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Why Should You Invest Now in Leading Secondary Funds?
November, 2023
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The secondary market is an essential part of the alternative investment space and flourishes especially during and post downturns. According to the current market dynamics, Secondary funds with a proven track record, are expected to deliver excellent results and are therefore one of the most promising investment opportunities currently available.
What are the main principles guiding secondary funds?
- Access to established assets: Secondary funds offer access to mature private equity investments that have already been through a significant portion of their investment cycle. This can be particularly appealing in a volatile market environment, as it reduces the risk of investing in early-stage or unproven companies. This results many times in a very low loss ratio in secondary funds.
- Diversification benefits: Secondary funds can help to diversify an investment portfolio by providing exposure to a variety of private equity funds, geographies, and sectors. This diversification can help to reduce overall portfolio risk.
- Growing Inventory: Companies tend to stay private much longer before considering going public, if at all. In addition, primary funds raised increasingly huge amounts of funds which generated a fast-growing pool of assets which is addressable to secondary funds.
- Low capital exposure and a flattened J-curve: Investors in secondary funds are usually not exposed to more than 40-60% of their commitment. This limited exposure is attributed to the receipt of distributions quite early in the life of the fund. As shown in the chart below, committing to secondary funds shortens and flattens the J-curve substantially in comparison to primary funds.
In addition, secondary funds should be able to leverage the current market conditions for multiple reasons, including:
- Distressed sellers and search for liquidity:During downturns market dynamics generate attractive deals with deep discounts, not because the assets are overpriced per-se, but due to sellers searching for liquidity or institutional investors required to balance their portfolio according to certain investment mandates.
- Attractive discounted valuations: Secondary market valuations are often determined through negotiations between buyers and sellers, rather than being dictated by public market sentiment. This can create opportunities to acquire interests in private equity funds at a discount on their net asset value (NAV). Discount margins have substantially increased since the start of the downturn as clearly shown in the chart below:
- Dry powder and competition:Unlike the high level of dry powder in buyout funds due to record levels of fundraising in recent years, the dry powder of secondary funds is substantially lower (as shown in the chart below) and therefore, encountering less competition on secondary opportunities.
It is essential to remember that there are also risks associated with investing in secondary funds like in any other alternative investment:
- Limited transparency:Investors in secondary funds may have less visibility into the underlying investments than they would with primary private equity funds. This is because secondary funds often acquire interests in limited partnership (LP) interests, which carry limited disclosure obligations. This can be mitigated by investing in the leading secondary funds having access to information.
- Illiquidity risk: While secondary funds are more liquid than primary private equity funds, they are still illiquid compared to publicly traded investments. Investors should be prepared to hold their investments in secondary funds for several years.
- Market risk: The value of secondary fund investments can still decline if the overall private equity market experiences a downturn.
Overall, secondary funds have historically generated attractive returns for investors. Over the long term, secondary funds have outperformed primary private equity funds on a net IRR basis. Therefore, especially in the current market conditions, investing in secondary funds is a very viable strategy for investors seeking to diversify their portfolios and potentially enhance their returns.
