In a recent article in The Financial Times, Harvard Business School Prof. Josh Lerner closed his discussion on the performance of portfolios of private equity partnerships by noting:
“But a large portion of the differences [in the performance of private equity portfolios] seems due to simply superior decisions about funds to invest in, and which relationships to terminate.”
As a participant in the secondary private equity market through VCFA Group, I was immediately drawn to Prof. Lerner’s somewhat euphemistic notion of terminating a relationship. There are essentially two ways to terminate a relationship with a private equity fund:
First, the investor can sell an interest in the secondary market and use the cash received to redeploy capital either in a different private equity fund or a different asset class entirely. Alternatively, an investor may choose not to renew with a fund group and over time the individual partnership will become a smaller percentage of the overall private equity portfolio.
Historically, most long-term investors in private equity have taken the later approach, though there is no reason that it needs to remain the status quo. Indeed, we are increasingly finding large institutional investors seeking to sell a portion of their limited partnership interests to better manage their portfolios. Choosing whether to terminate a relationship via a non-renewal or sale can be a difficult choice. Here, then, are some key considerations for the investor:
Advantages of non-renewal
Arguably the simplest way to terminate a relationship with a general partner is to not recommit to the next fund. I liken this approach to an “underweight” rating in a public equity fund. Assuming investors continue to add to their private equity holdings, over time, the relative amount invested with the terminating general partner will diminish.
Early distributions from the partnership group will further accelerate this process. The primary advantage to this method is that there is no transaction cost associated with doing nothing. In a different asset class, studies of public market performance have shown that the performance advantage of a mutual fund manager is often eliminated by trading and other market frictions. One could argue that the same advantage should also be true for private equity.
An additional advantage to using the non-renewal method that is unique to the private equity asset class is the perceived benefit of being seen as a long-term “buy and hold” investor. Given that top-performing general partner groups are often oversubscribed, being seen as a “good LP” may be one of the few differentiating factors.
In the past, LPs sometimes feared that selling an interest in a fund might make it more difficult to secure an allocation with another general partner group. As the secondary market has developed, the stigma once associated with selling a private equity fund interest has greatly diminished. Most general partners now recognize that secondary transactions are part of the landscape and can be used as a tool for their own benefit.
As the secondary market has developed, the stigma once associated with selling a private equity fund interest has greatly diminished.”
David Tom, CFA, VCFA Group
General partners who desire to take a more active role in shaping their investor base may bring limited partners who decide not to renew into the secondary market. As General partners have canvassed their investor base in preparation for the next fund raise, some have simultaneously sought to uncover investors interested in selling their interests. The GP will then help to match the non-renewing LP with a potential buyer that may be able to benefit the GP.
We have participated in several transactions where general partners have found that many of their current investors are no longer interested in investing in private equity. In such cases, it is in the best interests of all parties for a secondary transaction to be consummated.
Secondary market advantages
The primary advantage to using the secondary market to terminate a private equity relationship is the resources (both financial and human) that can be redeployed by virtue of a sale. While not-renewing with a fund often appears to be the less expensive option, this fails to account for the time that the limited partner must invest to monitor and manage the fund investments.
As most institutional investors in private equity are extremely resource and personnel constrained, a secondary market transaction can often benefit investors by allowing them to focus on the most promising investments, whether in private equity or in another asset class.
We recently encountered a large pension fund that was seeking to increase its allocation to the private equity asset class. However, the small investment team was overburdened managing a portfolio of investments that totaled only several tens of millions of dollars. The institution sold its smaller investments and reinvested in larger funds that could accommodate a more meaningful stake for the institution.
By narrowing the focus of its private equity efforts, the institution was able to generate substantially higher dollar returns. While the institution might have maximized IRR by holding its smaller investments, the investment team would almost certainly have missed the superior investment opportunity absent the secondary transaction.
Secondary transactions also can be extremely useful when the anticipated exits from the fund are difficult to predict. A limited partner may find that a fund has investments that may lead to multiple extensions to the life of the fund. We are expecting a final distribution this year from a fund that was established in 1984 and intended to end in 1996.
The close of the fund will come 23 after its formation and over 10 years after its first extension. As exits are taking longer for venture capital funds, a 10-year life for funds may become less standard. Waiting for the fund to terminate on its own may simply take too long to be acceptable.
Finally, if a fund is particularly troubled, a limited partner may find that the fund in question consumes a disproportionate amount of time for minimal upside. In this case, a secondary transaction is nearly a perfect fit.
Investors who avoid the secondary market to maximize returns on an individual private equity investment may be disappointed with the result. In an older liquidated VCFA Group secondary fund, the average annual return to the investors whose interests we purchased was 6.2 percent.”
David Tom, CFA, VCFA Group
We are aware of a few situations where partnerships have completely disintegrated and LPs have sued general partners and, infrequently, one and other. While we are staffed with the professionals to handle such special situations, most investors in private equity would prefer to avoid such conflict.
Risks of holding on
One common misconception about the secondary market is that the seller is always better off holding the investment. Just as with any other investment, secondary transactions are a mix of winners and losers. In one case we purchased an interest in a limited partnership at what the investor had thought was a steep discount.
Within a few months, one of the key portfolio companies severely underperformed expectations. Had the investor held its interest, it likely would have received a substantially lower price. Pricing of secondary transactions must consider appropriate risk-sharing between the seller and the buyer.
Behavioral economics describes a market inefficiency called “confirmation bias” by which investors tend to look for information that confirms what they already believe and discount information that may contradict their beliefs. We find this phenomenon to be especially prevalent in private equity, as general partners are usually highly optimistic about their investments—as they should be.
As a result, general partners tend to under-rate the risks for their underlying portfolio investments. New information tends to “confirm” a positive outlook and negative information tends to be minimized. Limited Partners should carefully consider if things really can only get better when evaluating their private equity portfolios.
Investors who avoid the secondary market to maximize returns on an individual private equity investment may be disappointed with the result. In an older liquidated VCFA Group secondary fund, the average annual return to the investors whose interests we purchased was 6.2 percent. Had these original investors held their fund investments instead of selling to VCFA, they would have earned 8.5 percent.
If the investors had instead reinvested their secondary sale proceeds with VCFA, or another high-performing institution, they could have earned returns in excess of 30 percent. An intelligent redeployment of capital would have dwarfed the minimal incremental returns the investors would have generated by holding their private equity investments.
There is little reason that a limited partner choosing to terminate a relationship should not consider both the non-renewal method and the secondary market. The particulars of the situation will determine the choice that will provide the most immediate and long-term benefit to the general partner.
David Tom, CFA, identifies and advises on investment opportunities for VCFA Group, which pioneered the secondary private equity market. VCFA is currently investing a $250 million buyout secondaries fund and a $250 million venture secondaries fund. Tom can be reached at email@example.com. This article was adapted from a post on Tom’s blog at PEHub and available at: www.vcfa.com/blog.