AT MIDNIGHT ON On August 31, 1602, the public offering of shares of a new type of company was closed. The charter of the company, the Dutch East India Company, granted it a monopoly of trade with Asia until 1623, when it was assumed the company would be liquidated. Twenty-one years is a long wait for the return of capital. Small shipping businesses were usually wound up and the spoils split after three or four years, when (and if) the ships returned. The shareholders therefore had a opt-out option after ten years. It didn’t matter. A faster way out soon opened.
The merchants who gathered daily around Amsterdam’s New Bridge to trade spices and grains showed willingness to buy and sell stocks. These developments are reported in “The World’s First Stock Exchange”, by Lodewijk Petram, historian. One of the many lessons from the book is that wherever there is a primary market for a new type of asset, there will soon be a secondary market.
There is a modern analogy in the treatment of holdings in private equity funds. Limited partners of these companies – pension plans and sovereign wealth funds that provide capital – are typically hired for the life of the fund, which is typically ten years or more. The reality is different. A thriving market for “secondaries,” negotiated sales of limited partnerships, has emerged with the maturity of private equity. Private equity investors today are no more stuck on their commitments than the bourgeoisie of Amsterdam were four centuries ago.
Secondary markets are driven first by asset holders who really need cash. The first sales on the Amsterdam stock exchange were usually made by merchants who could not afford the promised subscription. In private equity, the first secondary transactions were usually struggling sales. They were often hit with large discounts – 25% or more – to the appraised value of the fund’s assets.
Over time, the stigma of selling faded: in 2019, around $ 85 billion in stakes changed hands. These days, the reason for selling a stake is often strategic. This may involve rebalancing portfolios by geography, industry or year for risk management reasons, for example, or to reduce the number of relationships with general partners of private equity firms. Many limited partners simply want to manage their private assets as actively as their listed assets. Often the 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 conducted by general partners, says Andrew Sealey of Campbell Lutyens, a consulting firm. It could be that a ten-year fund is about to expire whose general partners are unwilling to sell the business portfolio because the timing is not right for a good exit price. However, some of the sponsors will need their money.
The solution is a continuation fund. One example is Nordic Capital VII, a fund established in 2008, which transferred its nine portfolio companies to a € 2.5 billion ($ 3 billion) continuation fund in 2018. A price was set by auction. . Investors had the choice of selling their holdings at a premium over estimated value or staying five more years. Most chose to stay.
The boom in secondary trade has been supported by the rapid growth of specialist funds. Twenty years ago there were only a handful; now there are dozens of them. Five of the ten largest private capital pools raised last year were for specialized secondary funds.
The secondary market attracts large fund managers who want to offer their clients the full range of assets, including private ones. For starters, it seems a lot less crowded than the main business. “Anyone can set up a buyout fund,” says one fund manager. Funds often compete with each other to buy the same companies. In a secondary fund, on the other hand, there is a better chance of benefiting from the expertise. It requires sophisticated analysts and good information gathering to assess a stake in a portfolio of companies when it is put up for sale. The general partners have the right to approve the buyers of second-hand shares. These are high barriers that potential rivals must overcome.
Paradoxically, the rise of the shorter-term secondary market has allowed the formal time horizon of private equity funds to expand almost indefinitely. In this area as in others, private equity follows the Amsterdam of the 17th century. In its early days, the Dutch East India Company was supposed to have a limited lifespan. This was still going on almost two centuries later.
This article appeared in the Finance & economics section of the print edition under the title “Going Dutch”