Risky business for secondaries buyers

Secondaries buyers acquiring limited partner fund interests need to understand how to mitigate risks on a fund manager-level basis and on an investment-by-investment basis.

One of the most obvious risks on the secondaries market is the effect of the quantity and quality of information that is available, according to Coller Capital risk management partner Crispin Payne, who co-authored the PEI book New Strategies for Risk Management in Private Equity. For example, some general partners don’t allow their LPs to share information or discuss their fund with potential secondaries buyers.

“Even if the GP is allowing the sharing of information, the quality and quantity of information varies tremendously – some GPs provide pages of detail on each company in their portfolio, some provide little more than a name and an amount invested,” Payne told Secondaries Investor. 

So when a secondaries firm is acquiring an LP fund interest, it’s essential they understand what exactly they’re acquiring. Furthermore LPs in the secondaries firm’s funds need to have this level of understanding too.

In the book, Payne outlines other risks including asset allocation, foreign exchange, alignment, ESG, credit and tax risks. Payne can’t pinpoint a single risk that outweighs the others because the balance of risk varies for each portfolio.

“Any one class of risk can be the cause of significant loss or reduced return,” he said.

Alignment risk for example can be “a trickier issue” for secondaries funds buying LP stakes as referenced above. Buying into a fund that is in carry or goes into carry isn’t an issue, but when a secondaries investor buys into a fund that fails to generate carry, they risk spending money on an asset that sits there for years without cash flows, Payne explained.

ESG is another issue that can be riskier because there is much less opportunity for detailed ESG due diligence on the secondaries level.

“It is rare for a secondary buyer of an LP position to be able to conduct in-depth due diligence with the management of an underlying company,” Payne wrote in the book.

Last month, Secondaries Investor talked to secondaries firms about their ESG practices. One Europe-based GP explained the complexities involved in buying portfolios of fund stakes or multiple assets in one go – trying to further cherry-pick items that only meet a buyer’s ESG requirements complicates things even further (and could potentially cause the seller to move on).

Lastly, asset allocation can create diversification constraints. Diversification is automatically achieved when buyers acquire positions via portfolios of LP interests, but the buyer could easily become overweight or underweight in a particular geography or sector. Fund interests can easily overweight a buyer’s asset allocation model, Payne added.