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Take a Second to Think About Secondaries

An interesting trend is developing in the private equity world: the rise of “secondaries.” The business model of private-equity companies “scouring obscure corners of the business world” for undervalued firms is becoming a thing of the past. ((Buy-in Barons,The Economist, Jan. 18, 2014, available at http://www.economist.com/news/finance-and-economics/21594331-buy-out-firms-selling-each-other-much-their-investors-annoyance-buy.))  Instead, the idea of purchasing companies owned by other private equity firms is slowly gathering momentum. This type of deal is called “secondaries.” ((Id.))

The rise of two factors contributed to the increase involvement in secondaries. First, the task of actually finding a hidden gem is surprisingly difficult. ((Id.)) Engaging in secondaries, essentially, allows a private equity firm that is pressured to make a purchase to take over what is already identified as a good target. And that leads to the second point. In the aftermath of the financial crisis, many private equity firms were “left with slimmed-down teams,” and therefore, they are less likely to commit to the costly due diligence of actually finding a diamond-in-the-rough. ((Id.)) Dusting off the old documents from the previous sale is cheaper and potentially safer.

Studies have shown that secondaries are no less lucrative than the traditional private equity investments. ((Sabrina Wilmer, Calpers Said to Enter Buyout Secondaries Business, Bloomberg Personal Finance (Nov 13, 2013), http://www.bloomberg.com/news/2013-11-13/calpers-said-to-enter-buyout-secondaries-busines.html.)) The increased involvement in secondaries is shown by the fact that, in 2013, half of the deals conducted in Europe were secondaries. However, some large pension funds are less happy with movement toward buying and selling what is already identified by other private equity firms. ((Buy-in Barons,The Economist, Jan. 18, 2014, available at http://www.economist.com/news/finance-and-economics/21594331-buy-out-firms-selling-each-other-much-their-investors-annoyance-buy.)) These funds are concerned with the actual creation of value when private equity firms engage in this type of business. ((Id.)) Furthermore, many of these pension funds invest in both the buyer and the seller, which means the pension fund is the only loser in the transaction (transaction and lawyer fees) ((Id.)). Some other mega funds, however, welcome this new business model. California Public Employee’s Retirement System (CalPERS) is the largest U.S. public pension plans to start directing as much as $600 million a year to secondaries. ((Sabrina Wilmer, Calpers Said to Enter Buyout Secondaries Business, Bloomberg Personal Finance (Nov 13, 2013), http://www.bloomberg.com/news/2013-11-13/calpers-said-to-enter-buyout-secondaries-busines.html.)) Other international funds, including Abu Dhabi Investment Council and Canada Pension Investment Board, have already expanded their involvement in secondaries in the recent years. ((Id.))

Practically speaking, it is potentially a good idea for pension funds to get more involved in secondaries. First, it allows the large funds to lower their administrative and transaction cost. ((Id.)) Large funds do not need to pay investment firms to comb through investment options. ((Id.)) The funds are also able to invest in firms with proven record, which is paramount for funds that are risk-adverse.

On the other hand, this type of investment could be detrimental to these real diamonds-in-the-rough firms. ((Buy-in Barons, The Economist, Jan. 18, 2014, available at http://www.economist.com/news/finance-and-economics/21594331-buy-out-firms-selling-each-other-much-their-investors-annoyance-buy.)) The fund that would have gone to them is now directed to other firms that already have financial support. This movement toward conservative investment could slow down the development of innovative mid-size firms. This new trend also tends to keep the money within some selected high-potential firms at the expense of firms with, perhaps, even higher potential.  Further, this is a problem for the private equity industry as a whole. As pointed out earlier, if the middlemen are unimportant, and if all they are doing is to piggyback on someone else’s prior investment, then what is the point of having these expensive professionals at all? Sure, the large private equity firms will survive because, after all, these funds need to acquire the assets from somebody, but the smaller private equity firms are less likely to have a portfolio to attract these large funds.

Regardless of the cons, having more involvement in secondaries has become a new trend. It will most definitely change the way private equity firms conduct their business if they do not want to be marginalized.

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Robin Liu

Vol. 3 Associate Editor

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