Finding uncorrelated returns through lower mid-market secondaries

Secondaries transactions in the private equity market have boomed in recent years. In terms of volume, 2017 set a record by a hefty margin – some $58 billion worth of transactions, according to advisory firm Greenhill Cogent, easily eclipsing the prior record of $42 billion in 2014. Meanwhile, both the number of dedicated funds closed and the aggregate amount of capital raised for them hit new highs, at $40 billion and 35, respectively, last year. Secondaries are hot.

It’s easy to see why. Secondaries provide an increasingly accepted option for fund LPs who want to exit a particular fund manager ahead of schedule, whether it is to rebalance a portfolio, make a strategy change or shift resources to other managers. Buyers of such interests, on the other hand, typically do so because they are able to invest in mature funds whose portfolio companies are already known and measurable, and for what can be sizeable discounts to net asset value given the illiquidity of LP interests in funds. For investors in secondaries, this flexibility allows them to potentially reduce risk and diversify across manager, vintage, strategy and industry. It’s a compelling combination.

At the same time, the lower mid-market – defined as companies with annual sales of $10 million to $150 million and a niche we call the “growth engine of America” for its outsized contribution to economic performance and job creation – offers a number of advantages when viewed through the lens of secondaries transactions. It is highly fragmented, as transaction sizes are small and companies are often under the radar, meaning valuations can be more attractive due to lower competition. From a portfolio perspective, companies in the lower mid-market tend to be even less correlated with the volatile swings of publicly traded instruments than larger companies due to factors such as less correlation to global macroeconomic factors. Finally, the pricing of secondaries interests in the fragmented landscape of funds that concentrate on the lower mid-market can be advantageous because of a dearth of buyers focused on this space and transaction sizes that are typically smaller than the majority of secondaries funds need to deploy.

When the two are combined, an appealing picture emerges that can result in attractive, uncorrelated risk-adjusted returns. But as with most niche areas of a market, secondaries in the lower mid-market are not for the faint of heart. They require increased labour intensity to analyse plus significant domain expertise in dealing with smaller companies and the smaller funds that invest in them. They can also result in the need to roll up your sleeves and get involved with active management of smaller funds and their underlying portfolio companies.

Indeed, having and maintaining strong relationships with general partners which invest in companies within this niche is extremely important in sourcing, researching and quickly analysing secondaries opportunities. Familiarity with the lower mid-market, both directly and from the perspective of platform relationships, becomes a paramount advantage in terms of risk mitigation. This is due to the insights on such things as existing fund positions, LPs that might be looking to buy or sell them, portfolio company trends and valuations and the latest trends in deal structures. The more the secondaries investor is comfortable analysing and understanding smaller businesses from the ground up, the more effective these insights are. Accounting in smaller funds can be more variable providing both risks and hidden gems that may not be transparent at face value.

Ultimately, the growth in private capital fund secondaries in general, and in the lower mid-market in particular, is a testament to the added utility, value and risk reduction possible in prudently structured transactions. However, there is no such thing as a free lunch – it takes significant resources and experience to successfully navigate the challenges inherent in this niche at scale – fund sizes, LP positions and portfolio companies are all small, yet the due diligence work requires the same level of commitment as for larger transactions. Just knowing how to structure a secondaries transaction is not enough – it takes time, specialisation, deep market knowledge and broad coverage to consistently do it right.

Done properly, the combination of secondaries transactions and the lower mid-market can result in a tremendous source of absolute returns and risk-adjusted returns that are largely uncorrelated with both public assets and larger private equity trends. However, investors should take care to work with those investors that can demonstrate not only deep expertise and experience in the secondaries space, but also have the specialised infrastructure in place to originate, analyse and monitor these attractive but labour-intensive opportunities in the lower mid-market.