Bear Stearns and current chief executive officer of NYPPe, the New York Private Placement exchange.

The risk associated with investing in a secondary market fund may be lower than that of a venture capital investor, but so are the returns— at least historically. “The return is quicker because the assets are mature, but the exit multiples are lower than you would otherwise get,” says Tony Roscigno, a partner in Landmark Partners, which has reported 30 percent net returns annually since it began investing in secondary private equity in 1989.

According to consulting and research company Greenwich Associates, secondary private equity funds returned 27 percent annually between 1990 and 1999, compared with 43 percent for primary equity funds. But as the public markets soured, the numbers for primary investing went topsy-turvy. For the 12-month period ending September 30, 2001, secondary private equity funds returned 22 percent, while venture funds lost 32.4 percent, according to Greenwich Associates, the private equity research group Venture Economics, and VCFA.

On the surface, purchasing stakes that someone else wants to sack seems imprudent, but buying into a fund can be a good way to speculate conservatively—if you can tolerate the high risk. “Quite often, an individual doesn’t have the [assets] to invest in numerous venture funds and thereby get diversification,” says Brett Byers, managing director at VCFA. “We believe by buying on a secondary basis you can improve returns and reduce risk.”

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