Why secondaries are not a free lunch: the myth of education

Secondaries are often seen as providing the best of private markets with shorter time-to-cash-flows. They also give a sense of control to buyers who can see the actual assets in portfolios for sale. The huge amount of information required to gain an advantage, however, means that it is no market for the inexperienced.

Sellers do not communicate their reasons for selling and are structurally more knowledgeable than buyers, which creates strong asymmetries of information. Sellers have done a full due diligence on the manager before investing, and then followed the development of the fund.

Buyers, on the other hand, can inherit difficult situations. They receive no comprehensive due diligence, only a light package of information including the last two to four quarterly reports of funds, statements of capital accounts and possibly some marketing material. Their access to fund managers and portfolio companies is usually limited– if not prohibited.

Unless a prospective buyer is already an investor in the funds for sale and/or has performed extensive and recent due diligence on the fund managers involved, the information gap not be closed. The discount on NAV at transaction time is meant to compensate for this gap. Therefore, unless information improves significantly for buyers, discounts should remain stable. As information has not improved and discounts have decreased, the risks have in effect been transferred to the buyers, without compensation.

Secondaries implies making concentrated bets with scant information on random funds. This could lead to portfolio imbalances due to a lack of diversification in terms of vintage years, regions and/or strategy. The time constraints associated with the transactions compound the risks. Small and mid-sized transactions are supposed to happen within 30 to 45 days. After portfolio discovery, valuation, formulation of offers and negotiations, there is little time left to look at the underlying businesses in detail – and even less to learn the ropes of private markets investing.

Seeing secondaries investing as a crash course is misleading. It is not an educational exercise but an expert intervention. And it is no place for tourists. There are no shortcuts in the learning curve of private market investments. The best way to learn is to do due diligence on primary funds over multiple years. Any error made in primary investments will be diversified, and investors can team up with managers or consultants.

Secondaries not only require expertise, but dedicated resources and focus. Transactions represent only a fraction of the opportunities sent to prospective buyers. Some owners want to test the market. Others want to get valuations at no cost: as some fund regulations include pre-emption rights, prospective buyers in effect establish an independent price for fund stakes. Out of the pool of opportunities, a limited proportion will go through. And there is always a risk of a being outbid. There might also be strings attached, in the case of staple financing or fund restructuring, for example. It takes time and resources to build the informational advantage required.

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.