iCapital Network: The Potential Benefits of Investing in Private Equity Secondaries
In this guest post from Kunal Shah and Tatiana Esipovich at iCapital Network, the authors explain how secondary funds offer the potential for diversified private equity exposure and an attractive risk profile.
By: Kunal Shah and Tatiana Esipovich
The secondary private equity market comprises the buying and selling of preexisting investor commitments to private market funds. Secondary funds (secondaries) purchase these existing commitments from limited partners (LPs) seeking to exit primary private equity funds before they are fully liquidated. In recent years, the secondaries segment has grown and matured, and may offer significant appeal to investors.
Exhibit 1: An Overview of Secondary Transactions and Participants
An accessible entry point into private markets
Secondaries offer several potential benefits for investors and may represent a particularly attractive entry point relative to primary private equity funds because of their unique risk and return characteristics.
Diversification: Secondary funds are typically more diversified than primary private equity funds (such as growth equity or buyout funds) because they assume preexisting commitments in multiple funds. As such, secondary funds may offer significant diversification across managers, industries, geographies, strategies, and vintage years. This diversified approach has the benefit of offering private equity exposure with less risk compared to an investment in a single primary private equity fund.
Shorter duration and faster return of capital (mitigated J-curve): In primary private equity funds, it typically takes five to six years to deploy capital, and it can be several years before investors start receiving distributions. By contrast, secondary strategies deploy capital faster and distributions typically begin quickly – in some cases as soon as the fund’s inception – because they are investing in mature underlying funds. This mitigates the private equity J-curve, in which primary private equity funds typically have “negative” returns in the first few years (as investors have to pay management fees and initial investment costs from day one), that then turn into positive returns as the underlying investments mature and start to generate returns that may significantly outweigh the fees and expenses. Exhibit 2 illustrates the typical return profile of a primary private equity fund versus a secondary fund.
Exhibit 2: Typical Return Patterns of Primary and Secondary Private Equity Funds
Discounted access to private equity funds: The ability to exit private equity funds early has historically come at a price to sellers – secondary fund managers would buy preexisting interests in funds at a discount to their net asset value (NAV). As the market grew more competitive in recent years, that discount declined (in 2019, however, secondary portfolios still traded at an average of 93% of NAV1). Secondary investors would benefit immediately from this discount as well as any value creation that takes place subsequent to the investment.
Limited blind pool risk: Investors in primary funds don’t know in advance what investments the fund manager will make. This is known as blind pool risk. Secondaries mitigate blind pool risk by investing in existing commitments. In other words, they know which assets they are acquiring before they invest, enhancing the potential for due diligence and providing visibility into potential future performance.
The state of the market: challenges and opportunities
One upside of the recent market volatility is that pricing levels in the secondary market are expected to potentially adjust downward, leading to a more attractive buying opportunity for secondary fund managers. The secondary market was previously trading at all-time high levels, with large buyout funds being sold at a record-high 100% of NAV.1 These elevated pricing levels were leading to compressed return expectations.
Going forward, a downturn-driven reset will instead see the secondary market readjust to lower valuation levels, enabling secondary fund managers to purchase positions at greater discounts. In all market environments, those managers who succeed in identifying assets outside of competitive auctions or in proprietary situations — or where they benefit from an information advantage — are likely to outperform.
Another element for investors to consider is that, while secondaries can provide a mitigated J-curve and faster return of capital, the cash flow profile of secondary funds is reliant on distributions. If distributions slow (as they might in today’s recessionary market environment), return profiles could lower. Therefore, it is important to select disciplined managers who are keenly focused on downside protection and have a proven track record in navigating market cycles.
For high net worth investors, the secondary private equity market offers several potential unique portfolio benefits. For investors seeking to gain private equity exposure through a primary fund but concerned about the duration or significant gap between making a commitment and receiving distributions, secondary funds may be an attractive option. As with any private equity investment, manager selection is critical to realize the benefits of these strategies.
About the Authors
Kunal Shah is Managing Director and Head of Private Equity Solutions at iCapital.
Tatiana Esipovich is a Vice President on the Research & Due Diligence team at iCapital.
1) Source: Triago Quarterly October 2019.
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security offered by Institutional Capital Network, Inc. or its affiliates (together “iCapital Network”). Past performance is not indicative of future results. Alternative investments are complex, speculative investment vehicles and are not suitable for all investors. An investment in an alternative investment entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital Network assumes no liability for the information provided.
Products offered by iCapital Network are typically private placements that are sold only to qualified clients of iCapital Network through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described involve long lock-ups and do not provide investors with liquidity.
Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. (d/b/a iCapital Network). These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. iCapital and iCapital Network are registered trademarks of Institutional Capital Network, Inc. Additional information is available upon request.
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