The consultant’s case for secondaries

The strategy suits both fledgling and mature portfolios – with caveats – says Cambridge Associates.

Sister publication Private Equity International recently caught up with Cambridge Associates’ Andrea Auerbach, author of research note When Secondaries Come First, to discuss how the strategy fits into a wider institutional portfolio and the key questions investors should be asking managers. Here are some of the takeaways:

It’s not just for first-timers

Secondaries is increasingly accepted as a sensible jumping-off point for institutions building a private equity programme from a standing start. As capital is deployed and returned more quickly than in primaries, you can “demonstrate success earlier than you could with other strategies”, says Auerbach, not to mention the immediate vintage year diversification.

But it isn’t just for newbies; there’s a strong argument for more mature programmes to include 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 cashflow element, it’s an ability to capitalise on dislocations in the secondaries 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.”

IRRs look great, but shouldn’t be taken at face value

Cambridge data show that in 2011 the median net return for secondaries funds was an eye-catching 20.9 percent. This compares with 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 secondaries 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.”

“[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. So your IRRs can start brightly and then start to fade a little bit.”

Leverage can confuse matters 

“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,” says Auerbach. “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.”

This leads to a number of vetting questions investors need to ask managers, she adds. “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.”

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