Portfolio design

The case for secondary allocations

BlackRock |Sep 13, 2019

Secondary market exposure is viewed as a permanent component of private market allocation by many sophisticated investors, even if their illiquid alternatives programs are mature. In this paper, we discuss the evolution of the secondary market, the role it plays in both newly started and mature private market programs and why the risk-return profile of secondary strategies may be diversifying and accretive to other private market strategies.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

 


Private market secondaries involve the sale and purchase of investors’ existing interests in illiquid alternative investment funds, and sometimes in portfolios of direct investments in private companies or other illiquid assets. Purchasers (secondary funds or other investors) typically acquire interests in a fund’s remaining assets and assume the seller’s commitments to meet future capital calls. Historically, most secondary transactions involved the sale of limited partnership (‘LP’) interests in individual funds or portfolios of funds. The secondary market has since evolved to include more complex and customized liquidity solutions including both direct secondaries (defined as portfolios of direct investments in companies or assets not held in typical fund structures), as well as manager-led secondary transactions.

The secondary market exists principally to provide liquidity in an otherwise illiquid asset class: it is one of the few ways for LPs to exit early or opportunistically from their investments in what is typically a 12-year vehicle structure. Private investors seek liquidity in the secondary market generally as a matter of portfolio management, much as public market investors periodically sell stocks to rebalance their portfolios. The secondary market also allows investors needing more wholesale changes to their portfolios – think financial institutions needing to fully liquidate private assets in response to regulatory or strategic changes.

Secondaries in newly started private market programs

Secondary market exposure has historically been viewed favorably by private market investors, due to the ability to invest in mature, substantially funded assets with reduced blind-pool risk relative to making new private market fund commitments. Secondaries have the potential to generate attractive returns with lower risk, given this visibility into underlying asset and portfolio performance.

Secondaries are typically acquired at a discount to NAV, and often to comparable company and transaction multiples. The underlying manager economics (fees and carried interest to underlying managers of the fund interests acquired) can be deducted from portfolio pricing. Cash-on-cash returns and net money multiples are attractive in secondaries given the potential for quicker deployment and return of capital. In fact, secondaries as a strategy have historically delivered the highest net median returns among private equity strategies, on a standalone basis and also relative to the standard deviation of returns among private equity strategies.

In addition to strong performance, secondaries have traditionally provided the following benefits to investors new to private markets or seeking to ramp their exposures, each of which is expanded upon below:

  • Diversify and accelerate deployment by back-filling older vintages through acquisition of interests and portfolios
  • Act as a portfolio hedge/potential for counter-cyclical exposure
  • Mitigate the J-curve
  • Cash efficiency
  • Potential for strong risk-adjusted returns.

Cumulative cash flows over time

Cumulative cash flows chart

Source: Expected returns and dispersion. Obtained through Monte-Carlo simulation: All analyses are based on diversified private equity programs investing evenly and equally during four years in primaries, secondaries and co-investments. All programs are constructed in a random manner by sampling, without replacement, from a large universe of existing investments of which the full cash flow and historical valuations were available. Cash flows of underlying investments are aggregated to a program level and then aggregated to calculate the program IRR and TVPI, net of all management fees and carried interest at underlying and at provider level. In total, 10,000 simulation runs were performed. Results are representative for investors in these programs, not in individual investments or transactions.

Secondaries in mature private market programs

An increasing number of institutional investors have chosen to make secondary market exposure a core component of their illiquid portfolio, even when their private markets portfolio has reached maturity and benefits such as J-curve mitigation and gaining exposure to prior vintage years may be less relevant. Such investors commonly cite several reasons for continued secondary exposure including:

  • Secondary market structure is attractive – supply-demand imbalance favors the buyer
  • Opportunistic strategy – ability to capitalize on dislocations
  •  Potential for superior risk-adjusted returns.

Expected return and dispersion obtained through Monte Carlo simulation

Expected return and dispersion obtained through Monte Carlo simulation chart

SourceExpected returns and dispersion. Obtained through Monte-Carlo simulation: All analyses are based on diversified private equity programs investing evenly and equally during four years in primaries, secondaries and co-investments. All programs are constructed in a random manner by sampling, without replacement, from a large universe of existing investments of which the full cash flow and historical valuations were available. Cash flows of underlying investments are aggregated to a program level and then aggregated to calculate the program IRR and TVPI, net of all management fees and carried interest at underlying and at provider level. In total, 10,000 simulation runs were performed. Results are representative for investors in these programs, not in individual investments or transactions.

Key takeaways

  • The secondary market for illiquid alternative investments has grown rapidly over the last 25 years and has now become a core allocation for many institutional investors.
  • Investing in secondary strategies can provide an attractive risk-return profile that can be diversifying and accretive to other private market strategies such as primaries and co-investing.
  • The market has continued to bifurcate between traditional and non-traditional secondary strategies with each strategy having distinct characteristics.