Are secondaries too good to be true?

Cyril Demaria, head of private markets at Wellershoff & Partners, argues secondaries provide a false sense of security to investors and that the benefits of mitigating the J-curve may have been oversold to LPs. Sister publication Secondaries Investor caught up with him about his latest study looking at the performance of secondaries versus funds of funds.

Your latest research says there is ‘no free lunch’ when it comes to secondaries. What does this mean and what did you find?

Secondaries are often seen as providing the best of private markets with shorter time-to-cash-flows. They also give a sense of control to buyers who can see the actual assets in portfolios for sale. Secondaries are therefore reassuring: investors are under the impression that they cannot go wrong as portfolios include assets clearly identified, theoretically diversified, supposedly at a discount, historically exhibiting a high return while requiring a shorter time exposure. This impression is so strong that investors are tempted to ditch primary investments altogether for pure secondaries programmes.

Cyril Demaria

This is dangerous. Secondaries provide a false sense of security. In fact, they are an expert’s game. Non-expert buyers should aim at a rationale beyond returns, as market conditions are unfavourable. These extra reasons include getting access to coveted fund managers for future commitments, or chasing opportunities in niches or under the radar. The former can be expensive and the latter requires expertise.

Are the promises for secondaries “too good to be true”?

In finance, risks and returns have a direct connection. In private markets, this relationship is a triptych: risks-returns-liquidity. If you want more of one, the others have to give. Secondaries are supposed to provide buyers with faster cash inflows than with primaries. Logically, returns are lower. In secondaries, investors in effect trade returns for liquidity.

When we write that secondaries are “too good to be true”, we refer to the fallacy of using internal rates of returns (IRRs) to measure their performance. Secondaries return cash fast, and IRRs are highly time sensitive. The measure is rigged from the outset. A fairer measure is cash-on-cash (through distributed-to-paid-in, DPI) on a base 100 if primary-secondary comparisons are involved (to avoid biases associated with credit lines). Primary-secondaries comparisons should also factor total costs and actual drag on performance of unused cash.

You talk about the “myth of education” through secondaries. Are buyers deluding themselves when it comes to due diligence?

Buyers might be optimistic or naive. It is a well-known cognitive bias to give more weight to what we see and what we know, than what we can’t and don’t. Buyers assume that as they can look at assets for sale on the secondaries market, the game is easier and they can learn a lot in a short time frame. This is not true.

Asymmetries of information are structurally higher in secondaries than in primaries, due to differences in time constraints (a few weeks in the first case versus months in the second) and in terms of quantity and quality of information (a few quarterly reports versus a full due diligence). In fact, secondaries discounts exist to compensate this information asymmetry and that time pressure. In that context, thinking that investors can learn private markets investing through secondaries is akin to learning how to surf by just watching the waves.

Have the benefits of mitigating the J-curve been oversold to LPs?

Yes and no. Secondaries fit a specific role: they are a tactical instrument completing strategic allocations through private markets primaries. They can be useful, but should be used discerningly. In an ideal world, opportunities would show up exactly as investors want them.

This rarely happens. When it does, market conditions are usually difficult and investors tempted to wait and see. With hindsight, starting a private markets programme in 2008 by loading up on secondaries of quality with deep discounts while simultaneously launching a long-term primary programme was a great idea. Doing it was rather difficult.

The complaint of the “pain of the J-curve” is also overplayed. In a programme of primaries, the J-curve happens only once: at inception. As serious investors deploy capital regularly, their programme at cruise pace recycles distributions to fuel further commitments, while creaming off performance. In that context, are secondaries necessary? On the contrary, a theoretical programme consisting purely in secondaries imply a series of steep but systematic “J-curves”.

Cyril Demaria focuses on illiquid assets and is based in Wellershoff’s Zurich office. His prior experience includes founding multiple funds and being in charge of private markets research in the chief investment office of UBS.