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Secondary funds: a good alternative

03 May 2019

By Gerald Moser, Chief Market Strategist

From time to time we will use a section of our monthly “Market Perspectives” to introduce and discuss broad topics in financial markets. We start this series with a look at secondary funds in private equity.

Private capital in a nutshell

Private capital is an important piece of an investment puzzle as it allows investors to harvest an illiquidity premium and diversify away from publicly traded markets. But an investment in private capital, of course, is only possible if the liquidity needs are already covered with the rest of the portfolio.

Investments in private markets can be defined according to the target asset (equity and debt), the purpose (leveraged buy-out, infrastructure, real estate, energy and power), the way of investing (direct or fund of funds), the stage of the investment (venture capital or growth capital) or the maturity of the private equity fund (primary or secondary).

In this article, we focus on the differentiation between primary and secondary funds, providing more explanations on secondary investments.

In a traditional primary private capital fund, investors agree to commit capital to a fund which invests this capital based on investment opportunities which are broadly defined according to the categories aforementioned.

The capital can be drawn at any point, usually in the first few years, as fund managers find investment opportunities. But it can take time for the capital to be invested and start generating returns.

This delay in generating any return on investment is called the J-curve effect. It illustrates the general trend for private equity investment to have negative cash flow earlier on before turning into investment gains as the portfolio matures.

Initial negative cash flows come from management fees, investment costs, underperforming investments or investment in non-profitable companies.

Private equity J-curve

Why consider secondary funds

Investing in private equity can be daunting. It is a long-term investment, with limited opportunities to exit it, no visibility on how the funds will be invested (the so-called “blind pool” risk) and no investment control. On top of this, returns are uncertain as committed capital could never be called if fund managers cannot find suitable investment opportunities.

Secondary investments offer several appealing characteristics which mitigate those risks while still offering most of the advantages of private equity:

  • Investing in secondary funds limits the “blind pool” effect as most of, if not all, the capital has already been called and invested

  • Linked to the previous point, the J-curve effect is mitigated. Secondary investment happens when the fund is close to breakeven, ie distributions to investors start to match and even outpace capital calls. The return on investment is therefore more certain than for primary fund investment

  • Secondary funds are often available at a discount to their net asset value. This compensates. partially at least, for the upside for secondary investment usually being lower than for primary funds as the investment happens at a more mature stage of the fund’s life

  • Secondary funds also improve the diversification of a private equity portfolio. It is possible to get several vintage years in a portfolio, reducing any risk associated with the timing of the investment and the impact of the economic cycle on performance.
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