Always auction

In recent years, finding a reliable gauge of pricing in the secondary market for private equi-ty funds has been the institutional investor's equivalent of a Sherlock Holmes mystery – a guessing game to the end. Speakers at private equity conferences are inevitably asked for their insights on the subject; and to the audience's dismay they are rarely able to give a conclusive answer.

Why the shroud of uncertainty? One culprit is a dearth of historical information about secondary transactions. Even in an industry where confidentiality is the rule, deals for secondaries may be the most closely guarded. This has remained true even as the secondary market has grown in size and importance within the private equity sector.

For institutional investors seeking to optimize their portfolios through the sale of secondary assets, estimating market value with-out solid data becomes little more than a shot in the dark. To realize an asset's true potential in the marketplace, portfolio managers need more information about recent secondary transactions and the range of bids received in the auction process.

Cogent Partners recently conducted a study encompassing more than 100 fund interests transferred on the secondary market. While the study sheds light on current pricing levels in the secondary market, the data show that there's no such thing as a ?market price.

Instead, the numbers reveal several key findings that may surprise and enlighten the institutional investing community:

selected bidders in a competitive auction process increases the likelihood of obtaining the highest price.

As institutional investors consider accessing the secondary market, the following discussion provides an in-depth look at the widespread bids the market presents, the reasons behind the disparity, and its implications for sellers of secondary assets.

PRICING SPREADS ARE EXTREME
As shown in Figure 1, the average high bid (the simple average of the highest individual bid received for each asset) across all assets in the sample was 110.2 percent of the net asset value (%NAV) reflected on the most recent fund financial statements, with an average median bid of 88.5%NAV and an average low bid of 61.1%NAVThe buyout funds in the sample priced substantially higher than venture funds, with an average high bid of 155.5%NAV versus venture's 894%NAV.

Perhaps even more noteworthy than the average high bids are the disparate spreads of the bids. Even in openly competitive situations with equal information supplied by the seller's intermediary, bids for secondary assets were, quite simply all over the map.

Across all 105 assets, the average spread between the high bid and the low bid (again, measured as a percent of NAV) was 49.1 percentage points. The spread between the median bid and the high bid was 21.7 percentage points.

In our sample, examining the spreads by asset class provides counterintuitive data. While buyout funds are arguably easier to value from financial statements than venture funds, the buyout funds produced the larger spreads of the two classes (High-Low bid spread of 73.3 percentage points for buyout versus 41.8 for venture; High-Median bid spread of 34.6 percentage points for buyout versus 17.4 for venture). This unexpected result is due to the limitations of examining only the gross NAV spreads. This method does not indicate the relative impact that overall pricing has on the spread. Essentially as overall pricing on a fund is lower, the spread of the bids appears more dramatic. For example, when a fund is pricing at 20%NAV, a spread of only 10 percentage points increases the price by 50 percent.

ODDS FOR FAVORABLE PRICING INCREASE WITH NUMBER OF BIDDERS
The dispersion of the bids provides insights into the composition of buyers in the marketplace. Most bids came close to the median bid received, with more than half of the bids falling between 90 percent and 110 percent of the median bid received for the fund. This median-focused distribution is consistent across all asset classes, though venture funds did experience more outlier bids at over 150 percent of the median.

The results of this study are demonstrative of the value created by a well-run competitive transaction. Sellers often question the strategy of bringing numerous potential buyers into a process, believing that only two quality bidders will ultimately drive to the ?market price. The numbers tell us differently Although the average high bid was 130 percent of the median bid, the chances of achieving that level of pricing with only one or two bidders is small. In this sample, there is only a 20 percent probability that any single bid will be more than 110 percent of the median. By engaging a second bidder, those odds of exceeding 110 percent of the median improve only modestly to 36 percent. The lesson here is that while most potential buyers submit rather predictable bids, increasing the number of bidders in the process increases the chances of receiving an outstanding price.

So why do some potential buyers bid so much more than others? The answer can be found in their varying perspectives. Pricing of private equity secondary interests involves valuing the invested assets, estimating a realistic return given the risk level of the assets, and assessing the blind pool risk associated with uncalled capital. Different bidders, however, interpret the information in different ways.

EFFECTS OF BLIND-POOL RISK
For buyout funds, the data does not support an assertion that different perceptions of blind pool risk create wide bid dispersion. Though admittedly a small sample, the four funds between 50 percent and 70 percent called had an average high bid of 130.5 percent of the median bid, while funds more than 70 percent drawn had a high bid of 125.2 percent of the median bid. Interestingly, the average low bid for the more drawn funds was weaker (68.3 percent of median) than the low bid for the less mature funds (81.7 percent of median).

If blind pool risk was a major contributor to pricing spread, one would expect the pricing spread to tighten as the amount of blind pool risk in an asset was reduced. For these buyout funds, however, the opposite is true. For funds between 50 percent and 70 percent called, the difference between the average high bid and average low bid was 48.8% of the median price. Funds over 70 percent drawn had a high bid to low bid spread difference of 56.9 percent of the median bid.

The data for venture funds leads to different conclusions. For venture funds under 50 percent drawn, the average high bid was 230 percent of the median bid received for the fund. Again, the wide range may be explained by the differing perspectives of the bidders. Principal investors who don't specialize in secondary transactions are more likely to view the uncalled capital as they would any private equity investment, and bid based on the value of the assets. Secondary specialists, however, may apply a discount to the current bid that equalizes their required return from the uncalled capital and the return projected for the fund manager.

A THOROUGH AUCTION PROCESS IS ESSENTIAL
From an abundance of data and analysis comes one striking realization: when determining what the market will bear for secondary private equity assets, it depends on who you ask. Despite the fact that the bids in the sample were collected in an openly competitive process; despite the fact that all bidders had access to standard information and asset insight from sell-side representation; and despite the fact that all bidders were qualified institutional investors making presumably aggressive bids, the range of prices presented for secondary assets remains exceptionally wide.

As institutional investors seek to obtain optimum pricing for their secondary assets, they may draw several valuable conclusions from this study: The market for secondaries is strong, but there is no substitute for the value of a competitive process when running a secondary transaction. Given the extremely broad range of bids in the auction process, it is highly unlikely that engaging only one or two buyers will yield the highest possible price.

The data also underscores the value of a carefully chosen pool of bidders with differing approaches and investing motivations. Allowing a diverse array of prospective buyers to evaluate the assets generated an incremental 29.6 percent of potential value above the median bid for each asset. In the most convincing case, the average high bid for immature venture was an incredible 230.8 percent of the median bid.

With these thoughts in mind, institutional investors can enter their next secondary transaction with a seasoned approach and a sense of renewed optimism.

Colin McGrady, CFA, is a managing director at Dallas-based private equity advisory firm Cogent Partners. This article is adapted from a broader study released by Cogent Partners titled ?Secondary Pricing Analysis 1H2005: Where is ?the market? and how can institutions achieve optimal pricing? For a copy of the complete study, contact Cogent Partners. www.cogent-partners.net