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The Secondary Market and The Structured Partnership Transaction

William Sanford, Colombia Strategy LLC


The Structured Partnership: Extracting Maximum Value from Secondaries Transactions While Avoiding Steep Price Discounts

Structured Partnership Definition

A secondary private equity transaction where parties structure deal terms to address the gap in price expectation between buyer and seller through the transfer of distinct, alternative values, which are identified through the synergies created by the convergence of differing parties.

Structured Partnership Example

A strategic corporate venture group may wish to remove the volatility of private equity investing from its parent's balance sheet, while wishing to retain the strategic value of the holdings. The corporate venture group would seek to structure a secondary transaction with a financial buyer who would purchase a majority stake of the holdings to obtain financial returns. Since continued participation of the corporate venture group with the portfolio increases the likelihood of the portfolio's success, due to its inherent business expertise and experience managing the portfolio, the financial buyer would grant strategic input/ access to the corporate venture group, while taking on all or most of the financial and management risk, as well as the majority of potential financial upside. In this example, opposing needs between parties become complementary and supplementary in the restructuring of portfolio ownership through a structured secondary transaction. This structured partnership results in a win-win situation.

Background

The secondary market for private equity has seen tremendous expansion and growth since 2001. Although the pioneering days in the secondary market originated nearly 20 years ago, in the early 1980s, growth prior to 2001 had been modest and contained within a very select group of niche players. The secondary market has traditionally been recognized as a platform providing exits and liquidity for divestment; however, it has also proven to be one of the most exciting areas for investment in private equity today. Furthermore, expansion of the secondary marketplace is being fueled by the concept of "structured partnerships," which has enabled a slew on non-traditional secondary private equity investors to extract additional value from this market. In addition, structured partnerships, in a large part, have contributed to the sustainability of the secondary market going forwards.

Transactions in the private equity secondaries can be segmented into two categories: distressed and non-distressed sales. Distressed sales of private equity holdings in the secondary market are outright sales driven by the need to generate liquidity quickly. Distressed sellers are investors that either: cannot meet capital calls, cannot afford the volatility of private equity investing, require cash immediately to support other internal operations, or, for a number of various reasons, are forced to make an exit. Non-distressed secondary sales of private equity holdings are sales by sellers who no longer wish to remain in certain private equity positions. Motivational factors range from simply seeking exits from underperforming assets or investments that are no longer strategic to changes in management, and, often, the desire for an outright exit from the asset class as a whole.

During 2001 and much of 2002, the majority of transactions in the secondary market were spurred by distressed sellers seeking immediate liquidity, at high discounts. However, the majority of distressed sellers have since exited, leaving many non-distressed sellers taking their time to find the most prudent arrangement to exit their positions. This has encouraged the development of the concept of structured partnerships, where buyers and sellers are developing creative alternative structures in the transaction of private equity assets in the secondary market.

Structured Partnerships

The Concept

The concept of structured partnerships was developed by the secondaries specialist firm, Columbia Strategy, in the widely acclaimed secondary market research report it produced in 2002, Opportunity in Adversity: Private Equity Secondaries and Directs. Structured partnerships are secondary private equity transactions where parties structure deal terms to address the gap in price expectation between buyer and seller through the transfer of distinct, alternative values, which are identified through the synergies created by the convergence of differing parties. As the respective needs differ between parties, a process of self-organization emerges where each individual party's gaps/ needs become directly accommodated by opposing parties. The parties achieve mutually favorable outcomes by carving up ownership of the portfolio in creative ways, where both (if not multiple) parties assume the type of risk they are most comfortable with in effort to obtain respectively desirable future upside and/ or other tangible benefits.

Distressed sellers rarely engage in structured partnerships because they simply do not have the time to find suitable partners for the transaction and conduct extensive due diligence. As a result, they typically chose an outright sale to generate cash. On the other hand, many non-distressed sellers, who have traditionally quietly shopped their holdings in search of a satisfactory price, are now seeking structured partnerships with a buyer or syndicate of buyers where they can retain ownership of certain unique components in the original investment that are most attractive to their business initiatives, while jettisoning the remaining pieces that are not optimal in their respective risk/ reward profile.

The move towards structured partnerships has been in part due to the increased visibility of the secondary market and increased awareness among sellers of available options. Several precedent-setting transactions have yielded an increased confidence in the secondary market as a viable exit scenario. This increased transparency has encouraged non-distressed sellers to explore secondary options, where they might have otherwise been scared away from the secondary market because of the reported deep discounts received by distressed sellers. With this increased awareness, potential sellers have become increasing more sophisticated with respect to leveraging the secondaries market to achieve strategic and financial objectives. This added complexity has resulted in secondaries intermediaries becoming increasingly prevalent to aid potential sellers and buyers in the structuring of such transactions and overcoming the unique hurdles inherent in a secondaries deal.

The move towards structured partnerships has also been largely driven by competitive pressures in the secondaries market. Many distressed sellers sold their investments during the 2001 through 2003 timeframe, leaving those who are not so "distressed" diligently exploring their secondaries options. These less distressed sellers are generally not capital constrained, not undergoing massive restructuring, and are better prepared to ride out the extended investment cycle of private equity. Therefore, the bulk of sellers under enormous pressure to exit have already sold their positions. Today's sellers are more optimistic, as the market has improved substantially, and while they may want to sell or spinout investments for a variety of specific reasons, they will not do so out of panic in a 'fire sale.' The move from distressed to non-distressed sellers has been coupled with a great deal of capital moving into the secondaries market, particularly towards the larger end of the market. Existing secondaries funds have increasingly raised dedicated funds in excess of a billion dollars, levying significant pressure on the large players to compete aggressively for larger transactions. As such, secondaries funds have become increasingly flexible and willing to work to meet the needs of sellers. In short, acquiring the best assets today requires creative structuring that is favorable for the seller. This dynamic is unlike the 'here is your price, take it or leave it' approach of buyers negotiating with distressed sellers in the past.

Transactional Considerations

Structured partnerships are found in a variety of structures, including spin-outs, divestiture entities, and synthetic funds. Structured terms can include distribution preferences, future investment rights, business development rights, sharing of all or part of future cash flows, carving out future upside based on specific investments within the portfolio and essentially an unlimited variety of terms that fulfill both buyer and seller needs. In order for a structured partnership to succeed, there must be a cooperative working relationship between parties, where they understand each other's needs and work diligently to maximize the return for both parties. Such a relationship is pivotal to enable both participants to identify how deal terms will be devised and placed into practice.

Once buyer and seller have established a well-working relationship, both parties must conduct a bottom-up analysis of the portfolio to understand each portfolio company's: net asset value, exit options and time frames, constraints, strategic value, likelihood for success, management teams, products and customers, willingness to approve transfers to secondary buyers, as well as the other numerous metrics that define the likelihood for portfolio company success. Both parties' deep understanding of the portfolio will identify the value that each respective party will bring to the portfolio in partnership and will decide how risk and return will be divided. A strategy for the partnership must be developed jointly where terms must carefully accomplish each party's unique risk aversions, while determining the appropriate role for each party on a going-forwards basis. Upside returns must also be carefully defined and distributed with emphasis on strategic rights and financial distributions.

Due to the requirement that parties involved in a structured partnership must have complementary needs and strengths, often a single buyer will not be able to sponsor the entire transaction or will chose to participate only in select aspects of the deal. As a result, many buyers form syndicated groups. These groups will consist of multiple entities that include domain specialists, who have the technical expertise to assign value to assets, and financial sponsors, who can invest a large amount of capital for purchase consideration and follow-on investment. Intermediaries have become especially valuable in structured partnerships, due to the extensive process, cooperative negotiating and detailed review involved in each transaction. Intermediaries offer the ability to orchestrate the deal by assisting in the formation of the syndicate that will best reflect the needs and requirements of the seller, while maximizing value for all parties involved.

Risks

Structured partnerships can be used to carefully manage risk to the comfort of all parties. However, in addition to the many risks inherent in secondary transactions, other pitfalls such as execution and integration are present, including cost overruns, extensive due diligence, longer transaction times, ineffective deal structures, and the risk of exposing detailed confidential information to counterparties. In particular, if not managed properly, the deal timeframe can become too protracted, running the risk that the seller's position or motivations prior to transaction may change. Structured transactions will generally bear greater costs, both administratively and in the amount of time required to generate, structure and cooperatively manage the deal. However, they can result in significant increases in the risk/ reward profile and encourage those to sell, who might not otherwise do so.

Additionally, structured partnerships involving direct company investments typically require a manager or a general partner to be spun-out with the investments or be recruited and packaged with the deal. The manager must be sufficiently incentivized and capable of successfully managing the portfolio and enhancing returns. Intermediaries have played a strong role in designing these structured partnerships, minimizing the associated risks, managing the parties' expectations, and ensuring that the proper management of directs is in place, on an ongoing basis.

Conclusion

Structured partnerships is a concept that allows existing private equity investors to expand their scope of secondaries opportunities. Structured partnerships build upon the strengths of opposing entities to achieve returns that are generally unobtainable by the individual entities themselves. In addition, structured partnerships can be used to satisfy the parties' needs while carving out specific risks according to the parties' appetites. Similar to the idea of competitive advantage, structured partnerships not only enable risk/ return profiles that were previously deemed difficult to achieve, but spur integration and innovation among multiple parties from various, unique positions throughout the investment field.

The primary risk of attempting a structured partnership is resulting in a failed attempted partnership. The inherent complexity of the process does not make it certain that a partnership will succeed, and a failure will result in significant losses in time and capital. However, in understanding the risks and enabling a mutually, value creative environment for the development of a partnership, risks can be vastly minimized.

Structure partnerships are driving the innovation and growth in the secondary marketplace today and will remain a long-term iteration of secondaries.