Discounts don’t necessarily lead to outperformance. So why are so many market participants fixated on them?
If there’s something I’ve learned in my first month as editor of Secondaries Investor, it’s that everybody seems to be obsessed with discounts.
But talk to a number of secondaries buyers in greater depth and it becomes clear that focusing excessively on discounts to net asset value (NAV) can be distracting or even detrimental.
“Discounts matter less than people think, but everybody likes discounts because discounts provide downside protection,” said Joe Marks, managing director and head of secondaries at Capital Dynamics. “Some deals at par do well. Some discounted deals don’t do well.”
And some buyers will tell you that deals they’ve paid a premium on can end up being their best performers.
So what gives? In the very short term, discounts do matter as they allow buyers to immediately report a gain on paper. Let’s say a buyer purchased a fund stake with a net asset value of 100 at 90, or at a 10 percent discount; the buyer will be able to immediately report it on its books at 100, showing a gain. If they pay a premium, or above par, for a fund stake, they’ll immediately report a loss.
“The high performance of bottom-quartile secondary funds from recent vintage years are not indicative of the true-long term performance of these funds, but merely a reflection of written-up discounts to NAV for recently acquired primary fund stakes,” found a 2013 study conducted by Oliver Gottschlag of HEC Paris and Bernd Kreuter of Palladio Partners, which was focused on the correlation between discounts and returns on secondaries investments.
In the first few years following a secondaries deal, discounts are typically beneficial to the performance of a secondaries fund, the study found, but that relationship quickly dissipates afterward.
“The resulting effect of discount/premium investing can have a substantial impact on the annualised performance of the secondary fund shortly after an investment, but will naturally vanish over time,” said the study. Final performance is typically reached after two to three years of the fund’s life, it found.
“Investing in low quality funds at a deep discount therefore offers certain window dressing opportunities,” the study noted. But in the long run, investing in a bottom quartile fund with a 50 percent discount will still get you lower returns than investing in a top quartile fund at a 20 percent premium.
That’s not to say that we should forget about discounts all together, but the takeaway is that buyers are better off focusing on the quality of the funds they are targeting, by doing their homework and understanding the true value of a fund’s portfolio companies, their underlying cash flows and potential future exits.
“The discount should be the product of you analysis, not your starting point,” said one Europe-based secondaries investor.
There are other factors, too, which suggest an overreliance on discounts can be misplaced.
For example, one source noted that even though discounts have gone down this year compared to the first half of 2014, it actually doesn’t mean much, because the NAV on many private equity funds has gone up since then, as a result boosting the dollar amount buyers are paying.
And going back to doing thorough homework on an investment, the fact that many secondaries transactions are being executed through auctions can often artificially impact a discount just because of the competitiveness and desire to win a bid.
But as another investor noted, there are some circumstances – like in the aftermath of the global financial crisis – when deep discounts are a boon, because NAVs snap back pretty quickly.
“Everyone likes discounts,” the source said. “They can help when the market tanks, when there’s a surprising hit in your fund or when you got your analysis wrong. Discount can avoid a whole lot of pain.”
But they shouldn’t be a linchpin of anyone’s strategy. I guess the idea is to try to find the right balance.
What’s your view? Drop me a line at email@example.com