Wednesday, February 12, 2014

Unreported Abuse: Stapled Secondaries

Unreported Abuse:  Stapled Secondaries

In periods of euphoria, institutional investors and banks tend to get overweight in whatever is the hot asset class.  It’s like dining at an all you can eat buffet and winding up with too much on your plate.  If investors or banks pile up too much equity or fixed income, it’s usually pretty easy to clear their plates by selling securities or firing managers.  However, if they’ve overindulged in private equity (PE) or real estate (RE), the disposal process is much more complicated.  Not only are these investments illiquid, but also the partnership agreement routinely prohibits the investor from transferring the investment without the approval of the general partner.  The sale of an existing partnership interest in a PE or RE fund is known as a “secondary.”

Sketchbook #7 (2001)

This situation brings three unfortunate factors into play.  First, selling illiquid assets usually brings out the vulture in potential buyers.  Since the institution or bank is in a jam, buyers want to take maximum advantage of the situation.  Unless the seller can surface multiple potential buyers, the seller is likely to face a hefty discount.

Second, there’s the embarrassment factor.  I don’t know of many investors who are eager to reveal that they’ve overindulged.  Most investors and banks would prefer to remove the excess private equity or real estate exposure from their plates as inconspicuously as possible.

Finally, there’s the step of getting the private equity or real estate manager to consent to the sale.  Some of these managers will readily grant approval, so long as the buyer is a reasonably reputable investor.  And I can understand why a PE or RE firm would be reluctant to allow a hedge fund or other aggressive investor to assume the holding.  However, some PE and RE managers see the secondary sale as an opportunity to squeeze the seller.  They’re basically saying, “I’ll only help to clear your plate if you give me a big tip.”  The tip in this case is where the “staple” comes into play.

The manager will approve the transfer if the seller or buyer agrees to invest in the manager’s next fund.  Thus, the transfer is stapled to the secondary sale.  In many cases, the manager probably doesn’t have a very good track record, so the staple is a way of coercing an investor into committing to his next fund.  Whether the seller or buyer agrees to the staple, the seller is the one paying the price.  If the seller agrees to invest in the manager’s next fund, the seller has only gotten a temporary reprieve from exposure he’d rather not have.  If the buyer agrees to the arrangement, he’s going to factor the concession into what he’s willing to pay the seller for the secondary.  One way or the other, the seller is going to be squeezed by the very PE or RE manager to whom he’s paid huge fees.

Dan Primark, who writes the daily newsletter Term Sheet[1], reports in the last couple of days that he’s gotten a few anonymous emails from investors who feel they’ve been abused by stapled secondaries.  As I mentioned earlier, embarrassment plays a large role in the secondary process, so the abuse will go on unabated.


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