Late secondary funds carry greater risk

Secondary funds targeting tail-end funds carry a higher risk than those targeting younger funds, according to a new study released on Monday by 17Capital and PERACS.

In the other words, secondary fund risk increases with the age of the primary funds targeted. This is because the differential between top and bottom-performing funds in an underlying portfolio increases over time.

By way of definition, early secondary funds target primary funds that are up to three years old, mid secondary funds target primary funds between four and seven years old, and late secondary funds target primary funds that are at least eight years old.

“We were surprised by the findings,” said Oliver Gottschalg, an associate professor at HEC Paris and the founder of PERACS. “If you only look at the net asset value, it’s a risky bet.”

For the study, London-based 17Capital, a specialist preferred equity investor in private equity funds, and PERACS, a provider of quantitative analytics for the private equity industry, simulated performance of a secondary investor in more than 700 global buyout funds and assumed the transaction was done at par, but they didn’t study actual secondaries transactions.

“Of course, it justifies that investors require a greater discount in the real world,” he added. “The NAV is only a book value, it doesn’t tell you everything.”

Other drivers of risk that investors in secondary funds should also take into account include the economic cycle when the secondary fund acquires the primary fund, the general partner’s underlying fund quality and the acquisition’s structure, according to the study.