private markets insights primer secondaries: risk...

The private equity secondaries market has thrived in recent years as investors search for sources of potential outperformance, risk reduction, diversification, and portfolio flexibility.

Initially a niche strategy, the use of secondary transactions as a portfolio rebalancing tool has become mainstream, with upwards of 800 institutional sellers involved in secondary market deals in 2017.1 These investors are taking advantage of the strategic opportunity to adjust their exposures to meet changing allocation targets and investment goals in a relatively illiquid asset class. As a result, secondary market transaction volume is growing faster than the broader private equity market, at a compound annual growth rate of 25% in the period 2010 to 2017, to reach a record $58 billion.2 Increased general partner (GP) involvement, as well as the rising value of both maturing and newly raised primary funds, should continue to broaden the opportunity set in secondaries for the foreseeable future.

WHAT IS A SECONDARY TRANSACTION?Traditional private equity secondary purchases simply involve one party buying an existing limited partnership interest in one or more private equity funds from another party. However, as the secondary market has evolved, an array of more sophisticated transaction types has emerged (see “The Secondary Market: An Overview” on p. 5). These non-traditional transactions involve the same or similar underlying assets, but carry an added element of complexity as a function of the way in which those assets are held, the objectives of sellers, and the goals of GPs, among other factors. The complex segment of the secondary market continues to expand more rapidly than the traditional end of the market.

At the same time, the market for traditional secondary transactions has become more competitive and more efficient. Value can still be found in the traditional segment, but less competition and greater market inefficiency within the complex segment often translates into greater return upside.

Increasingly, GPs themselves are actively leading the transaction process, rather than limited partners (LPs), but the universe of secondary investors capable of finding, cultivating, and executing 1 Evercore Private Capital Advisory, 2017 Secondary Market Survey

2 Greenhill Cogent, Secondary Market Trends & Outlook, January 2018

PRIVATE MARKETS INSIGHTS PRIMER

SECONDARIES: RISK REDUCTION WITH ATTRACTIVE RETURNS

DECEMBER 2018

SECONDARIES: RISK REDUCTION WITH ATTRACTIVE RETURNS / page 2

Private Markets INSIGHTS

0

5

10

15

20

25

Global Buyout / Venture Capital

Global Secondary 0

5

10

15

20

25

Global Buyout / Venture Capital

Global Secondary

Percentage of Funds Returning < 1.0x

1.8%

20.5%

IRR Dispersion2002-2013 Vintage Year Funds

�1st Quartile

�3rd Quartile

�3rd Quartile

�Median

�Median

�1st Quartile

CHART 1: Reduced risk

and strong return profile of

secondary funds

Source: Preqin, as of September 30, 2017. Data in left chart is based on Preqin’s database of 8,000+ private equity funds, including 204 secondary funds. Data in right chart is based on 2002-2013 vintage funds. This industry data reflects the fees, carried interest, and other expenses of the funds included in the data set. The fees, carried interest, and other expenses borne by investors in a HarbourVest fund / account may be higher or lower than the fees and expenses of the funds reflected in the data set. Past performance is not a reliable indicator of future results.

complex secondary transactions is relatively small given the differentiated skill sets required. These types of transactions are generally more resource-intensive, demand more time and patience to complete, and often carry greater execution risk. Some of the specialized skills necessary include the ability to:

>> Originate investment opportunities outside of the traditional secondary market, where intermediaries play a more active role>> Navigate multi-party negotiations and solve for multiple, sometimes competing, transaction objectives>> Create and structure new legal entities with customized governance and economic provisions>> Meet significant additional legal, tax, accounting,

and reporting obligations

It is important to note, however, that while execution risk may be elevated, the risk profile of the underlying assets being acquired in complex secondary transactions has not historically been fundamentally different than for traditional ones. Complex deals just offer a differentiated way to access similar assets.

WHY INVEST IN SECONDARY FUNDS?There are many benefits to allocating to secondary funds that may make them an excellent investment, both for investors initiating a private markets program and those looking to complement existing holdings.

Some key attributes of secondaries include:

>> Compelling risk-return profileSecondary investments usually offer an internal rate of return (IRR) that compares favorably to those of primary funds, frequently supported by gains and liquidity early in the life of the investment.3 Furthermore, investing later in the fund cycle may help lessen downside risk, due in part to reduced blind pool risk – the risk assumed when investing in primary funds, where the precise identity of the underlying investments is unknown. This is reflected in a lower incidence of secondary funds generating a loss and less dispersion in their performance (see Chart 1).

3 Internal rate of return, or IRR, is a measure of the absolute annual rate of return used in private equity that takes both the timing and magnitude of cash flows into account.


> CHART 2: Secondary

funds usually have shorter

drawdown periods than

primary funds Indicative

capital calls and distributions

of primary and secondary

investment strategies

It should be noted, however, that primary funds may generate higher returns on a money-multiple basis, which helps make secondaries and primaries complementary strategies within a well-diversified portfolio.

>> Rapid and sustained portfolio diversificationAn allocation to secondary funds can potentially offer rapid diversification across stages, industries, geographies, and vintage years. This multi-dimensional diversification may make secondaries a good entry point for investors looking to access private equity for the first time,

in addition to providing complementary exposure for experienced investors.

HarbourVest’s analysis of quarterly time-weighted returns from its Dover Street secondaries program from January 1, 2000, to December 31, 2017, highlights that secondaries may have the potential to act as a diversifier in a broad multi-asset investment portfolio. Over this period, quarterly model returns from the Dover program exhibited a low correlation with the rest of the private equity market and an even lower correlation with public equity markets.4

Source: HarbourVest. This is intended to be an illustrative example of the pace at which capital may be called by the fund. Investors and prospective investors should bear in mind that the future data presented is hypothetical and, as such, does not reflect actual timing or underlying investment performance and should not be construed as predicting the future. Hypothetical assumptions are based on experience of prior funds, current market conditions, and current fund expectations. The actual pace and timing of cash flows is likely to be different and will be highly dependent on the funds’ commitment pace, the types of investments made by the funds, the investment pace of the underlying partnerships, and market conditions. Market conditions have a strong impact on investments and realizations and could materially change these projections. These projections should be used solely as a guide and should not be relied upon to manage your investments or make investment decisions. Past performance is not necessarily indicative of future results, and there can be no assurance that future funds will achieve comparable results. Investments in private funds involve significant risks, including loss of the entire investment.

-50

-40

-30

-20

-10

0

10

20

30

40

50

13121110987654321

� Primary Capital Calls� Primary Distribution� Secondary Capital Calls� Secondary Distributions

% o

f Com

mitt

ed C

apita

l

Years following final fund close

4 As of December 31, 2017. Dover data set includes all cash flows between January 1, 2000 and December 31, 2017 within the funds comprising the Dover Street Program (Dover Street I-IX (Dover 1b excluded)). Correlation coefficient calculated as follows:


Private Markets INSIGHTS

Source: Cambridge Associates. Data as of June 30, 2016.

>> Accelerated capital deploymentA secondary fund is likely to have a more compressed drawdown period – the initial phase during which committed capital is invested – than a primary fund (see Chart 2). This may appeal to investors looking to quickly meet allocation targets.

>> More rapid distributionsThe relative maturity of underlying holdings in most secondary transactions means that distributions to investors from secondary funds tend to occur earlier than for primary funds (see Charts 2 and 3).

>> J-curve mitigationSecondary funds can potentially generate gains sooner than primary funds, primarily due to the opportunity for buyers to acquire assets at a discount to fair value. This can provide an immediate post-acquisition increase in the value of the investment. These earlier returns may help reduce the J-curve effect typically associated with primary private equity funds – where fund performance initially may be negative as investments are made, before turning positive later in the fund cycle as these investments begin delivering gains.

For more information on the secondary market, and to find out how HarbourVest can help you realize your investment goals, please get in touch with your HarbourVest contact or email [email protected].

> CHART 3: Secondary funds

tend to return capital more

rapidly than other fund types

PE Fund-of-Funds Average

Global PE Fund Average

Secondary Fund Average

Years to Achieve 1.0x Distributionsto Paid-in Capital (DPI)

6.6

7.8

11.1

Timing of Fund Distributions as Percentage of Total Distributions to LPs

0

20

40

60

80

PE F-o-F Average

Global PE Fund Average

Secondary FundAverage

19%

21%

40%

7%7% 4%

9%

31%

17%

52%

�Years 1-3

�Years 4-5

�Years 6-8

% o

f tot

al d

istr

ibut

ions

to L

Ps

The universe of secondary investors capable of finding, cultivating, and executing complex secondary transactions is relatively small given the differentiated skill sets required.

SECONDARIES: RISK REDUCTION WITH ATTRACTIVE RETURNS / page 5 SECONDARIES: RISK REDUCTION WITH ATTRACTIVE RETURNS / page 5

> SECONDARY MARKET TRANSACTION TYPES

GP-LED TRANSACTIONS

TRADITIONAL

MORE COMPLEXTRANSACTIONS

The sale of an LP interest or group of LP interests by a single seller.

LP TENDER OFFERSA secondary buyer offers to acquire LP interests in one or more of a GP’s funds. LPs are given the option to sell or hold.

ASSET SALES

>> Fund Recapitalization/Asset SaleThe sale of all or a subset of assets by a GP to a new vehicle financed by a secondary buyer and managed by the GP. LPs typically have the option to either sell or receive an interest in the newly formed vehicle.

>> Preferred EquityThe issuance of a newly created preferred equity security in a fund to a secondary buyer by a GP. All assets remain in the fund, but the secondary buyer receives a priority claim on future distributions. The proceeds may be used to make a distribution to LPs.

>> Strip SaleThe sale of a fixed percentage of the underlying companies in a fund by the GP to a new vehicle financed by a secondary buyer and managed by the GP. LPs receive a distribution from the sale.

TEAM SPINOUT / BUY-INThe purchase of a portfolio of direct investments by a secondary buyer, either alongside the existing management team or together with a new team.

PUBLIC MARKETThe de-listing of a publicly traded private equity vehicle either through a share purchase or the purchase of the underlying assets, resulting in a liquidating distribution to shareholders.

STRUCTURED LIQUIDITY SOLUTIONSA customized solution provided by a secondary buyer designed to meet the liquidity needs and transaction objectives of a seller that cannot be resolved through a traditional sale.

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APPENDIX

THE SECONDARY MARKET: AN OVERVIEW


Private Markets INSIGHTSPrivate Markets INSIGHTS

� GP-led Volume� Other Transaction Type Volumes

0

10

20

30

40

50

60

2017201620152014201320122011

33

7

28

9

44

14

34

8

26

2

23

1

25

$ Bi

llion

s

> GP-LED DEAL VOLUME AS

SHARE OF TOTALThe growth in

GP-led deals has outpaced that of the overall market since

emerging in 2012, accounting for 24%

of deal volume by 2017.

0

20

40

60

80

100

120

140$

Billi

ons

’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17 ’18E ’19E ’20E ’21E ’22E

Forecast Range> SECONDARY

MARKET GROWTHSecondary market

deal volume rose at a 25% compound

annual growth rate in the period 2010-2017. This

rapid expansion is expected

to continue.

Source: Greenhill Cogent, Secondary Market Trends & Outlook, January 2018, Preqin, HarbourVest estimates

Source: Greenhill Cogent, Evercore


39%Buyout

22%Venture

14%Real Estate

10%Mezzanine / Distressed

8%FoF / Secondaries

5% Energy 2% Co-investment

> SELLER TYPE BY NUMBER OF SELLERS

Reflecting the growth of GP-led deals, GPs

have become one of the two largest

institutional sources of private equity

secondary market sales, alongside

public pension plans.

Source: Greenhill Cogent, Setter Capital

� Public Pensions� General Partners� Financial Institutions� Endowments & Foundations� Fund-of-Funds� Corporations� Other

20% 18%10% 14% 16%

24%

18%

14%15%

18%

24%24%

19%

25%10%

14%

12%14%

14%15%

24%

24%

16%12%

11%16%

18%

6%

6%

10%

10%

12%

12%

24% 20% 16% 13% 12%

201720162015201420132012

> FUNDS MARKETED

BY STRATEGY IN 20171

While buyout funds remained the most

common strategy being sold on the

secondary market, the opportunity

set has continued to broaden across

private markets.

1 Weighted by fund countSource: Greenhill Cogent transactions

Beijing | Bogotá | Boston | Hong Kong | London | Seoul | Tel Aviv | Tokyo | Torontowww.harbourvest.com

HarbourVest is an independent, global private markets investment specialist with more than 35 years of experience and more than $50 billion in assets under management. The Firm’s powerful global platform offers clients investment opportunities through primary fund investments, secondary investments, and direct co-investments in commingled funds or separately managed accounts. HarbourVest has more than 400 employees, including more than 100 investment professionals across Asia, Europe, and the Americas. This global team has committed more than $34 billion to newly-formed funds, completed over $19 billion in secondary purchases, and invested over $8 billion directly in operating companies. Partnering with HarbourVest, clients have access to customized solutions, longstanding relationships, actionable insights, and proven results.

private markets insights primer secondaries: risk...

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