Why secondaries are not a free lunch: the myth of better performance

In the second part of our series, Cyril Demaria, head of private markets at Wellershoff & Partners, examines the evidence that secondaries perform better than funds of funds.

Cyril Demaria

Historically, IRRs of secondaries funds look attractive when compared with funds of funds. The simple arithmetic average of net IRRs of secondaries funds created between 2002 and 2014 is 15.3 percent, while funds of funds’ reach 10 percent. However, this approach is simplistic and biased for two reasons.

Firstly, IRRs are overly time-sensitive and do not reflect real performance. As secondaries funds buy into existing assets, their time-to-cash flows are inherently shorter than that of funds of funds, which finance new funds. Moreover, IRRs wrongly assume the immediate reinvestment of distributions, at no cost and at the same rate. Most of distributions are in effect left on money markets for a while, until new investment opportunities are taken up. Unlike primary opportunities, secondaries are highly unpredictable and investment costs are higher given the resource intensity and the expertise required.

Credit can backfire

Secondaries funds also tend to use leverage. Investors get to deploy less (or no) capital upfront, as fund managers draw on credit lines to invest. This magnifies their fund’s IRR, but in effect reduces cash-on-cash performance, as funds have to pay interest. This further confirms that IRRs are irrelevant as a performance metric, and also that the expectation that secondaries put capital at work rapidly stands on shaky ground.

Buyers on the secondaries market need to carefully assess the consequences of the increasingly widespread use of credit lines in underlying funds. This practice can backfire in radical ways.

Financial leverage can significantly lower returns: if secondaries assets are overpaid) and deliver modest results, the cost of debt will absorb a significant portion of the proceeds that should be paid to investors. As stakes are currently traded at a modest discount or at a premium, this should give investors pause.

Buyers are more likely to overpay today, as NAVs have largely been marked-to-market since 2007 to reflect the “fair market value” of assets. Fund valuations have caught up with financial markets in 2007 and 2008, meaning that there is no ‘hidden value’ in NAVs anymore. While secondaries funds were previously acquiring assets booked at historical cost with a 20 to 30 percent discount, they now do so at a 5 to 10 percent discount on marked-to-market valuations.

Discounts are not the only drivers of performance in secondaries investing: buying assets of high quality is also important. However, if these assets are priced at or above their fair market value, generating attractive returns will be more challenging and require expertise.

In conclusion, not only will current and future returns be lower due to lower discounts and mark-to-market valuations, but there is also little room for mistakes. Secondaries buyers are exposed to significant risks due to downward shifts in valuations if listed stock prices fall.

Beyond cosmetic returns

To avoid IRR biases, we use a cash-on-cash return metric: the distributed-to-paid-in ratio, which is not time-sensitive, takes into account the cost of any credit line (as distributions are net of any fees and costs) and compares the output to the capital put at work by investors. We compared risk-return profiles of secondaries funds and funds of funds based on DPIs. We chose funds of funds as they are the closest proxy to a diversified portfolio of primary funds selected professionally. Secondaries funds look less attractive, though their risk-return profile is still modestly better than funds of funds.

Cyril Demaria focuses on illiquid assets and is based in Wellershoff’s Zurich office. His prior experience includes founding multiple funds and being in charge of private markets research in the chief investment office of UBS.

Read the first part of Demaria’s research here.