Secondaries: In your starting line-up

Whether your private equity programme is gearing up for the first pitch or already in the seventh innings, there’s a place for secondaries on the roster.

 For investors looking to gain initial exposure to the private equity industry, secondaries can make a lot of sense; the dreaded J-curve is significantly mitigated thanks to lower fees and faster cash distributions. What’s more, returns are not only robust but secondaries funds offer a narrower and more consistent band of returns.

“If you are starting a private investment allocation, what’s often most important to CIOs and to the practitioners is that their efforts have a yield that is viable,” says Andrea Auerbach, managing director at Cambridge Associates and author of a recent research note, When Secondaries Should Come First, which argues secondaries make more sense than funds of funds as a starter option for limited partners.

“Secondaries gets your cash back faster, so you could demonstrate success earlier than you could with other strategies.”

And these characteristics are not only attractive to CIOs just starting out in private equity; there’s a strong argument for more mature programmes including an allocation to secondaries.

“I think it would behove anyone managing an established programme to reflect on ‘what is the return profile offered to me by secondaries, does it have a place in my programme?’” Auerbach says.

“What we’ve observed in our clients is that the answer to that question is yes. It has a faster cash flow element, it’s an ability to capitalise on dislocations in the secondary market when there are dislocations, buying things at even more of a discount and writing them up. It does appear to have a mainstay element, especially when you consider the private equity arena just continues to mature and offer these more specialised areas of investment.”


Cambridge data show that in 2011 the median net return for secondaries funds was an eye-catching 20.9 percent. This compares to 7.9 percent for funds of funds. The pooled return for US buyout and growth equity funds from 1990-2014 was 13 percent.

But these data points take a bit of interpreting.

“Let’s be clear, you’re getting a very different source of return with your secondary fund than you are with your primary fund,” Auerbach says.

“[With a primary fund] your money is out for longer, compounding and returning a return for longer, and for a lot of CIOs and a lot of institutions, especially right now in a low return environment, the longer your money can be working to generate a compelling return, there’s some value to that.”

What’s more, because secondaries transactions can begin generating distributions as early as day one, initial high IRRs may not tell the full story.

“[Secondaries funds] can put their money to work faster, so the J-curve mitigation is real, they often can write up the assets they acquire, so there’s a quick pop in the IRR, and it’s distributing capital faster,” Auerbach says. “So your IRRs can start brightly and then start to fade a little bit, whereas private equity and funds of funds build to their return over time.”

While secondaries funds also outperformed funds of funds in 2011 on net total value to paid-in capital – 1.39x compared with 1.14x – the US buyout and growth equity funds observed between 1990 and 2014 posted a TVPI of 1.6x.

Auerbach also points out that secondaries funds’ return profile goes up and down.

“Take yourself back to 2011 – we were climbing up and out of the global financial crisis, so secondaries funds were able to buy things at more of a discount probably than they are today, and so the benefit to investors in those vintage years was great, across the board.”

Auerbach also points out that secondaries funds’ return profile goes up and down, influenced heavily by pricing. Secondaries pricing for buyouts in 2011 was 86 percent, compared with 98 percent today, according to data from Greenhill Cogent.

“There’s a market cycle to everything including secondaries, so be wary.”

As with private equity more broadly, choosing the right secondaries managers to work with is key. As the secondaries market has matured and managers have diversified into more niche offerings, this can be complex for investors that haven’t committed to the strategy previously.

“I think they need to be mindful, especially in this heady environment in terms of prices, in the discipline and the track record of the manager. The other thing is to assess the sizing of the fund vis a vis its strategy,” said Alex Shivananda, senior investment director at Cambridge associates and co-author of the report.

“The other thing it’s important to understand is also the use of leverage in transactions, which can enhance the returns but also increases the risk. Those things are not the easiest to discern, you don’t see that off the cover, and so those are types of things people should be looking for.”

Auerbach added that the use of leverage, both at the transaction level and the use of fund-level finance, adds an extra layer of complexity of which investors should be aware.

“It sounds simple; let me go build an exposure by making a commitment to a secondaries fund, and I’ll get backward looking exposure to the private equity market at a discount,” she said.

“Then when you overlay transaction structure and being able to leverage deals, that adds another layer of information and awareness that investors need to better understand.”
Part of vetting the universe of available secondaries fund managers it to ask managers the following questions, Auerbach said:

“What is the source of your return? How much of the return am I getting through your ability to underwrite and purchase portfolios at a good discount? How much of the return is coming from the leverage you’ve used to underpin your purchase? Being able to deconstruct the components of return from a secondaries fund is important and it is a question many institutional investors ask.”