How to determine the price range of your transaction: Secondary sale of a portfolio of interests in closed ended funds
09. May 2017 | Didier Guennoc
The surge in the use of virtual data rooms has certainly increased the information readily at the disposal of the parties. However, every investment requires different sets of data to be successful. In this article, risk management expert Didier Guennoc presents different scenarios and key parameters for a portfolio sale.
Didier Guennoc, Managing Partner, LDS Partners
The purpose of this post is to map out the key parameters that drive a secondary transaction of a portfolio consisting of interests in unquoted closed-end funds having as investment strategies real estate, infrastructure, venture capital, buyout or any other strategy whereby the underlying assets are also mainly unquoted. Corresponding to this list of parameters, the data requirements to determine a range of possible values within which a transaction could occur will be described.
Parameter #1: Background of the transaction
The reasons why an investor is selling a portfolio of interests in illiquid assets, such as unquoted closed-end funds, drive the negotiation. While the seller has by construction this information, the buyer is interested to know whether the seller acts as a consequence of:
- Liquidity constraints
- Willingness to reinvest the proceeds of the sale in other more promising assets
Option 1 means a steep discount on the fair value of the portfolio might be accepted by the seller (see parameter #2), while option 2 might translate into a premium paid depending on the quality of the assets put on the market.
Data requirement #1: The buyer should gather information on the seller—notably whether the capital committed to the funds comes from its balance sheet or its clients. Note that some private banks invest directly from their balance sheet but on behalf of their clients who will be called by the bank. This way of proceeding blurs the picture for the buyer. Unless information is readily available on the liquidity position of the seller, balance sheet records can provide information on its solvency and liquidity.
Parameter #2: The fair value of the portfolio and of its underlying assets
Because the interests in the closed-end funds are not quoted, the transaction will be done mostly on best estimates of their fair values—i.e. values resulting from appraisal processes and not from observed prices in an active market.
As the fair value does not result from observed prices of transactions, the seller and buyer will need a significant amount of information on the underlying assets to calculate their own fair value. Experience shows that market participants tend to see the fair value of the funds as the sum of the fair value of the underlying instruments invested in the underlying assets. This is not wrong per se but the calculated value potentially suffers from not accounting for (i) the impact of future capital calls/investments (see Parameter #3), (ii) an underestimated correlation between assets and (iii) FX rates movements—if relevant. All these disregarded factors might result in a fair value at the fund level being far away from the net present value of the expected cash flows from and to the fund.
Data requirement #2: Gathering all historical cash flows from and to the fund and valuations of the portfolio as a whole and the ones of individual assets plus their key financial metrics and characteristics to recalculate their fair value. Both parties might have difficulties rebuilding the fair value chain from underlying assets to the one of the fund due to limited information on the underlying assets provided by the fund managers to their investors. When the sale is done via auction, the time given for due diligence might be short to rebuild the fair value chain. In such situations modelling methods at the fund level can provide for quantitative measurements to help the decision process (see below Parameter #4)
Parameter #3: The uncalled capital
Beyond the fair value, a secondary transaction is also driven by the uncalled capital that the seller should honour without the sale. Such uncalled capital is similar to liabilities with closed-end funds, calling the committed capital over periods of time exceeding several years. Transferring these liabilities from the seller to the buyer has a price tag attached to it and correspondingly impacts the discount on the fair value discussed above.
Data requirement #3: The amount of uncalled capital is not easily calculated by deducting from the committed capital the capital already called. Specific contractual clauses, such as reduction in size of the fund after a certain period of time (e.g. real estate funds) or recallable distributions (e.g. real estate and buyout funds), require a thorough analysis of the applicable by-laws of a fund at the time of the transaction and a reconciliation of the corresponding amounts. Both sides of the transaction also take into consideration any forex impact when their functional currency is different than the ones of the funds. In such a case another layer of difficulty is added when determining the amount of uncalled capital as future forex rates will play a role.
Parameter #4: Distribution of expected returns
The future forex rates mentioned above also impact the expected future returns of the underlying instruments. These expected future returns of both sides of the transaction are limits defining the boundaries within which the seller and the buyer are willing to transact. The less sophisticated approach consists of setting three scenarios for each fund to determine these boundaries: low, base and high case scenarios. This deterministic approach usually considers superficially the correlation between underlying assets and impact of forex rates. The more sophisticated approach will be based on stochastic models that forecast expected future cash flows (amount and time of occurrence) to extract a distribution of potential returns of the portfolio with their corresponding probabilities, allowing to extract such indicators as the value at risk, median value, etc.
Data requirement #4: The data required are external data, such as returns on comparators, public indices, past Forex rates and other elements required to run the models presented above. The challenge is to compile these data from different sources and to make them compatible with the models used and also with the funds being studied (e.g. determining whether a real estate fund used as comparator deploys a value added or an opportunistic strategy is not a straightforward exercise).
What makes the transaction materialise?
Taking into consideration only situations by which the seller is not constrained by a liquidity shortage means the transaction occurs when the price offered by the buyer results in a return that is higher than the minimum value of the distribution of expected returns modelled by the seller (by construction this price should allow the buyer to meet its objectives based on its own estimated distribution of future returns—taking into account potential acquisition leverage). Only when the seller’s expectations of the returns of reinvestment alternatives of the proceeds of the sale and the freed capital calls compensate for a too low offered price can it result in the transaction materialising.