Secondaries derivatives

Private equity derivatives provide LPs with an alternative to a traditional secondaries sale and a way of securing value by hedging exposure to their fund interests, writes Kishore Kansal.

There has been an assumption in the private equity secondaries market that investors’ reasons for selling private equity interests were identical to their reasons for reducing exposure to those interests.

They are not at all the same, and the advent of private equity derivatives provides a tool that allows us to see the difference and treat these concepts separately.

Investors must sell because they have short-term liquidity needs or cannot meet future drawdowns. We can call these investors “forced sellers”, as selling is an imperative rather than a choice.

On the other hand, there are a multitude of reasons an investor may have for reducing exposure to private equity: regulatory pressures, strategic or tactical allocation changes, portfolio reduction and issues regarding excess risk or volatility.

Kishore
Kansal

These are investors who, by definition, are non-distressed and who do not have to sell. Such investors are often described as “willing sellers”, but this notion is a clear oxymoron. Why would an investor sell if liquidity wasn’t their primary objective? The answer is, because historically they’ve had no other choice, leading many to the incorrect assumption that the method is inseparable from the motive. Moreover, for every one forced seller, there are at least 10 investors who are not compelled to sell.

The stark conclusion is that the secondaries market, estimated at between $30 billion to $35 billion in size, is only a fraction of a far larger and untapped universe of investors seeking portfolio management.

Derivatives represent a tool to be able to distinguish between different portfolio objectives. For the forced seller, unfortunately, there is no alternative to the secondary market as they require a pure liquidity solution.

However, for willing investors seeking to reduce exposure to private equity, they can now use derivatives to accomplish this. Derivatives offer investors something rather simple: the ability to lock-in a fixed return by hedging out exposure to a fund or portfolio. This is a relatively straightforward technique employed in every major asset class apart from private equity. For proof of this, we need only look back to the mid-nineteenth century to see that asset classes such as commodities, public equities and bonds have been using derivatives for quite some time.

Crucially for many investors, hedging offers better pricing than secondaries. As a vendor, not only are you able to retain your interest in the funds but you are able to lock-in a higher value than if you had sold. To give a sense of the scale of the benefits, demonstrated pricing based on previous processes we have run this year showed a 5 percent discount for a traditional secondary, based on March NAVs, compared to a 15 percent premium for a derivative hedge.

What this means is that you can often secure far better value for your assets than you could with a traditional sale, not to mention retaining your relationship with the manager and still being able to access co-investments.

This nascent market operates strictly on an invitation-only basis and allows only the most sophisticated institutions to participate. Derivatives provide different solutions to what is already available. The road is lit by more mature asset classes and derivatives are set to play an increasingly important role in private equity.

Kishore Kansal is Managing Partner of PEFOX.