Secondaries as a private equity portfolio management tool

As private equity continues to mature as an asset class, sophisticated investors are increasingly turning to the secondaries market as a method of actively managing their private equity exposure. Here Ivan Vercoutère and Wolfgang Müller of LGT Capital Partners outline the benefits and the challenges of using the secondary market as an active portfolio management tool from the perspective of both the “buyside” and the “sellside”.

Introduction

The secondary private equity market has experienced strong growth in recent years and has become an established sub-segment of the private equity industry as a result of the significant growth of primary commitments over the last decade. Investors are also beginning to recognise the benefits of adding and/or increasing the allocation to secondaries within their private equity fund portfolios.

Until recently, the sale of private equity fund interests has been primarily motivated by various external factors. These include: becoming “over allocated” to the asset class on account of the deterioration in value of public markets; changes of management; changes of ownership; changes in the regulatory environment; and need for liquidity. More recently, increased deal flow of secondary transactions has been driven by the need to more actively manage private equity portfolios.


Benefits of buying private equity interests on a secondary basis

Reduced “J-curve” effect
One of the main attractions of adding secondaries to a traditional private equity fund portfolio is that secondaries generate early returns, thus smoothing the J-curve effect of a young private equity portfolio.

Generally, private equity partnerships show negative performance in the early years of the fund life (years one to four or the investment period), as investments are held at cost and management fees and expenses drag the returns down. As the portfolio matures (years four to eight or the distribution period), value is created and realisations lead to positive returns. Hence the creation of the J-curve returns profile.

Compared to the familiar J-curve of a primary portfolio, the return profile of a secondary investment often shows an inverse J-curve return. This is because secondary transactions are often completed at a discount to the general partner’s reported value, leading to an immediate accounting gain and consequently to a high initial internal rate of return (IRR). While the accounting gain is not realised and might come down, distributions in secondary investments should kick in earlier due to the greater maturity of the portfolio. This means early realized returns and superior IRRs.

The addition of secondary investments to a primary portfolio can lead to a significantly smoother J-curve, showing positive returns for a balanced (primary and secondary) private equity portfolio from the outset.

Primary portfolios invested over the last 3-4 years show a particularly deep and long J-curve effect as the difficult economic environment, challenging capital markets and the bust of the technology boom, have led to early write-downs and write-offs of portfolio investments, and fewer exits. Additionally, management fees and expenses compared to invested capital have been particularly high as fund sizes have increased and the investment pace has slowed down. For these reasons, adding a secondary component to a primary fund portfolio in today’s market is particularly compelling.

Accelerated build-up of a diversified private equity portfolio
Buying secondary interests in private equity funds is a useful tool to accelerate the build-up of a diversified private equity portfolio and achieve higher investment levels earlier. While investing in primary funds can take time, as desired funds are only coming to market every three to five years, secondary purchases allow the more rapid addition of targeted funds that are also close to the harvesting phase. Additionally, the target exposure to the asset class can be achieved earlier, as secondary investments are usually focusing on mature funds with limited undrawn commitments.

Increased diversification
Building a private equity portfolio over two to three years on a primary basis results in a limited vintage year diversification. By adding secondaries to the investment programme, the vintage year diversification can be increased significantly – mitigating the risk of being exposed to underperforming vintage years. In addition to vintage year diversification, secondaries offer a broader diversification across managers, sectors, geographies and investment strategies.

Improved risk profile of portfolio
The lower risk profile of secondaries can be a useful tool in improving the overall risk-return profile and hence the efficiency of a private equity fund portfolio.

When investing in a private equity fund on a primary basis, the assets that will be selected for the portfolio are not yet known. This risk is often referred to as the “blind pool” risk. To partially mitigate this risk, the primary investor focuses its analysis on the manager’s skills and track record in sourcing and executing private equity investments. Although this approach should help to more accurately forecast the type and quality of assets the fund manager will acquire, it is not unheard of for managers to modify their investment approach or to react to external factors by adopting a more opportunistic investing style. In both cases the blind pool risk can be exacerbated.

When investing in a private equity fund on a secondary basis, the assets are already known and the fund is closer to the harvesting phase. The ability to value an identifiable set of assets and to negotiate a price eliminates the blind pool risk and provides more confidence in expected returns. In this regard, strong evaluation skills (i.e. company by company bottom-up analysis) and pricing discipline are imperative, especially in the current market environment.

Rebalancing the private equity portfolio
When building a private equity portfolio an investor typically has certain views and strategic objectives on how the portfolio should look in terms of exposure to investment strategies, geography, vintage years or sectors. However, after numerous years of investing, the portfolio might have a different allocation than determined at the outset for several reasons (such as limited dealflow or a different investment pace in certain segments).

Additionally, the market environment and available opportunities change and evolve over time. This might lead to the desire of the portfolio manager to readjust the previously determined portfolio allocation and capitalise on new opportunities. Buying private equity interests on a secondary basis can be a powerful tool to rightsize the portfolio and increase the exposure to underweighted segments and capture new market opportunities (e.g. distressed).


Benefits of selling private equity interests on a secondary basis

Rebalancing the private equity portfolio
There are many reasons why portfolio managers might find themselves under- or overexposed to particular vintage years, sectors, strategies, and geographies within their private equity portfolio in both asset value and uncalled commitment. Selling private equity interests on a secondary basis represents an efficient and flexible tool to re-adjust allocations. Additionally, secondaries free up capacity and capital to capitalise on other upcoming opportunities.

Increased quality and return potential of portfolio
Besides being a powerful tool for adjusting portfolios in terms of allocation to vintage years, sectors, strategies, and regions, secondary sales are useful in reducing or eliminating the exposure to certain funds and general partners in the portfolio. A portfolio manager might want to reduce its commitment to certain funds and/or general partners for several reasons (such as reducing the number of relationships, underperformance, loss of confidence that a manager will provide satisfactory returns, or shift in the strategy of the manager).

Another argument for selling certain funds is that portfolio managers sometimes feel over-diversified in certain segments (e.g. in venture capital). As many investors have been building large portfolios with a large number of funds and general partners to monitor, secondary sales can be an effective tool to reduce the number of relationships in this particular segment which will reduce monitoring and administrative requirements, thus freeing up resources for more value-adding activities.

Locking-in returns and generating cash
In difficult market conditions the sale or IPO of portfolio companies will be delayed, resulting in distributions coming in to limited partners more slowly than anticipated. With secondary sales an investor can still generate liquidity and cash if so desired. In addition, investors might already feel satisfied with the
returns achieved thus far by a fund and prefer to lock in returns today instead of waiting longer for liquidity. This path is often chosen by investors in connection with “tail-end funds” where most companies have already been exited and a small number of companies remain in the fund portfolio.


Implementing secondaries as a portfolio management tool – the challenges

As discussed above, there are numerous benefits to using secondaries as an active private equity portfolio management tool. The question that now arises is how and to what degree a private equity fund investor can actually implement the use of secondaries, whether as a buyer or seller of such assets.

Implementation on the buyside
There are basically three options for a manager of a private equity portfolio to add secondaries to the portfolio: (i) direct secondary investments with in-house expertise, (ii) investing in a secondary fund or a fund of funds with a significant secondary component, or (iii) co-investing alongside a secondary investor.

Leading and completing secondary investments on its own has the advantage that secondary transactions can be used in the most active and flexible manner, as the portfolio manager has discretion on which fund to buy on a secondary basis. However, many investors in private equity do not have the resources and the expertise to source, analyse and complete secondary acquisitions. While there are some synergies, the skills required for investing in secondaries are different from the skills required in primary investments. A secondary investor needs strong valuation, structuring and negotiation skills that are based on substantial experience in direct private equity investing. Additionally, transactions have to be sourced proactively, which requires substantial resources and a global network.

By investing in a dedicated secondary fund, a private equity investor gets secondary exposure in an efficient and immediate manner allowing the investor to benefit from the key advantages of secondaries, such as mitigating the J-curve effect, increasing diversification and improving the risk profile of the overall portfolio. The downside is that investing in a secondary fund is less flexible than completing individual secondary transactions. Additionally, rebalancing a portfolio and capturing opportunities might be more difficult to achieve if committed to a secondary fund. The asset mix acquired by the fund may not accord with the investor’s particular portfolio model.

Investors have also the option to invest in a fund of funds with a significant secondary component. The advantage compared to a commitment to a pure secondary player is that i) primaries and secondaries would be integrated in the same portfolio and the fund of funds manager would make sure that the portfolio is well balanced avoiding any overexposure to certain segments and assets and ii) funds of funds managers could opportunistically pursue young secondaries (i.e. secondaries with significant unfunded commitments) leveraging their experience, track record and strong GP relationships as a primary investor. Additionally, the fund of funds manager, having the option but not the obligation to allocate a certain portion of the portfolio to secondaries, would be more selective in its secondary investments. This is a powerful advantage as secondary investing is an opportunistic business and there are times when the market environment is more attractive or less attractive for secondary investments.

Investors in secondary funds or funds of funds with a secondary component might be able to co-invest in certain transactions alongside the secondary investor. Co-investments have the clear benefit that secondary expertise and resources do not have to be developed in-house. The closer and the more important the investor is to the secondary fund (in terms of relationship or size of commitment, for example) and the smaller the fund is, the more likely it is to take advantage of co-investment opportunities.

Implementation on the sellside
A seller of private equity interests on the secondary market normally seeks to achieve the following objectives: selling non-core assets; achieving a fair price for the assets; completing the sale process in a fast and efficient manner; maintaining a good relationship with the general partner; and ensuring that the process remains strictly confidential. Some of these objectives are conflicting, as involving more parties as potential buyers might maximize the price, but could be detrimental to the efficiency and confidentiality of the process and consequently damage the relationship with the general partner.

For this reason it is critical for the potential seller to clearly define, and prioritise if needs be, the purpose and the objectives of the sale from the outset. Sellers should then decide whether to retain an intermediary to assist in the sale process or to do it themselves, and whether to talk to a large group of potential buyers, a select group or perhaps only one buyer. In the case of large commitments and where the seller wants to keep a good relationship with the general partner, the seller should involve the general partner at the beginning of the process.

What often turns out to be much more of a challenge for investors using secondary sales as an active portfolio management tool is the fact that in many cases secondary sales are completed at a discount to the general partner’s reported value, leading the portfolio manager to report a realised loss on the transaction. Especially on sales of under-performing assets or assets in a challenging market environment (for instance, venture funds), high discounts tend to be the norm. Often, incentive schemes for portfolio managers are tied to yearly performance targets and a secondary sale at a discount can have a negative effect on compensation, being interpreted as a bad investment from the outset. For these reasons portfolio managers often prefer to hold on to an asset instead of booking a seeming loss by liquidating the position. This is despite the fact that a secondary sale might be beneficial from an overall and long-term portfolio perspective as resources and capacity could be freed up to allocate to more promising opportunities.


Conclusions

Buying and selling secondaries can be a useful portfolio management tool in order to improve the risk-adjusted return profile of a private equity portfolio. Buying secondary interests can smoothen the J-Curve effect, improve portfolio diversification and reduce the risk profile. Selling secondaries is a viable liquidity option and a powerful tool to rebalance and improve the quality of a private equity fund portfolio.

Investors have recognised the benefits of adding secondaries to their portfolios and have started to increase their allocation to secondaries funds, or funds of funds with a significant secondary component, over the last years. Until now, the sale of private equity fund interests has been primarily motivated by external factors, whilst using secondary sales as an active portfolio management tool is a concept still at its early stages of development. This is in no small part driven by the reluctance of portfolio managers to accept write-downs in the short term.

While there is a clear trend of increasing use of secondary sales as a portfolio management tool, it will be critical for portfolio managers to recognise and clearly communicate the long-term benefits of secondary sales and to what degree a certain transaction outweighs a potential immediate write down. This is a pre-condition for the secondary market developing further. It will also have an impact on the primary market, as capital would be freed up through secondary sales and some of this capital could then be recycled into new funds. It is this kind of dynamic investment approach to private equity, arguably quite remote from the tradition of committing capital to a portfolio of private equity funds for the long term, that will add a new dimension to an asset class free from the stigma of illiquidity.

 

LGT Capital Partners is a leading European manager of alternative assets with a team of over 50 people currently managing $2.4 billion in private equity and $1.5 billion in hedge funds. LGT Capital Partners is based in Pfäffikon (near Zurich), Switzerland.

The preceding article was extracted from Routes to Liquidity, a 224-page Research Guide just published by Private Equity International. To order your complete copy please call the order hotline on +44 (0)20 7906 1188 or click here.