Semi-liquid vehicles have to strike a fine balance between returns and duration. Some managers of such vehicles believe the secondaries market could be the perfect solution to this issue.
Private capital semi-liquid or evergreen vehicles can be offered to a broader swathe of investors than a traditional closed-end fund, catering to those that require the ability to withdraw their money. This process often involves partial exposure to cash or a cashflow-generating asset class such as secondaries, which enables them to offer regular subscriptions and redemptions.
Sponsors take on the management of liquidity in these vehicles, looking to balance returns and duration while seeking to minimise risk, Bob Long, chief executive of StepStone Private Wealth, tells affiliate title Private Equity International. Of the 550 deals the firm closes each year, StepStone carefully selects transactions that fit the needs of its evergreen funds.
“[If a deal] had a little more return, but its duration was also a little longer… that means the next deal needs to have a little shorter duration, and we can sacrifice some return,” Long adds. “We are trying to achieve the right mix of [return and duration] while seeking to minimise risk, generally expressed as diversification.”
Long has a bullish outlook on secondaries for these vehicles. “It’s not a coincidence. In fact, it’s a causal factor, a direct correlation that the growth and increasing efficiency of the secondaries market has correlated with the wave of democratisation,” he says. The secondaries market has allowed for the democratisation of private capital “because it creates the ability to quickly diversify a portfolio with shorter-duration assets”.
Semi-liquid vehicles aim to get as close as possible to the returns achieved by closed-end, illiquid PE funds.
The enemy of these vehicles is cash drag, which is caused by the need to plan for potential redemptions, HarbourVest Partners managing director Simon Jennings, who focuses on business development and strategy across EMEA and Asia, explains. “It will dilute the return, and although some clients might find that return perfectly acceptable, it is just a cost of providing a degree of liquidity.”
Secondaries works well to mitigate against cash drag, given the natural cashflow from more mature portfolios, requiring less cash to be held, he adds. “Holding an optimal level of cash… in an evergreen vehicle is really where the art and the skill is.”
Secondaries also offers discount benefits, Victor Mayer, a managing director at Pantheon who heads up the firm’s international private wealth efforts, says. “Discount means immediate markup, because you’re buying NAV that is discounted for reasons that generally have little to do with [the] fundamentals of the asset.”
Furthermore, transactions in this market have a more predictable duration, market participants explain. The performance track record of secondaries has also been predictable.
While IRR for secondaries has varied across different market cycles due to the different speed of distributions coming back, “when you look at it from a loss perspective and downside protection, the multiple of money has remained remarkably consistent across the whole industry”, Jennings says.
Key to diversification
The secondaries market offers diversification benefits across a number of strategies and solutions, which is key for a democratised product that seeks to minimise risk.
The secondaries market allows evergreen funds to buy assets that are “backward looking”, Mayer says. You can have diversification by geography, stage, segment, sector and type of investing style. “That’s really useful because you’re not relying on any single GP or any single sector or geography to generate dealflow and new returns.”
This in turn helps managers of semi-liquid funds achieve what their private wealth clients are after from a private markets strategy. An allocation to an evergreen vehicle could be the only private markets holding a private wealth investor may have, Jennings says. For that reason, “it has to be high quality, well-constructed and diversified”.
PEI spoke with firms that invest in both LP-led portfolios and GP-led transactions. GP-leds tend to fall into a similar profile to co-investments, with both transaction types more concentrated, they tell us. These deals can, however, offer more upside potential.
Co-investments and GP-leds have very different features with distinct benefits, Mayer explains. Co-investments tend to be negotiated on a no fee, no carry basis, which brings down the total expense ratio of the semi-liquid vehicle.
With GP-leds, “in exchange for the visibility on the quality of the asset and the existing relationship between the GP and the company, investors tend to pay fees”, Mayer says.
There are currently discounts in the GP-led market. “It’s small discounts, but it matters. A 5 percent discount, for example, goes a long way.” These deals can also be marked up before the end of the first 12 months because they have been owned by the GP for some time, he adds.
No easy task
Managing a semi-liquid vehicle requires a balancing act across all investment types in order to generate returns while managing liquidity and risk factors.
Investing in secondaries requires a lot of resource and expertise, Jennings says. Managers have to evaluate hundreds of underlying funds when assessing a transaction and make calls on when valuation uplift and distributions will eventuate. Additionally, Mayer says, there are “50 shades of secondaries” ranging from top-tier NAV with a smaller discount, to higher discount, lower-quality NAV. This needs to be managed particularly closely by evergreen vehicles.
Another theoretical drawback of secondaries in constructing a portfolio is the sharper increase in NAV, and a related drop in NAV when distributions occur, Jennings explains. Combining secondaries with directs is a great way to mitigate this.
“We’re doing lots of deals, and so you backfill your NAV as you go along,” Jennings says. To achieve this, firms must have scale to keep consistently investing over time. “[A sharp drop in NAV] can be mitigated by buying less-mature portfolios that do have longer to run and do have some unfunded commitments but are more diversified.”
Ultimately, these vehicles require a “huge commitment” to data and analytics, Long says. While firms must hire the right people and make sure interests are aligned, these vehicles have regulatory and reputational requirements to meet liquidity needs. “It’s not our intuition we’re relying on – we’ve done the work.
We have robust, deep, back-tested tools [that] allow us to forecast this liquidity and construct a portfolio.”