Why ‘secondaries’ is a misnomer

The strategy should be known as private portfolio investing, says Morningside founding partner Henry Zhang, arguing the name better captures its actual activities.

To say the industry commonly known as “private equity secondaries” has changed over the last decade is an understatement. In a strategy historically defined loosely by an investment style, secondaries players have succeeded in significantly expanding the scope of the industry through segmentation, specialisation and occasionally migration. An apt parallel can be drawn to the evolution of the private equity primary market from generalists to more sector, region and capital structure-specific funds. We have attempted to re-define and re-segment this established and growing asset class in a more intuitive and comprehensive manner.

Henry Zhang Morningside
Zhang: ‘Secondaries’ is a legacy moniker

To define the asset class, we must first explore the source of secondaries funds’ historical outperformance. This alpha generation doesn’t come from operational improvements or meaningful secular or company specific insights. Therefore, the main source of secondaries investment alpha generation is value creation at entry. This can take the form of either buying portfolios at a price lower than the sum of the underlying assets or, in the case of portfolio financing, structuring investments with return profile in excess of the buyers’ risk taken. In more recent years, financial engineering has also been used to amplify returns.

This value creation at entry is possible primarily because secondaries funds invest in portfolios of private assets, which gives the buyer three main advantages. First, it allows secondaries firms to avoid competition from single asset buyers, who are not set up to invest in portfolios, hold investments without direct control or pay economics to an incumbent GP. Second, investing in portfolios is inherently solution-oriented and therefore justifies a return premium. The need to sell or raise capital against a portfolio rather than individual assets typically comes from structural considerations (eg, fund termination) and/or misalignment of stakeholder objectives (eg, investment horizon and return expectations). In such situations, price can rank below a buyer’s ability to craft and deliver on tailored solutions. Lastly, buying portfolios of assets without direct control means secondaries funds can achieve higher degrees of portfolio diversification per investment professional. Diversification lowers the overall risk profile of the fund, increases its value and makes possible the use of financial engineering tools to enhance performance.

Therefore, a more investor-centric terminology for secondaries – and one that more comprehensively captures the actual activities of the market participants today – is simply private portfolio investing, defined as investments in existing portfolios of private assets through or in LP-GP structures. For capital allocators, this definition intuitively differentiates the asset class and highlights the competitive edge that enables its attractive investment attributes.

“A more investor-centric terminology for secondaries – and one that more comprehensively captures the actual activities of the market participants today – is simply private portfolio investing, defined as investments in existing portfolios of private assets through or in LP-GP structures.”

This definition captures strategies such as NAV loan and preferred equity. While these strategies have a private credit like risk-return profile, their returns are derived from the same enabling factors – and their dealflow is typically sourced through the same channels – as equity-oriented portfolio investing strategies.

To provide a comprehensive view of the market’s strategy landscape, we consider three attributes that matter the most when it comes to private portfolio investing: type of underlying asset, type of solution provided and type of counterparty. The first two attributes are consistent with how private investment managers classify their investment strategies. When it comes to solution-oriented private portfolio investing, we argue the counterparty in the investment matters just as much. Buying a portfolio from an LP, a tail-end fund or a bank with a captive GP has meaningful implications for transaction dynamics, the buyer’s access to information and alignment of interest with the underlying GP, in addition to sourcing approach.

Applying the above framework to classic LP secondaries, we can describe the transaction as buying equity (solution type) in one or multiple limited partnership interests (underlying asset) from a single limited partner (counterparty). From this description, if we were to substitute the counterparty with multiple LPs in the same fund, we would have GP-led tenders. Similarly, if we change the solution provided from buying equity in to issuing debt against, we would be describing what is commonly known a structured LP portfolio sale. This three-variable framework provides sufficient versatility to capture most active strategies in the market.

No doubt, the term “secondaries” will continue to be used by market participants and understood to refer to professionals, firms and transactions commonly featured in Secondaries Investor. However, it is a legacy moniker that no longer fully describes the activities of the market and, semantically, limits the potential scope of the industry. Instead, private portfolio investing more clearly differentiates the asset class’s unique investment approach and core competitive advantage that has enabled its stellar performance over multiple cycles. Furthermore, it is our expectation that more granular specialisation in certain sectors and regions as well as new liquidity solutions with the use of innovative financial engineering tools will continue to expand the scope of the industry.

Henry Zhang is the founding partner of Morningside Capital Management, a Toronto-headquartered investment firm that specialises in fund restructurings, portfolio financing and GP financing. Prior to founding Morningside, Zhang spent five years focusing on private equity funds and secondaries at Canada Pension Plan Investment Board.