According to Greenhill, secondaries firms are sitting on $180 billion of dry powder, almost twice the annual traded volume. The level of competition in the market has also dramatically increased over the past few years, with new institutions, including primary investors, becoming active. This has led to supply-demand imbalances and increased the average clearing prices for portfolios of LP interests.
Fees, leverage and cost of capital
To remain competitive, many institutions are using leverage to decrease their cost of capital. This allows them to submit more aggressive bids during auction processes and to underwrite LP books using lower unlevered target returns.
Nonetheless, credit is limited, and the secondaries market is already swamped with credit facilities, nav-based solutions and other deferred payment and vendor financing structures.
Despite this competition, the level of fees in the market has remained stable with management fees between 0.8 percent and 1.25 percent and carried interest between 10 percent and 15 percent. Some investors offer sizeable co-investment opportunities, but only to large LPs.
There is absolutely no incentive for the incumbent players to modify these economic terms. Yet this level of fees is highly attractive for many institutions willing to enter the asset class.
More competition in the future?
One of the main trends in the asset management industry relates to the pressure on costs. The use of technology and machine learning has allowed many large institutions to provide investors with cost-effective sophisticated investment products, putting the whole mutual funds industry under pressure.
As it is maturing, the secondaries market seems to be an ideal target for institutions active in the low-cost/high-assets under management segment such as Vanguard or BlackRock.
First, PE is an asset class in high demand from many investors. Second, secondaries offer a high degree of diversification. For instance, a secondaries fund with 400 funds having on average 10 remaining underlying companies can provide exposure to 4,000 underlying unlisted assets. Finally, the level of fees remains high.
Therefore, one could expect to see a disruptive player appearing in with a low-cost data-driven fund focusing on LP books. This low-cost fund could potentially have a primary pocket with no carry to ensure access to GPs.
Pricing portfolios of LP interests is usually done by analysts who cover hundreds of companies a quarter. Machine learning provides a cost-effective, systematic and fast alternative to price diversified fund book opportunities by mimicking the bottom-up analysis performed by deal teams. The use of data and technology allows to reduce the costs and accelerate the analytical process.
Moreover, the risk-return framework of an institution charging, for example, 0.50 percent of management fees and 2.5 percent carried interest allows to be more competitive in auctions and to outbid other participants for high-quality portfolios.
Therefore, a low-cost vehicle managed by a credible institution, winning on the high-quality plain-vanilla opportunities, and using leverage like all the other players seems to be an attractive offer for both large and small PE investors compared with the status quo.
After all, some US pension funds have backed the first quantitative hedge funds in the 1990s such as Renaissance Technologies or DE Shaw.
Perhaps, we will witness the first quantitative PE strategies in the coming years. And secondaries will be the entry point.
Harry Vander Elst founded RockSling Analytics to provide insight on the risks and returns of private equity investments using algorithms. He previously worked as an investment manager and data scientist at Coller Capital and as a quant at Bank of America Merrill Lynch.