Direct secondary market sales: the trend continues to build

Direct, secondary market transactions among private equity companies are surging, according a recent survey by PitchBook (co-sponsor of the new PitchBook/BVR Guideline Public Company Comps Tool™). Already, PE investors have completed 56 deals this year—compared to only 45 for all of 2009. These sales accounted for nearly a third (28.1%) of total U.S. exit activity in the first half of 2010, up from 23.5% in the first half of last year and 18.7% during the second half. “2010's median deal amount is about the same as last year's at $206 million, much higher than the overall PE deal median at $120 million,” say the Pitchbook surveyors. “With a $400 billion capital overhang, portfolios of mature investments and favorable credit markets, it's likely we'll continue to see many more secondary deals during the remainder of the year.”

“We foresee a tsunami of secondary transactions on the horizon,” comments Bo Brustkern, whose analysts at Arcstone Equity Research have been working intensively with industry leaders SecondMarket and Sharespost. The perfect storm will continue to build in the private secondary markets as 1) PE and VCs grow more comfortable on the buy- and sell-side; 2) legal counsel grow more comfortable with the transaction mechanics; 3) management gets more frustrated with the lack of exit options; 4) company-designed liquidity programs (such as those pioneered by SecondMarket) become more broadly implemented; and 5) credible research/valuation reports (such as those by Arcstone Equity Research) proliferate.

When will secondary transactions furnish reliable indications of FMV? ”For the foreseeable future, valuation analysts must closely analyze these transactions to understand how and why they transpired,” Brustkern notes. Further, “companies involved in significant secondary market transactions should consider incorporating such activity in their periodic 409A valuation updates.”  But until the private secondary markets begin to exhibit more profoundly the qualities of an efficient market—e.g., similarity of transactions, proximity, volume, supply/demand balance, participants, information quality, information symmetry, and sophistication—“it is quite likely that the valuations arrived at through a fundamental 409A analysis will not yet be equal to the price obtained in secondary transactions,” Brustkern says.

BVR notes that providers of DLOM databases (FMV Opinions and others) are also following these new secondary market transactions closely.  Since many involve discounts because of illiquidity, they are perceived as a valuable new proxy for DLOL and DLOM analyses.