The credit crisis and general economic conditions have caused a rising number of investors to flock to the secondary market in search of liquidity. (See related story) The Harvard University endowment has announced plans to sell about $1.5 billion in leveraged buyout funds, and other large institutions have taken similar steps. Financial institutions including Citigroup Inc. and affiliates of American International Group Inc. have also been prominent sellers. Overall, the industry is experiencing a significant supply-demand imbalance, which should widen in 2009.

Market forces have also made pricing very attractive for secondary buyers. Secondary transaction pricing is typically based on a percentage of the fund's net asset value or the limited partner's capital account balance. According to secondary market investment banking firm Cogent Partners, the simple average high bid for interests in venture and buyout funds fell from 84.7% in the first half of 2008 to 61% in the second half of 2008. This decline is consistent with public equity values in 2008 and could accelerate in 2009, given the increased supply of secondary interests and continuing turmoil in the public markets. Although these statistics are helpful, fund pricing is driven largely by underlying portfolio assets, so the notion of a "market discount" will not apply in most secondary sales.

Although the secondary market is relatively mature, it remains highly fragmented. Some large financial institutions have secondary funds, but a number of independent funds dominate the market. While advisory firms are active in the secondary market and can add value in the pricing and bid process, many limited partners are sophisticated enough to proceed on their own.

Cooperation of the general partner or fund manager is critical to the business due diligence process. Legal due diligence focuses on the fund's partnership agreements and any side letters.

Most fund agreements require general partner consent for transfers and substitutions, and some fund agreements contain right of first refusal procedures that the general partner may need to observe or waive.

The typical transfer documentation will consist of an assignment agreement, a purchase agreement and subscription materials. A separate purchase agreement is often used to ensure confidential treatment of the purchase price. The purchase price, calculated by discounting the fund's NAV or the seller's capital account balance, is typically adjusted downward for any distributions or upward for any capital contributions made since the last measurement date.

As a substitute limited partner, the buyer will step into the seller's shoes for purposes of the fund agreement -- as if the buyer had been the limited partner from inception. However, as between the buyer and seller, the buyer will seek to limit any exposure to investor liabilities that predate the transfer through indemnification provisions in the purchase agreement.

Alternatively, a seller may take the position that a secondary sale should be conducted on an "as is" basis, particularly if the fund interest is priced at a discount.

The seller will typically give basic representations regarding ownership, title, etc., but will resist any representations regarding the underlying fund investments or performance. The buyer's representations will focus on its status as an accredited investor and other securities issues.

As private equity and buyout funds do not permit periodic redemptions, and the life cycle of these funds typically ranges from eight to 12 years, the secondary market offers an attractive liquidity option to investors during challenging economic times.

During the bull market of recent years, a limited partner could rely on periodic distributions made by the fund upon the sale of a portfolio company or other liquidity event. However, the freezing of M&A as well as the initial public offering and debt markets has dramatically altered those expectations. For a limited partner experiencing a short-term liquidity crunch, the secondary markets may be the only solution.

Ted Wern is a partner at Perkins Coie LLP.