The dynamics of secondaries

And with Asian SWFs such as the China Investment Corporation (CIC) already stepping forward as major customers for secondaries – this week, possibly for up to $600 million of Warburg Pincus fund positions previously held by Bank of America – it’s worth considering what these assets entities can do for new investors to the asset class, and how well they really are matched to deliver what the buyers seek.

The J-curve effect

Secondaries are very often marketed as a J-curve expediter, to reduce the long wait for returns on a primary private equity portfolio. “On a standalone basis, secondaries offer compelling risk adjusted returns and early liquidity.  As a component of primary vehicles, secondaries help to mitigate the J-curve, provide vintage diversification and smooth distributions,” remarks Doug Coulter, Head of Private Equity for Asia Pacific at LGT Capital Partners. For a new investor in private equity, affirms Jason Gull, Partner and Global Head of Secondary Investments at Adams Street Partners, says “you need a fairly substantial allocation to secondaries to help mitigate the compounding J-curve that results from layering on primary commitment over the first few years.”

Another factor abating the J-curve is not quite as straightforward. “The other, albeit more cosmetic, factor is the immediate write-up in value that can occur when a secondary purchase is made at a discount to reported NAV,” notes Jeffrey Keay, Principal with HarbourVest Partners in Boston. This underlines that part of the value of J-curve mitigation may actually come in justifying the performance of the private equity program before the LP’s investment committee. “In the early days of investing your money into primary funds, investors tend to be looking at a trending-down in valuation, with the payment of management fees and investments valued at cost, which could cause some issues,” confirms says Lucian Wu, MD and Head of Asia at Paul Capital., while Gull cautions that And actual results in J-curve mitigation may hinge on such incidentals as fund accountancy practices.

PV Wang, Partner at Adams Street Partners, also sees J-curve mitigation as inextricably linked with how fully funded the secondary position is.  “The more fully funded it is, the more effective it is at mitigating the J-curve,” he notes. And the J-curve effect needs to be set in context against other priorities. “iIt is important not to lose sight of the fact that a secondary investment is a purchase of assets, and if these assets are purchased at the wrong price, the short-term J-curve benefits may be overwhelmed by the long-term negative impact on portfolio returns,” warns Monte Brem, CEO of StepStone Group. Also, as Dr. Stephan Schäli, Partner and Head of Private Equity at Partners Group, emphasizes, “it’s not recommended to build up a program of only secondaries, because you need to have primaries as well.” Buyers like CIC looking to jumpstart their programs with large secondary purchases might do well to remember this.

Pricing and performance

The entry price, preferably a substantial discount, is a key performance factor in the final outcome of the secondaries investment. And recent market circumstances have been unusually favorable to first-time buyers.

“Secondary market discounts in 2009 reached an all-time high of c. 46%, exceeding the tech bubble peak of 2002,” says Marshall Parke, General Partner at Lexington Partners.  “This was exacerbated by high levels of leverage, unprecedented market volatility, and urgent seller liquidity needs.” However, he adds, the steep discounts resulted in very few actual sales.

As pricing levels slip back up, the benefits of secondaries for the J-curve decline. “If pricing is very high, where you’re paying par, a premium, or even a slight discount, you’re not going to get that immediate impact of the higher IRRs,” Gull warns.
Overall appetite for the asset sub-class, however, remains high. “Demand for secondary funds has been strong from investors in 2009 and 2010, and has proved to be one of the few highlights in an otherwise difficult private equity fundraising environment,” Parke says.

Early or late?

Purchase and performance of secondaries is perennially linked to their funding stage, whether early/young or late/fully funded. New buyers, such as Asian LPs, proverbially opt for young secondaries, but the consequences for performance are worth remembering.

Gull sees this as a tradeoff between IRRs and multiples. For young secondaries, he remarks, “you’re going to have likely lower IRRs relative to a more funded secondaries program, but higher multiples and longer hold periods.” But early secondaries are often more about manager access and portfolio diversification than performance. “You are buying a lot into the unfunded part of the fund, which is more like primary investing, and its outcome depends primarily on the ability of the GP to generate outsized risk-adjusted returns in new investments,” Wu says.

Early/young secondaries are also a relatively new portion of the market, and historically, very small, notes Brem. “During the financial crisis, many investors were forced to dramatically change their private equity exposure and seek liquidity from any source, some reasonable and others quite unreasonable. This led to the increased supply of early secondaries. I would not expect that to continue.” Supply is already dropping, he adds.

As a result, investors may need different skill sets according to whether they opt for early- or late- stage secondaries. “When you’re buying highly unfunded secondaries, pricing the assets doesn’t matter,” Gull asserts. “What really matters is the quality of the GP.”

This could actually benefit new entrants to the field. “Non-traditional secondary players may feel more comfortable pursuing these transactions, as opposed to more funded, traditional, secondary investments that require more intensive company-level due diligence,” remarks Keay. And Wu confirms, “for late stage secondaries, you really have to have very strong skill sets to assess the quality of the assets, as well as the GP.”

Schäli in any case says the distinction can be overdrawn. “For an investor that starts purely from scratch, all types of secondaries have a merit,” he notes. “If you mix all of them in a good basket, that’s probably best for a new investor.”

Future access

Many investors in early or unfunded secondaries appear to have other priorities than returns in mind. One of the most obvious is access rights to the GP for future fundraisings. Here, the benefits are ambiguous.

The promise of access may even be used to erode the discounts essential for successful secondaries investing. “Sellers of funds managed by highly sought after GPs often expect secondary buyers to pay full prices as some form of ‘access premium’,” Keay says, with the implication that, “as a result of becoming an LP via a secondary, the buyer will be guaranteed a spot in the GP’s future funds. That’s not always the case.”

At least one market player maintains, “There’s no link whatsoever … GPs are not really seeking relationships with secondary buyers.” Not everyone takes such a firm view, but even those who do maintain that a secondary can offer some access to a prized GP admit that the purchase is only the beginning, and that the new LP will have to work hard to cultivate the opportunity in order to gain future re-up rights.

As part of the post-GFC movements in the industry and GP/LP relations, GPs are often looking at their relationships much more closely. “The fact that you are able to acquire a secondary position means that the GP wants you in,” Wang says. “Nowadays, GPs are quite actively managing their secondary transactions. That is a good start, but it also depends on how you work the relationship with the GP.”

The problem, in fact, is fundamental to the rationale of secondaries. “You cannot build a program just made on secondaries,” Schäli asserts. “It’s very important for the managers to recognize you for a relationship that you also help them with their future funds.”

Asia’s secondary appetite

For Asia Pacific LPs then, secondaries can be a valuable tool - but a poor single bet - in building out their private equity exposure. Most will have to build away from their home base and invest internationally, thanks to the dictates of the market. “Naturally 80-90% of the assets to be disposed are non-Asian assets,” observes Schäli. “Anyone serious about building a portfolio would by definition build a global portfolio.”

“The secondary market in Asia is still very nascent and a smaller part of the overall market opportunity,” confirms Lexington’s Parke. “Seller expectations have often been unrealistic resulting in a standoff with buyers reluctant to pay-up for interests with a higher degree of risk.” What sellers there are in Asia - most of them banks - are concentrated in Japan and Singapore, he adds. Furthermore, as Coulter confirms, “the majority of LPs are still under-allocated to Asia and would rather increase exposure to the region than divest.”

Asian buyers of secondaries, meanwhile, are still relatively few, with CIC and its peers rather skewing perceptions of the area. The major Korean institutions and SWFs are also participating, with Australia’s Future Fund likewise looking at opportunities. On the independent fund side, though, the universe of buyers is far smaller.

“I’ve not seen any Asian LPs as competitors in the secondary market, other than a couple of Asian-based fund-of-funds that have allocations to secondaries,” remarks Gull. And even CIC and the major SWF secondaries buyers, he adds, tend to have limited in-house capabilities, and to outsource due diligence and other essential functions. “They’ve tended only to look at situations that are very large, and have large buyout exposure, in managers that they already know,” he says.

“Asian secondaries are a very small, thinly traded market. So you have no choice but to look globally. And you should,” Wang concludes.  

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• Topics
• Funds
• Fundraising
• Secondaries
• Performance
• Lexington Partners
• Partners Group
• Jeffrey R. Keay
• Piau Voon Wang
• Adams Street Partners
• HarbourVest Partners
• Lucian Wu
• Doug Coulter
• LGT Capital Partners
• Paul Capital Partners
• Warburg Pincus Asia
• CIC