Secondary Private Equity Funds
Given current market dynamics, secondary private equity funds now offer a particularly attractive avenue for investors looking to participate in the private equity market. “Secondary funds” or “secondaries” are investment vehicles run by managers that specialize in acquiring interests in existing private equity assets from the original investor. By capitalizing on the relatively illiquid nature of private equity investments, secondary funds aim to realize considerable value for their investors by buying these private equity interests at significant discounts to Net Asset Value (NAV).
Christian Salomone
Chief Investment Officer
christian.salomone@ballastrockpw.com
Secondary private equity funds operate by acquiring private equity interest from institutional investors who are seeking liquidity in an illiquid investment. These assets typically include limited partner (LP) interests in private equity funds or direct stakes in privately held companies. Unlike primary private equity funds that invest directly in companies, secondary funds provide investors with access to a range of established investments that are diversified by manager, fund vintage, and industry. Plus, these funds generally distribute earnings much sooner than traditional private equity funds because the underlying investments are typically already in asset harvesting mode.
Because public equities greatly underperformed private equity last year, many institutional investors’ target allocations are now too heavily weighted towards private equity. This is known as the denominator effect: The value of one portion of a portfolio decreases faster than others, causing remaining assets to make up a larger percentage of the overall portfolio. Institutional investors are thus forced to sell performing private equity assets in order to rebalance their portfolios and bring their target allocations back in line with internally established limits. This forced selling creates opportunity and pricing power for secondary funds that can demand a fee for their liquidity in the form a discount to NAV.
Source: Greenhill Cogent, Jefferies Global Secondary Market Review, iCapital Investment Strategy, with data as of August 2022
The discount offered in secondary private equity transactions is a reflection of both the relatively illiquid nature of the investments and the desire of sellers to exit their positions. This presents one opportunity for secondary funds to generate returns. Due to the outsized demand for liquidity from institutional investors, discounts to NAV have currently been pushed down into the mid-20% range vs. a single-digit 10-year average.
In addition to the discount to NAV and the potential appreciation of the acquired assets, secondary funds can also generate income through ongoing cash flows generated by the underlying private equity investments. These cash flows may come in the form of dividends, interest payments, or proceeds from exits of portfolio companies. By acquiring stakes in top-quartile funds and the highest-quality assets, secondary funds seek to maximize risk-adjusted returns for their investors.
Furthermore, secondary funds have historically high returns, low loss rates and lower standard deviation than traditional private equity funds. Secondary funds accomplish these attractive risk-adjusted returns by acquiring interests in established private equity funds that have already passed the initial high-risk stages of investment. By investing in seasoned portfolios at a discount, which may provide downside protection, fewer secondary funds have lost capital for investors than global buyout or venture funds, according to data from Preqin.
Source: Preqin, as of June 30, 2021.
Diversification is another crucial factor that makes secondary private equity funds appealing to investors. By investing in these funds, investors gain exposure to a diversified portfolio of private equity investments. This diversification helps reduce the risk associated with any one investment and provides the potential for higher returns. The ability to access multiple investments within a single fund enhances portfolio resilience and increases the likelihood of capturing successful investment opportunities.
In summary, secondary private equity funds offer investors attractive investment opportunities by providing access to a diversified portfolio of private equity investments at a lower entry cost.
These funds mitigate risk through investments in established assets, offer enhanced liquidity, and provide the potential for higher returns through the optimization of acquired assets. The ability to invest in top-quartile funds at a discount and capitalize on ongoing cash flows further strengthens their appeal during the current economic instability.
Have questions? Contact your financial advisor or our team members at Ballast Rock Private Wealth at ir@ballastrockpw.com.
Disclosure: Past performance is not indicative of future results. The opinions expressed are those of Ballast Rock Private Wealth and should not be taken as financial advice or a recommendation to buy or sell any security. BRPW is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in BRPW’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Ballast Rock Private Wealth portfolio. Material presented has been derived from sources considered to be reliable. but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation, or an offer to buy. sell or hold any securities, other investments or to adopt any investment strategy or strategies.
