Investing in Secondaries
Issues to be addressed in this research paper
Investing in secondary opportunities in the alternative space is a growing investment opportunity with one source (Greenhill Cogent) estimating $40 billion worth of shareholder capital to have changed hands last year (chart 1). Approximately 80%, or $32 billion, involved limited partners (LPs) selling their fund interest, with the balance made up of transactions generated by general partners (GPs) through spin-outs, restructurings, etc.
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Other firms estimate the secondary market to be even bigger. Setter Capital reckon that the total secondary market as early as 2013 was no less than $75 billion. At least some of the difference between the two estimates can be explained by the fact that Greenhill Cogent does not include secondary transactions in hedge funds in its numbers, but hedge funds did not account for that many transactions in 2013 (chart 2), so it cannot be the only explanation.
Whatever the correct number is, the secondary market for alternative investments is an opportunity that warrants a closer look. In this research paper I will assess whether this is an opportunity worthwhile pursuing and, if the answer to that question is yes, where should one look for opportunities?
The DNA of the secondary market
In the first few years after the financial crisis, almost all investments in secondaries were driven by the aspiration to take advantage of selling shareholders’ need or desire to create liquidity in funds that for one reason or another were illiquid, but that is no longer the only reason why.
Many investment schemes created in pre-crisis times - whether open-ended or closed-ended - ran into liquidity problems as the financial crisis unfolded, and couldn’t honour the redemption terms offered to investors. Sometimes assets had been acquired too expensively; sometimes the underlying liquidity match between assets and liabilities were out of whack.
Whatever the reason, a significant proportion of those funds changed hands in the first few years after the crisis; however, the liquidity problem hasn’t entirely gone away. Fall-outs from the financial crisis continue to account for a meaningful share of all secondary transactions. That is probably best documented by looking at secondary transactions by vintage (chart 3). Admittedly, the chart only includes buyouts (private equity), but the indication is pretty clear.
Setter Capital reckon that, in 2013, about half of all institutional sellers were opportunistic sellers, and there is no reason to believe that the share of opportunists has since dropped. If one looks at overall secondary volumes, it would be fair to say that, around 2014 / early 2015, the fishing pond dried out for a while but, more recently, volumes have picked up again.
One hedge fund secondary buyer told us that there are currently more opportunities than ever and, according to him, the ample supply is a function of poor hedge fund returns. The combination of poor returns and high fees have turned many investors against hedge funds. If the hedge fund in question has also turned illiquid (or have had to create an illiquid side pocket), those negative feelings are even stronger – in particular if the investment in question is too small to move the needle.
Whatever drives the LP to sell, the GP is more often than not in favour of the shareholder capital changing hands – usually because a problem goes away. LPs who wish to redeem from illiquid offerings have a history of making life quite difficult for the GP - hence the inclination to approve the transaction.
That said, the similarities between the various model we have seen probably stop there. Some focus on supposedly liquid offerings – typically hedge funds - that have turned illiquid, whereas others are committed to illiquid offerings; funds that were always meant to be illiquid for a period of time, such as private equity or real estate; however, the price a private equity GP paid in 2005-07 for some of the underlying assets have made liquidation an unprofitable proposition.
In the ‘liquid’ space (i.e. funds that used to be liquid but are no longer), an attractive price is usually obtained by offering selling LPs liquidity, provided they are prepared to accept a discount to NAV. In the illiquid space, an attractive price can be obtained in two different ways. One can either acquire the equity at a discount to NAV, or one can pay NAV (or a price close to NAV) but acquire the underlying assets at an attractive valuation.
Say the open market (fair) value of a private equity portfolio is 7x EBITDA. If that portfolio can be acquired at 5x EBITDA, but at a price very close to NAV, you achieve two objectives; (a) you acquire the assets at an attractive price, and (b) all but the most sophisticated selling LPs are quite content, as liquidity has been obtained virtually at NAV. The fact that the price (EBITDA multiple) is low is often disregarded. The average private equity fund sold in the secondary market in 2015 changed hands at 90% of NAV, which suggests to me that buyers often use this technique when acquiring assets in the secondary market.
Having said that, our research so far suggests that a key to success in the secondary market is to always acquire performing assets. As one investment manager said, bad assets remain bad assets regardless of price.
Who are the sellers in the secondary market and what do they sell?
There is no industry-wide data available as to which types of funds dominate the secondary market, but we have obtained some data from Greenhill Cogent, which provides at least an indication. Given Greenhill’s prominent position as a broker in the secondary market for closed-ended funds, we wouldn’t expect their numbers to be dramatically different from the industry-wide ones.
When looking at chart 4, it is obvious that the secondary market for closed-ended funds is dominated by private equity buyouts. Venture capital and real estate are second and third respectively, with the rest accounting for only a modest share; however, real estate is by far the most rapidly growing investment strategy in the secondary market (Source: Greenhill Cogent).
In terms of selling shareholders, there is no particular pattern. The secondary market is dominated by endowments and foundations (chart 5), but those types of investors also account for a very significant share of the overall investor base. It wouldn’t really be fair to draw any conclusions on the basis of chart 5 other than the observation that all types of investors are well represented.
The opportunity set
Based on conversations I have had with various secondary managers, it would be fair to say that the vast majority of returns over the years have come from the discount on offer, and only a very modest share from the underlying investment strategy. As one secondary hedge fund manager only half-jokingly said: “110% of our returns come from the discount”.
That said, total returns in this investment strategy have been very attractive indeed, with many investment managers reporting (net) annual returns in excess of 15% on average.
Due to the fact that the underlying investment strategy doesn’t seem to have a meaningful impact on overall returns, one shouldn’t expect returns to be correlated to either equities or bonds. The correlation factor will obviously vary from case to case, but you should always expect it to be low.
Potential investors would have to choose between secondary fund offerings consisting of open-ended and those consisting of closed-ended funds, as no secondary funds (at least none of the funds I have seen) mix the two types of investment strategies. From a liquidity point of view, it probably makes little difference, as both types of secondary funds are multi-year in nature – typically 4-6 years in total.
Selling shareholders often sell because they need the liquidity, but it is by no means the only reason why. As the secondary market has turned more liquid, it has become a potent portfolio management tool, providing investors with access to liquidity in asset classes that used to be entirely illiquid.
Buying shareholders, on the other hand, can use the secondary market to better diversify their holdings across vintages. The risk is that, as a consequence of illiquid asset classes turning quasi liquid, the illiquidity premium may fall over time.
Key risk factors
When a secondary buyer acquires what is - at least at that stage – an illiquid investment vehicle, he obviously takes a punt on it turning liquid at some future point.
The managers I have talked to all do in-depth research on the fund in question before committing capital, but you obviously still get it wrong every now and then. It is an investment strategy based on deep research, but it is also to a degree a numbers game, which makes diversification so very important.
It should also be noted that, in times of crisis (e.g. a deep recession), some secondary hedge funds could see a substantial part, or all, of the discount at which the manager has acquired the assets go away, which would obviously increase the correlation factor.
Managers who have failed in this strategy have tended to run portfolios that were too concentrated, and they have sometimes allowed themselves to get involved in investment strategies they didn’t really understand. Diversification is important, but it is equally important that the secondary manager understands his own limitations.
Without having yet completed our research, it appears that return prospects are higher in the open-ended space than they are in secondary closed-ended funds.
We obviously need to research this more thoroughly, but it looks as if much of the capital that has flown into secondary funds have flown into ‘closed-ended secondaries’, whereas ‘open-ended secondaries’ have found it harder to raise capital.
One reason could be that institutional investors like what I call silo investing. They prefer if everything they invest in can be easily categorised, and a secondary fund that focus on private equity buyouts is easy to categorise. It is still a private equity buyout fund.
On the other hand, a secondary fund investing in hedge funds is much more difficult to categorise. Is it a hedge fund or …? I believe something as simple as that could be holding back many institutional investors from investing in secondary hedge funds, and therein lies the opportunity.
15 November 2016