When constructing or continuously managing a private equity portfolio, diversification is vital in reducing risk and increasing the expected median return of the portfolio. In a PEI article earlier this year (Private Equity – will you take the risk? May 2008, p. 106-109) we showed that diversification over vintage years is more efficient than over number of funds. A portfolio that is diversified over three vintage years has only half the risk of a portfolio that has been built in one single year when keeping the number of funds per vintage year constant at five.
Secondary transactions can add value to both established investors with existing portfolios and new investors. Established portfolios are often concentrated in terms of vintage years, geography or fund types. Secondaries are able to lower the concentration at various levels and increase diversification. New investors which would like to enter the asset class initially face the problem of very low vintage-year diversification. A portfolio of well selected secondaries over various vintage years addresses this problem and helps investors reduce their risk through a higher degree of diversification. The increased availability and quality of funds in the secondaries market allow for active management of a new or established private equity portfolio.
Besides the enhanced risk-/return profile, a secondary acquisition has two very positive effects on the overall portfolio:
In the following we analyse the effect of secondaries on the NAV and net cash flow of the total portfolio of an investor in more detail. We distinguish between three different cases:
For the modelling of the secondary fund, we assume that individual secondaries are acquired over two years at a price of 100 percent net asset value, which is a conservative approach. A reduction of the purchase price would enhance the net cash flow position of the investor and would shorten the time to break-even.
Capital Dynamics has developed a sophisticated cash flow and net asset value forecast simulator which is based on a “conditional historical approach” that uses a Monte Carlo simulation with 10,000 runs; each reflecting a random private equity portfolio and a random economic cycle. Rather than just showing the median case (white line in red area), like most conventional analyses, the model provides different percentiles of the empirical distribution, like the 25th and 75th percentile (white line between red and light red area), the 5th and 95th percentile (white line between light red and grey area) and the 1st and 99th percentile (white boundary to coloured area).
Portfolio A, consisting of primary funds only, needs about 5.5 years to reach the highest NAV which is approximately 80 percent of the committed capital in the median case. For the calculation we assume a commitment of $100 million to a diversified portfolio of private equity funds. In order to fund the portfolio the investor requires capital of $55 million in the median case (i.e. 55 percent of the committed capital).
Portfolio B is based on a commitment into a globally diversified secondary fund which includes various private equity funds with different strategies and geographies with an average age of three years. At the time of purchase the net asset value of the funds is equal to the amount of open commitments (50 percent each). As expected, the portfolio shows that reaching the target net asset value is accelerated. An NAV of 80 percent of committed capital is already reached after 3.5 years. The net cash flow curve shows that investors need the same amount of cash ($55 million) to fund their total portfolio but capital will be drawn quicker which results in a shorter J-curve. In addition, the breakeven of the cash flow curve can be reached earlier. While it takes about eight years for the primary portfolio, the cumulative cash flow J-curve is positive after 5.75 years in the median case as shown in figure 1 (p. 78).
Portfolio C assumes that an investor acquires a secondary portfolio that is more mature than portfolio B. This is reflected in a higher NAV to open commitments ratio which is 70 percent to 30 percent. In this portfolio the target NAV is reached even faster, while the funding is expected to be lower than in portfolio A and B. As pointed out in figure 2 (left), the investor only needs about $44 million of capital in the median case despite the higher NAV and price of the secondary portfolio. Moreover, the total portfolio would be net cash flow positive after four years. This shows that the maturity of the secondary has a large influence on the break-even point and deepness of the J-curve.
Based on the above we conclude that the maturity of secondaries affects the cash flows and net asset value of the investors' total portfolio. Distributions of secondaries can be expected earlier, and therefore they can fund capital calls of primary funds which lower the net cash flow requirements for the investor as shown in figure 3 (below left).
In summary, secondaries have positive effects on private equity portfolios by mitigating the cash flow J-curve, increasing the private equity NAV much faster and optimising the risk-/return profile of the portfolio due to a higher degree of diversification. Furthermore, careful modelling allows appropriate integration of secondaries into existing portfolios. While cash flow predictions and portfolio allocation questions can be addressed quantitatively, the qualitative aspects are very important as well.
underlying secondary portfolio is a crucial factor for a successful investment. Therefore, the investor or his advisor needs to have market knowledge of and relationships with the managers in order to source secondaries, analyse underlying portfolio companies and evaluate their quality to assess the “fair” price.
Dr. Christian Diller is a vice president at international private equity asset manager Capital Dynamics and leads the portfolio& riskmanagement team. Dr. MarcoWulff is a vice president in the investment management team and co-heads the firm's secondary activities.