AT MIDNIGHT ON August 31st 1602, the public offering of shares in a new kind of enterprise closed. The charter for the venture, the Dutch East India Company, granted it a monopoly on trade with Asia until 1623, at which time, it was assumed, the firm would be liquidated. Twenty-one years is a long wait for capital to be returned. Smaller maritime ventures were generally wound up and the spoils divided after three or four years, when (and if) the ships returned. So shareholders were given an option to cash out after ten years. It hardly mattered. A faster exit route soon opened up.
The merchants who gathered daily around Amsterdam’s New Bridge to trade spices and grain proved as willing to buy and sell shares. These developments are recounted in “The World’s First Stock Exchange”, by Lodewijk Petram, a historian. One of the book’s many lessons is that wherever there is a primary market for a new kind of asset, there will soon be a secondary market.
There is a modern-day analogue in the treatment of stakes in private-equity funds. The limited partners in such ventures—the pension schemes and sovereign-wealth funds that provide capital—are in principle committed for the life of the fund, which is usually ten years or longer. The reality is different. A thriving market in “secondaries”, negotiated sales of limited-partner stakes, has emerged as private equity has matured. Today’s private-equity investors are no more locked-in to their commitments than were the Amsterdam burghers of four centuries ago.
Secondary markets are first prompted by asset-holders who really need the cash. The earliest sales in Amsterdam’s stockmarket were usually by merchants who could not pay the promised subscription. In private equity the early secondary transactions were typically distressed sales. They were often struck at biggish discounts—25% or more—to the appraised value of the assets in the fund.
Over time the stigma to selling out has disappeared: in 2019 around $85bn worth of stakes changed hands. These days the reason for the sale of a stake is often strategic. It might be to rebalance portfolios by geography, industry or vintage for reasons of risk management, say, or to reduce the number of relationships with the general partners of private-equity firms. A lot of limited partners simply wish to manage their private assets as actively as their listed ones. Often funds will sell for more than the appraised value of the companies in the portfolio.
Over the past decade there has been a trend towards secondary transactions led by general partners, says Andrew Sealey of Campbell Lutyens, an advisory firm. It might be that a ten-year fund is about to expire whose general partners do not want to sell the portfolio of companies, because the time is not propitious for a good exit price. Some of the limited partners will need their money back, though.
The solution is a continuation fund. An example was Nordic Capital VII, a fund set up in 2008, which transferred its nine portfolio companies into a €2.5bn ($3bn) continuation fund in 2018. A price was set by auction. Investors had a choice of selling their stakes at a premium to appraised value or staying in for five more years. Most opted to stay in.
The burgeoning trade in secondaries has been underpinned by the rapid growth of specialist funds. Twenty years ago there were just a handful; now there are dozens. Five of the ten largest private pools of capital raised last year were for specialist secondary funds.
The secondary market attracts big fund managers who want to offer their clients the full range of assets, including private ones. For a start, it looks a lot less crowded than the primary business. “Anyone can set up a buyout fund,” says one fund manager. Funds often compete to buy the same companies. In a secondary fund, by contrast, there is a better chance of profiting from expertise. It requires knowledgeable analysts and good information-gathering to appraise a stake in a portfolio of companies when it comes up for sale. The general partners have the right of approval over buyers of secondhand stakes. These are high barriers for would-be rivals to clear.
Paradoxically, the flourishing of the shorter-term secondary market has allowed the formal time horizon of private-equity funds to extend almost to infinity. In this, as in other ways, private equity is following 17th-century Amsterdam. At its outset the Dutch East India Company was supposed to have a limited lifespan. It was still going almost two centuries later.
This article appeared in the Finance & economics section of the print edition under the headline “Going Dutch”