PRINT THIS PAGE

Secondary interests in private equity funds

Private equity secondaries funds can provide investors with diversification, lower risks and good returns. But they are not without risk. Michael Granoff and Brian Wright from Pomona Capital look at why investors are choosing this route and guide investors through the maze of choosing the right fund.

A secondary interest represents the purchase of an interest in a private equity fund from an existing limited partner who desires liquidity prior to the term of the partnership.

Why would an investor sell an interest in a venture capital or buy-out fund? 

The one generalisation that has proven true is that investors usually sell their interests for reasons having to do with their own situation and not as a result of their view of the investment itself. These reasons can include:

• Mergers or acquisition
• Change in strategy
• Change in personnel
• External reasons for investment not met, eg window on technology for companies lending business for banks
• Need for liquidity

The sale of an interest provides an investor with liquidity for an illiquid investment, allows reinvestment of proceeds, fixes the rate of return and eliminates the significant administration required to manage private equity investments.

Limited partners in funds sometimes need to sell their interests. The question for a potential investor in a secondaries fund is whether it is a good investment to buy secondary interests. 

The foundation for any secondary interest investment, is the performance of the underlying private equity funds. The rate of return of private equity funds has outperformed other asset classes by meaningful percentages over an extended period of time. The appeal of the asset class is confirmed by the huge flows of capital into private equity over the past few years.

Many secondary interest investors say that it is possible to gain the positives associated with the private equity business while mitigating many of the risks.  As a result their investment strategy is designed to take advantage of the inefficiencies of the private equity industry in three ways:

I. By purchasing interests in funds that are largely, if not totally, invested. Buying an interest in a private equity fund well into its life and analysing its assets eliminates much of the uncertainty and risk associated with a blind pool.
II. The illiquidity of the market, combined with the liquidity needs of sellers, allows for a price discount from net asset value. The purchaser has the opportunity to value the asset and decide to pay for them.
III. Buying into a partnership at a late stage results in a significant time discount, shortening the holding period and resulting in earlier distributions. This means that investors miss the lemons that ripen first and benefit from the successes of the fund. The cash flow dynamic for a secondaries fund is far different from a typical private equity fund.

These factors combine to create a relatively lower risk investment with potentially higher returns. When done correctly, secondaries investors receive a greater absolute return (because of their purchase discount) in substantially less time.

Secondary players also invest in funds with a range of maturities. An investor therefore also receives instant diversification across vintage years and instant seasoning to a portfolio across economic environments. These are important considerations for those new to the private asset class or those who desire to increase their exposure.

Just how much product is there? 

The market for secondary interests is a function of only two variables:

• The amount of money invested in private equity funds. The current private equity environment is marked by more investors putting more capital into more funds. Existing limited partners are increasing their private equity investments. Many new investors are entering the private equity area. The private equity market is broadening and deepening.
• The rate of turnover. Estimates range from one per cent per year to three per cent of a fund over its life. Turnover is a function of internal circumstances and overall economic conditions. There has been a noticeable shift in sentiment by limited partners who increasingly consider selling as a regular business decision.

Overall the secondaries market is rapidly expanding. As an example, Pomona's deal flow has increased ten fold over the last four years. Last year, we analysed over $3bn of product.

While the secondary interest business is inherently attractive it is very difficult to execute. What are the difficulties?

What is required to operate a successful secondary interest business?

• Finding sellers of interests.  Sellers typically do not advertise.
• Analysing transactions.  One of the distinct advantages of the secondary interest business is the opportunity to examine the assets of a fund. But the value is only as good as the analysis. It is difficult to analyse a portfolio of early-stage private companies in a matter of days and determine whether it contains rocks or gold.
• Closing transactions. Sellers are themselves sometimes complicated entities and they require complex and flexible structures.
• Transfers of fund. Interests require the consent of general partners and they are not always immediately cooperative.

So who buys secondary interests and how can investors participate? 

The business today is dominated by only a handful of dedicated funds with varying amounts of experience and the ad hoc activities of traditional private equity gatekeepers. Although the market is growing rapidly and remains inefficient, competition has increased. Many secondaries investors are displaying their own version of irrational exuberance, taking higher risks and paying higher prices.

In sum, secondary interest funds can provide a diversified, seasoned, lower risk, high return, private equity product to investors. But it is not without risk. Peter Lynch at Fidelity often says, ‘know what you own.'  Buying an interest in a poorly performaning fund at a discount is not a bargain. Buying an interest in a quality fund at a high price assumes a great deal of risk. The secondary interest business is attractive but difficult to execute. Investors should choose carefully.

Pomona Capital is a global private equity investment firm based in New York and London.  Pomona is structured into two major business units: The value arm purchases secondary interests in leading private equity partnerships from investors who desire liquidity prior to the term of a partnership. The growth arm purchases primary interests in the highest quality US and European  venture capital and leveraged buyout funds. They currently manage over $1.25bn  in four secondary interest funds and three primary interest fund of funds for a diversified group of blue chip US and European investors. mgranoff@pomonacapital.com, bwright@pomonacapital.com, www.pomonacapital.com