Including the expert opinion of Edoardo Levy, Founder of BZH Capital Partners
Market environment
In a low interest rate environment supported by high valuations, alternative investments remain a safe heaven: the right balance between the search for excess return and the need to contain risks. However, given this expansionary cycle is arguably approaching an end, future expectations will likely be impacted. Moreover, it’s worth noticing private equity valuations, after years of excellent performance, are still rather high, hence suggesting lower future returns and longer investment durations.
On the private debt side, the progressively loosened requirements for loans and mortgages altered exposure to certain types of debt, as well as classes of investors considerably riskier. Therefore, while it is correct to expose oneself to these asset classes, this must be done with care.
Therefore, in a scenario such as the one just mentioned, secondary private equity can represent an ideal compromise between the need to increase returns and the need to contain the level of risk.
Secondary private equity: characteristics and peculiarities
A well-developed segment of the private equity market, “secondary private equity funds”, has specialized in investing in either shares of private equity funds, or in portfolios of individual assets under their management. Secondary private equity funds offer the same advantages as fund of funds, where the manager buys shares in private equity funds launched years earlier by investors who, for various reasons, opted to exit their position early.
The sale of fund shares in the secondary market is typically necessary for either adjustments to investors’ asset allocation, to reduce the extent of relationships with general partners, or for alternative portfolio funding needs.
The size of the secondary market has reached a substantial size with assets under management around $300 billion at the end of 2020. Available liquidity around mid-2020, the so-called secondary “dry powder”, was around $125 billion.
Source: “private equity: la prospettiva del secondario”, Oddo BHF Asset Management.
These, in turn, are resources effectively available to investors in the primary private equity market, in the case they chose to divest before the natural liquidation of their investment. All of which contributes to a very high growth rate in the secondary market. Secondary funds, i.e. general partners acting as liquidity providers in the private equity market, have evolved from fund-of-funds-like structures (acquired after their closing) to funds with complex and diversified investment strategies. The stakeholders of secondary funds have also evolved from limited partners (i.e., investors in primary funds) increasingly to general partners of primary funds.
Some of the reasons associated with the increased popularity of the secondary market are:
- Reduction of the duration of the investment
- High diversification: investing in multiple funds allows to obtain a more diversified portfolio by managers, vintage, geographies, industry, sectors, etc.
- Visibility on investments: a secondary fund, by purchasing stakes in funds that have already (or almost) completed the investment period, allows to have a clear vision on the target companies reducing the uncertainty factor.
- Frequency in distributions: in a traditional private equity fund, investors typically receive distributions beginning from, and not before, the fourth or fifth year. In a secondary fund, distributions are much closer together, breaking down the J-curve.
Thanks to its characteristics, secondary private equity is particularly suitable for those who are approaching illiquid assets for the first time; in fact, secondaries allow you to invest even relatively small amounts, typical of beginners, while still benefiting from a higher degree of diversification. In addition, it allows one to aim for the returns typical of private equity but with a lower risk and volatility profile, thus moving the efficient frontier upwards.
Secondary private equity: the vision of Edoardo Levy
Do you think there may be disadvantages to being exposed to an investment in secondary private equity funds? In your view, what should an LP’s investment approach be in such funds?
Secondary private equity funds are a very important diversification tool within portfolio management of both institutional and, increasingly, non-institutional investors.
Through a secondary private equity fund, an investor can have a well-diversified exposure, with a later stage maturity than a traditional investment, and therefore with greater downside risk protection.
An investor could therefore analyse investing in such instruments based on the key qualities of a secondary private equity fund and thus focusing on:
- Maturity profile
- Diversification in terms of geography, sectors, strategies, and managers
- Discount to investments NAV;
These factors are key in understanding the economic profile of the investment in terms of both the expectation of more frequent distributions over time and the expectation of NAV growth over time. Answering the initial question, if anything, I see an advantage to the investor in adding such exposures to the portfolio, again with a view to diversification and creating a more stable distribution profile over time.
Given your experience on the pre-IPO side (Tech in this case), how have you seen the type of interest in secondaries change among different types of investors?
The world of pre-IPO tech is certainly evolving rapidly. In the aftermath of Covid-19, the incredible amount of available capital combined with low interest rates and relatively low returns from
traditional asset classes are creating a vacuum that the market is normally acting quickly to fill.
Pre-IPO techs are typically “late stage” companies focused on “disrupting technologies” that can change the status quo of markets, habits and products that we have been accustomed to buying traditionally in a certain way. Such companies tend to have valuations over $1 billion (Unicorns) and sometimes well over $10 billion (Decacorns). A combination of attention from the media, availability of large amounts of capital, and macroeconomic factors are driving more and more capital into these types of investments. Not only Venture Capital, but increasingly more Hedge Funds, Institutional Funds, Asset and Wealth Managers, Family Offices, up to HNWI are those who are directly involved with this asset class.
To the extent that pre-seed funding rounds are perhaps becoming too large for traditional VC funds, which find themselves in the uncomfortable position of having to carve out space at even earlier stages of seed and pre-seed, to continue achieving certain performance targets.
In our opinion, interest from less institutional investors will continue to grow, thus giving rise not only to new investment instruments, but also to new structures capable of facilitating access to such opportunities. In short, a true democratization of private markets is developing before our eyes.
Do you think the secondary trading process can speed up the actual listing process for different unicorns?
Indirectly yes, in the sense that secondary trading allows for liquidity development of such products, hence letting investors of different genres access to such investment opportunities. This, in turn, makes liquidity available in investment rounds prior to an IPO, thus enabling companies to achieve important economic objectives ahead of traditionally longer timeframes, eventually leading these to reach an exit/listing earlier.
Obviously, we must not forget that secondary trading is a technical factor that can play against the investor when the fundamental underlying component of the investment is missing. Given the times in which we find ourselves, where risk taking is ever increasingly gaining popularity, we must never forget the past and be cautious of speculative bubbles.
What do you believe is the most efficient method of obtaining liquidity in the pre-IPO secondary market (Private Placement, Brokers, Share Repurchase or Secondary Share Sales)?
The world of private equity funds is constantly evolving due to the enormous impact they are having on the global economy.
The traditional private equity fund may not yet be viewed in the same light as a company like General Motors or FCA are, but, at the same time, investors are treating public investments in such funds as alternative investments, not as traditional ones.
In our opinion, the role of the private equity fund in the market is still being studied and understood by investors on public markets. It is perhaps fair to state that the classification of alternative investment is not in tune with the innovation that such funds are bringing to the market by, for example, opening their shareholder base to investors historically accustomed to quite different things.
The increase in private equity fund listings is also linked to the enormous activity we are witnessing on the institutional capital markets whereby an increasing number of investment funds are directly acquiring blocks of interests in other private equity funds.
We believe that over time, activity on capital markets combined with direct listings, will lead to a greater understanding of these assets by investors in the public markets, combined with a greater streamlining of these fund
The information contained in the article does not constitute a solicitation to public savings and is not intended to promote any form of investment or trade, nor to promote or place financial instruments or investment services or banking / financial products / services.