Active secondary fundraising and the public announcement of several large secondary transactions have brought opportunities in the secondary market to the attention of institutional limited partners. As a result, many institutional investors are asking, “Should I be investing in the secondary market? How will secondary investments affect my entire private equity portfolio?”
The private equity secondary market offers an attractive opportunity to enhance portfolio diversification and risk-adjusted returns. Secondary investment characteristics with the potential to make a dramatic impact on private equity portfolio performance include accelerated cash flows, attractive historical returns, fund access, asset transparency and investment performance correlation.
Secondary investments provide accelerated cash flows because most purchases involve mature partnerships that are focused on monetizing investments at the end of the fund life cycle. The accelerated distributions shorten the secondary investment duration and the time it takes the secondary buyer to reach cash flow breakeven. In addition, secondary buyers purchasing assets at a discount are able to earn an average investment multiple equal to or greater than the multiple achieved by a primary investor in the same fund. The combination of a strong investment multiple and shorter investment period produces significantly higher internal rates of return for secondary investors.
Higher expected rates of return are usually accompanied by additional investment risk. Unlike primary investors, however, secondary buyers usually purchase mature partnership interests with little or no “blind pool” risk. The additional asset transparency should allow buyers to reduce investment risk through improved prediction of future cash flow streams. Some secondary buyers are also able to use structured transactions to provide incremental risk protection.
To test the effects of secondary investments on private equity portfolio performance, Cogent Partners conducted a quantitative analysis of the historical returns of more than 220 venture capital, leveraged buyout and secondary fund-of-funds partnerships formed between 1987 and 1999. The historical investment returns and return standard deviation for each sample are listed in Table 1. The data demonstrate superior performance of secondary investments, relative to primary investments in venture capital and leveraged buyout funds over this time period. Secondary fund returns outperformed leveraged buyout and venture capital fund returns by approximately 500 and 1,250 basis points, respectively.
In addition to the higher absolute returns achieved by secondary funds, this analysis also demonstrates the lower risk level associated with secondary investing. By purchasing portfolios of mature assets with reduced blind pool risk, secondary managers achieved higher returns with volatility 15-40% lower than venture capital and leveraged buyout fund managers.
The true impact of including secondary investments in a private equity portfolio can only be assessed using traditional portfolio optimization techniques. Institutional investors need to evaluate the effect of asset return correlation on the overall portfolio’s expected return and total risk. The correlation coefficient between assets measures the degree to which investment returns move together over time. A low or negative correlation between two assets indicates that the asset returns tend to move independently or in opposite directions. Constructing a portfolio that combines assets that have a low or negative correlation can provide an investor with a lower level of return deviation for a given level of expected return.
The estimated correlation coefficients between venture capital, leveraged buyout and secondary fund investments, calculated using the 220 fund sample, are displayed in Table 2. The estimates indicate a relatively low correlation between actual secondary returns and returns from venture capital and leveraged buyout funds for the same vintage year. The low correlations indicate a strong potential for total portfolio risk reduction by introducing secondary investments into the private equity portfolio.
The return correlation between venture capital and leveraged buyout funds can be used in conjunction with historical returns and return deviations to construct an efficient frontier for a private equity portfolio with no allocation to secondary investments. In the pure primary venture capital and leveraged buyout portfolio, the minimum variance portfolio is constructed using a 75% allocation to leveraged buyout funds and a 25% allocation to venture capital partnerships. This portfolio combination represents the lowest level of total risk for the private equity investor. Any portfolio on the efficient frontier between the minimum variance portfolio and a 100% venture capital portfolio provides the institutional investor with the highest expected return for a given level of risk.
Before testing the impact of secondary investments in a portfolio context, reasonable allocation amounts must be determined. Given the secondary market’s current size and number of available investment opportunities, creating a significant allocation (greater than 40%) to the market sector may be impractical for large institutional investors. However, asset managers could construct a portfolio with a 20-30% allocation to secondary transactions over a reasonable time frame by investing in secondary funds or by directly acquiring secondary investments.
Constructing an efficient frontier with secondary investment allocations of 20% and 30% shows the benefits of adding a secondary component to a private equity portfolio. By adding a secondary investment component to the minimum variance portfolio, a private equity investment manager can achieve superior returns while assuming a lower level of total risk. As fiduciaries, investment managers should consider the risk and return benefits that secondary investments can bring to their private equity portfolios.
Portfolio management is about maximizing return for a given level of risk. When investment opportunities exist that offer abnormally high risk-adjusted returns, prudent investors should allocate additional capital to those opportunities. Clearly, the private equity secondary market presents such an opportunity. By investing in secondary fund-of-funds vehicles and by participating directly as a buyer or co-investor in private equity secondary transactions, investment managers can create more efficient private equity portfolios.
Ian Charles is a senior associate at Cogent Partners L.P., a specialty investment bank that represents institutional investors in private equity secondary transactions. Charles is responsible for valuation analysis, transaction marketing and buyer coordination during client engagements. To learn more about Cogent Partners L.P., or the private equity secondary market, please contact Charles at firstname.lastname@example.org.