LP Radar: Secondary myth-busting

Secondaries are clearly pretty popular with investors at the moment, judging by all the money being raised for the strategy lately. According to PEI’s Research & Analytics team, secondaries specialists collected $22.2 billion in 2013, which means they’ve now accumulated $44.1 billion in the last two years. That’s up from just $9.6 billion in 2011 (whether this level of enthusiasm is entirely warranted is a moot point – although since total deal volume last year is thought to have been about $28 billion, it doesn’t seem excessive).

As such, at a recent private equity conference in New York, it was interesting to listen to a panel of current and former LPs with specific secondaries expertise talk about some of the myths surrounding today’s secondary market. One clear takeaway from their conversation was that it’s dangerous to rely on ‘conventional wisdom’, particularly in determining one’s appetite for secondaries – because it may well be wrong. Now more than ever, secondaries represent a moving target, they said; staying up on the current trends is a challenge for new entrants and experienced investors alike.

Take, for instance, the widely-held idea that secondary investing will inevitably deliver much lower returns than primary investing.

“The single biggest myth about secondaries is that there’s such a large spread between what happens on the primary side and what happens on the secondaries side,” argued one former LP. “When you look at a secondary fund, the general thought process is: ‘High IRR, shorter duration cashflows and a lower multiple’. But if you go back and spend a little bit of time looking at how some of the very large pension funds have done, and you look at the multiples [on the primary side], there’s actually not such a big difference.”

It’s true that most primary GPs target a return of 2x or above, while most secondary funds realistically target a multiple of around 1.3x to 1.4x, sources say. However, most buyout funds end up with at least one or two duds that bring the overall cash-on-cash multiple down below 2x, according to another LP who focuses exclusively on secondaries.

As a result, she says: “The myth that you give up so much multiple in exchange for IRR [in secondaries] I don’t think is actually true. We haven’t really sacrificed anything on the multiple side and we’ve done better on the IRR side. So there’s a clear path to say secondaries are better on a risk-adjusted basis than a pure primary programme.”

Still, it’s hard to make an apples-to-apples comparison. And it’s not as though big LPs could invest all their private equity allocation in secondaries even if they wanted to, because the market just isn’t big enough.

“You can’t deploy $40 billion in secondaries,” she adds. “So I think there is a caveat to saying [secondaries] are a better asset class.”

However, the overall performance of secondary investments has demonstrated less volatility than buyouts in recent years, according to the first LP.

“If you look at primary funds, there are managers that heavily underperform. But when you look at the secondaries side and you look at the dispersion of the returns, the clustering is all above 1x, not below 1x,” he said.

NOT SO END-OF-LIFE

Some of the newest (and most complex) types of secondary transactions are fund restructuring deals, which allow some LPs in the fund to cash out and others to invest in a newly created vehicle housing the remaining portfolio companies. There’s been a lot of talk about these transactions in the last couple of years. But finding a deal that makes sense for all concerned remains easier said than done.

“We like to buy quality GPs and we like to buy assets at the right inflexion point – usually three to six years into the life of the fund – where there’s still value creation to go and you’re not just left with the companies that are the losers,” another LP said.

“We like a GP that has a going concern and an alignment with us going forward. Those are hard boxes to check when you’re looking at 12 year old fund with a GP who will never raise capital again.”

One of the main challenges with fund restructuring deals is the fact that there is no track record of successful outcomes – purely because the area is no nascent.

“If you had asked us three or four years ago what was going to happen in the GP restructuring market, we would have said: ‘We have no idea what you’re talking about’,” one former LP said.

Secondary directs, where an LP makes a direct investment in an existing fund investment or portfolio of fund investments have also grown in popularity among LPs. But they tend to be riskier, at least for the uninitiated, the LP added.

“It is easier to lose money in the secondary directs. You’re backing a manager who didn’t necessarily start with this pool of assets, [and] you don’t really know that much about what’s going on. Frankly, that’s why there are dedicated firms who do that.”

So secondaries clearly still come with a health warning. But some LPs will tell you that – relatively speaking, and on a risk-adjusted basis – they’ve never looked more attractive.