Once seen primarily as a safe haven during times of distress, the private equity secondary market has grown rapidly over the past decade to become an active platform for investors to build portfolios of private investments, achieve diversification, and provide liquidity and rebalancing flexibility to sellers in a cost-efficient way.
According to a recent survey by Preqin, secondary transactions in private capital in 2017 totaled approximately $60 billion. Thirty-five funds that specialize in private secondary market investments — secondaries — closed in 2017, raising a combined $40 billion. Portfolio management and liquidity remain the main factors in the decision to use the secondary market to sell, with a large proportion of the deals coming from pension funds and fund of fund managers.
As of the start of Q2 2018, the average median net IRR for secondaries across all vintages was estimated at 15.8%. Secondaries are seeking an aggregate of $30 billion in new investments.
Brett Hickey, founder and CEO of Star Mountain Capital, discussed his perspective on the opportunities that the secondary market may offer to investors that are interested in increasing their private investment allocations. Star Mountain Capital is a specialized asset management firm focused on direct investments, fund investments, and secondary transactions in the US lower middle market.
CFA Institute: Can you give us an overview of the types of investment transactions that take place in the secondary market?
Brett Hickey: There are two basic types of private equity secondary transactions. First, a buyer may purchase a direct investment in an operating company or a portfolio of companies from another investor that wants liquidity (“direct interest purchase”). For instance, a high net worth individual may have made a co-investment in a company and is now looking to liquidate it through a secondary sale. Second, a buyer may purchase a limited partnership interest in a private equity fund from a pre-existent investor in that fund (“fund interest purchase”). For instance, you may have a foundation or pension fund that wants to rebalance its portfolio and reduce its overall allocation to private equity, or simply exit from a specific manager relationship. In this case, the buyer will acquire an interest in a portfolio of investments indirectly, through its interest in the private equity fund that holds those assets, and will also typically take over the remaining capital commitments of the seller in the fund.
What are the main advantages of a secondary fund purchase versus a primary fund investment?
A key advantage for us is that in secondaries you are dealing with funds that typically have already deployed a significant amount of capital, and you have the opportunity to analyze the actual assets that the manager has purchased, versus making a blind commitment to a manager at the inception of the life of the fund, and then relying on that manager to make good investments. In a secondary transaction, you have a lot more data and information on which to base your investment decisions.
Can you walk us through the key considerations in your due diligence process for selecting deals in the secondary market?
As a start, the fact that a fund interest or an individual portfolio investment is selling at a discount to its stated net asset value does not necessarily mean that it is a better investment than a fund interest or an individual asset that is quoted at NAV or above NAV. You really need to analyze the individual portfolio holdings in a fund to assess if the fund’s stated value is appropriate, and then determine what price relative to the stated value you are willing to pay. Sometimes we see that a deal that is quoted at net asset value can be a very attractive investment opportunity, because there is embedded upside that has not been incorporated in the stated value.
At Star Mountain, we run a rigorous bottoms up due-diligence approach: Whether we intend to purchase an investment directly or a portfolio of investments through a fund, we start by analyzing each of the companies in the portfolio. The same team that analyzes our direct investments is also responsible for our secondaries. Among others, we pay special attention to the industry, business fundamentals, structure of the underlying portfolio company, structure of the fund, valuation of the assets, and performance and management team of the individual companies. We require a lot of information and a lot of transparency. We have a very focused approach to investing: We only invest in the lower middle market, where we have specialized expertise along with information, underwriting, and portfolio management-capability advantages. When it comes to fund investments, there is also an additional layer of complexity, which is the analysis of the fund manager and its legal documents.
What are your key considerations in evaluating a manager’s and fund’s historical track record in your deal selection process?
As part of our due diligence process, we want to understand if the manager has been successful investing historically, and what are the sources of the manager’s returns in terms of performance attribution. Most importantly, we want to be able to make an informed assessment of how the manager may perform in the future. We look at the manager’s strategy, portfolio of investments, and infrastructure. Are they retaining top quality talent? Is the manager growing its business? Are they planning to start other funds in the future.
For a specific fund, we look carefully at the governance structure in the limited partnership agreement, subscription agreement, and private placement memorandum to analyze the terms and conditions that are offered to the various stakeholders. We consider who are the other limited partners: If the other LPs will have to make a vote, are they likely to share our views? Also, we consider the level of transparency that the manager is willing to provide on the activity of the portfolio companies. We provide very open and transparent communications to our investors, and we look for a similar level of transparency in our managers.
Secondary funds may help improve the IRR profile of a private equity fund investment by allowing investors to enter a fund at a later stage when cash distributions to investors are already taking place and offset, at least in part, any remaining cash outflows related to capital calls. In other words, investors may be able to avoid the drag on the IRR which typically occurs early in the life of a fund, when cash outflows greatly exceed cash inflows to the investor (the “J Curve effect”). Also, some argue that the early IRR for secondary funds may receive a boost due to the mark-up effect of purchases made at a discount and then written up in subsequent reporting periods, typically over a few years. How relevant are these effects from your experience?
At the fund level, the “J Curve effect” ultimately depends on performance of the assets, how invested the portfolio of the fund is at acquisition and how much cash it is generating versus any cash outflows relating to the remaining capital calls. What is the percentage of the portfolio that is already funded and that is generating cash flows from the investors? How much is the uncalled capital? In general, our secondary transactions tend to be in funds that are already 60% invested or more.
We also look at the length of the remaining investment period under the terms of the fund’s agreement. Does the agreement allow for an extension of the fund’s life? What is the plan for deployment of the remaining cash? Our focus is not on the mechanics of the IRR calculation per se, but on the quality and relative valuation of the assets in the fund. In terms of the IRR, we look carefully also at the IRR of the individual assets. The unrealized component, in particular, is critical. Actual performance for an investment depends on the accuracy of the valuation.
The use of leverage is becoming all the more common in private equity funds, particularly in the form of subscription lines of credit with longer terms (120 days and above). What are your key considerations in evaluating fund financing as part of your due diligence process?
Looking at the structure of a fund and its use of leverage is a key aspect of our due diligence assessment. We analyze the structure of the fund and we look to establish the type and contractual form of the fund’s leverage: Does the fund have asset-based leverage? Does the fund use a subscription line of credit and what are its terms and conditions? Are there any clawback clauses and guarantees?
In some cases, leverage can be easy to identify as it can be detected from the financial statements of the fund. However, there are types of leverage that are not always adequately disclosed in a fund’s financial statements, or may not show up at all. Guarantees at the portfolio company level present special challenges in this regard. Investors must look for off-balance-sheet liabilities and know how to ask questions to detect them. The quality of reporting and the approach to transparency varies widely among funds. We have explicit questions on leverage that we go through as part of our due diligence process, and we look for detailed answers.
Where do you see opportunities in the current market for secondaries?
In general, our focus is on inefficient markets. There are generally two sources of inefficiencies. The first is size: smaller deals and deals in smaller managers that are not well covered by brokers and by large, traditional secondary buyers. The second is complexity: We look for deals that are harder to analyze and harder to execute, such as fund restructurings for instance. A less efficient market typically provides for better investment opportunities. The cost of the extra return is labor: If you want to generate better absolute and risk-adjusted returns, we believe you need to be willing to invest to acquire the talent and expertise that is needed to identify, execute, and manage more complex and often smaller deals.
At Star Mountain Capital, we find our opportunities in the lower middle market: Companies that have less than $20 million in annual EBITDA, and that typically fall outside the radar screen of the larger asset managers.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Antonella Puca, CFA, CIPM, CPA/ABV, CEIV, is a Senior Director in the Valuation Services group of Alvarez & Marsal in New York and the author of Early Stage Valuation (Wiley, 2020). Prior to A&M she was part of the alternative investment group at KPMG/Rothstein Kass, where she helped launch RK’s Bay Area practice, the global hedge fund practice of EY in San Francisco and New York, the financial services team at RSM US LLP, and BlueVal Group in New York. Puca served as a director in the ethics and professional standards group at CFA Institute and as a volunteer focused on certifications and curriculum programs. She has served as an executive committee member of the board of the CFA Society of New York and as a member of AIMA’s research committee. She is a member of the Business Valuation Committee of the AICPA. Puca is licensed as a CPA in California and New York. She is accredited in business valuation (AICPA), holds the valuation analyst and the entity and intangibles valuation certifications. Puca is a member of the Italian Professional Association of Journalists. She holds a degree in economics with honors from the University “Federico II” of Naples, Italy, and a master of law studies in taxation from NYU Law School. She has been an adjunct faculty member at New York University, a research fellow at the Hebrew University of Jerusalem, and a member of the 420 Italian National Sailing Team.