A private investing strategy that can generate returns faster

While secondaries have been around for decades, they’re currently going through a time in the sun as many flock to see what they can pick up for a discount, with the added quality of offering the buyer liquidity.

“The purpose of secondaries is to gain liquidity from something that is illiquid, to unlock capital, which can be redeployed,” explains Dan Riverso, chief executive officer and chief investment officer at Jesselton Capital.

Known commonly as secondaries, secondary private equity markets are where buyers can pick up shares of a private equity asset from the primary market, usually marked down – between a 20- to 50-per-cent reduction – from the original purchasing price. Generally, the more distressed the asset, the more significant the discount.

“You receive a discount by providing liquidity to the seller, and then you can capitalize on the last two to three years of those companies before they are, likely, taken public,” says Riverso.

‘Decent return with a much shorter term’

“From a portfolio management standpoint, secondaries offer a decent return with a much shorter term. You can roll the money faster from one fund to another, taking advantage of opportunities.”

While the market started its uptick about a decade ago, the last two or three years have seen some heavier activity and it is now an attractive part of a manager’s investment strategy as it solves the issue of longer time horizons, along with the illiquidity experienced in the primary market, explains Riverso.

“There are private equity managers (GPs) themselves who use this market,” he says. “They use the secondary market to provide liquidity for their clients (LPs), who have been in the fund for the full 10-year term or longer.” The manager will basically put the LP interest on the secondary market to unlock liquidity.”

For family offices, especially those experiencing a new liquidity event, perhaps the first liquidity event they’ve had, private equity is a common area of interest and secondaries often make their way into the conversation, says Carol Schleif, chief investment officer at BMO Family Office.

‘Patient capital for investors’

“What you’re trying to do with private capital in general is provide patient capital for investors,” says Schleif.

“The whole reason and the whole rationale for a secondary market is creating a way to hedge that investment if your situation changes. The hardest part is, no matter how many different alternatives a family has thought through, inevitably something happens, so you need to think through that with investments.”

Schleif has also been involved in secondaries for decades, using them as a strategic investing tool in her clients’ portfolios, but as the interest in the market rises, the inevitable happens: there are good and not-so-good secondary investments.

“Every client we’ve ever put on one, both here and my predecessor firm, they’ve really liked their secondaries funds,” she says.

‘There’s a lot of money chasing it now’

“We like it conceptually as an asset class, but you have to be really careful about the people that are in it and making sure they have their pricing discipline down. Like so many things, there’s a lot of money chasing it now, there’s a lot of interest in it.”

The secondary market has continued to provide investment opportunities, which is why Northleaf has continued to build its offerings since raising its first dedicated fund in 2013, explains Matthew Sparks, managing director of private equity at Northleaf Capital Partners.

“Since then we have invested three dedicated funds, as well as investing capital in secondaries across other mandates. Deal flow continues to increase and has been driven by liquidity needs, regulatory reasons, or what is becoming more and more common, simply portfolio management or rebalancing of the LP’s investment portfolio,” he says.

Like private equity investments, secondaries have the ability to transform a portfolio by giving it exposure to assets in different industries, geographies, managers, and companies, which is a big part of its appeal.

But perhaps one of the other appealing characteristics of this market is its ability to flatten the J-curve investors experience in the primary market.

‘Generating value to investors much more quickly’

“With the J curve, [in the primary market] investors may experience a negative return for the first few years of the fund as managers are charging fees but haven’t really begun to create value in the portfolio,” explains Sparks.

“But you avoid that with secondaries because, typically, we’re buying more mature assets, at a discount to fair market value, that are already in the value creation phase and therefore generating value to investors much more quickly.”

Over the last decade Sparks says he’s seen the secondaries market grow from around a $20 to $30 billion market to a $115 to $120 billion market today and doesn’t see the appetite waning in the short term.

“It’s actually a great way to invest in private equity quickly, because you’re getting your money put to work rapidly with less blind pool risk, with an ability to conduct due diligence on the assets you’re buying, and with very attractive cash flow characteristics,” he says.

“I think investors see those benefits and are showing more and more interest in the space.”

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