Secondaries Market Overview Investors are facing significant headwinds across various asset classes
Interest rates are at unprecedented low levels, leading to major risks for fixed income. Equity markets are trading well above long term averages exposing investors to downside risk. Market volatility has increased in the last few months implying pressure on equity returns ahead. A glut of capital into PE has led to increase in entry prices thus diminishing the returns for the asset class. Finally, the lengthening of time to exit for startups has caused traditional VC funds to extend the length of their fund life and returns aren’t capturing the illiquidity premium necessary to justify the investment.
Faced with the dual challenges on both the asset and liability fronts, we believe that secondaries present an excellent risk-adjusted return profile, exhibiting defensive attributes while still providing attractive long-term returns.
1 History and growth of the Secondary Market
The secondary market dates back to the Global Secondary Transaction Volume 1980s, when a handful of firms started $billions selectively purchasing interests in buyout and VC funds. It took the market two decades to develop from a niche market to a functional and active market place.
We believe the strong growth since 2005 is a result of several factors affecting supply and demand. On the supply side, strong funding environments for primary funds from 2005 to 2008 followed by the financial crisis led to greater acceptance of secondaries as a tool for managers to meet liquidity and regulatory needs. The availability of well performing yet discounted assets led to a growing demand that fueled transaction volume.
Source: Prequin, 2018 Prequin Global Private Equity & Venture Capital Report, 2018
2 Still a lot of opportunity left to be realized
Despite strong transaction volume increases, Secondary Transaction Volume as % of Available Supply the proportion of secondary transactions in $billions relation to the unrealized valued of private equity is quite small.
Using NAV and unfunded commitments for US and European buyout and venture funds for the last ten vintage years as a proxy for available supply of secondaries, and assuming a 4 year time lag for primary commitments to become available on the secondary market, CAIA estimates that only 2% of commitments made between 2001-2005 have translated to secondaries. This conversion rate has increased dramatically as secondaries have become a more broadly accepted portfolio management tool. CAIA estimates this conversion rate reached 6.2% in 2015.
Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018
3 Buying at a discount
What makes secondaries an attractive Average high bid as percentage of NAV investment opportunity is the fact that in exchange for providing liquidity for those holding illiquid assets, investors purchase those assets at a discounted price to the current valuation or NAV. While these discounts can vary from deal to deal, on average investors can purchase assets at a 20- 40% discount. That discount has tightened during the past few years to closer to 10%.
Source: Greenhill Cogent, Secondary Market Trends & Outlook, 2016
4 Benefits & Return Advantages of Secondaries
5 Shallower and shorter J-curve effect
In the initial years of a traditional primary PE IRR Profile of Primary and Secondary Investments or VC investment, a fund will exhibit negative returns due to the front loaded nature of the fee structure. While this is normal, it IRR adversely affects the IRR. Acquiring a fund interest at a later stage of its life, after much of the fee load has already been paid, allows for partial or entire mitigation of the J-curve effect, especially if the interest is acquired at a discount to the NAV. TIME
6 Higher IRR compared to direct funds
According to data from Cambridge Associates, Average Net IRR secondary funds on average had a 4.1% Between 1993 - 2015 higher IRR than direct private equity and venture capital funds. This higher IRR is due to shorter holding periods in secondary investments and recognition of gains through purchasing assets at a discount.
Global Secondaries Global PE/VC
Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018
7 Secondaries consistently outperform other PE
Median Net IRRs by Vintage Years: Secondaries vs Private Secondary transactions have consistently outperformed other private capital funds over Capital Funds the last 8 years on a net IRR basis. More importantly, returns have increased in recent years as demand for liquidity, and thus a willingness to sell at a steeper discount, continues to grow.
Source: Prequin, Secondary Market Update Q1 2018
8 Higher returns with lower risk
According to data from Cambridge Associates, Volatility of Quarterly Returns the returns from secondaries were less Between 1993 - 2015 volatile on average versus direct private equity and venture capital funds. This analysis is based on the standard deviation on a series of quarterly net returns from Q1 1993 to Q4 2015 (92 quarters) and annualized thereafter. The lower volatility is likely due to investors entering funds at a later stage compared to the original investor, which allows them to identify and adjust buy-in pricing for the assets.
Global Secondaries Global PE/VC
Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018
9 Fewer secondary funds lose capital
According to Prequin, only 1.4% of secondary Percentage of Funds Returning Less Than 1.0x funds exhibited TVPI ratios below 1.0x $billions compared to 22.8% for direct private equity funds. This greatly diminished risk of losing capital can be attributed to the greater diversification compared to single funds, shorter time to liquidity, reduced blind pool risk, and the acquisition of assets at a discount to NAV.
Global Secondaries Global PE/VC
Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018
10 Accelerated cash back
Secondary funds typically begin to return cash Distributed-to-Committed Ratios to investors early in their fund life and show higher distributed-to-committed ratios compared to PE and VC funds. According to Prequin, a median ratio was more than twice as high for secondaries as for PE or VC funds.
Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018
11 Smaller funds outperform larger ones
The majority of secondary funds have AUM of Net IRR by Fund Size $1B and higher. Like much of Private Equity, Performance data up to Dec 31, 2015 smaller funds tend to outperform larger ones. This is typically because smaller checks allow managers to be more flexible thereby giving them broader acquisition opportunities to deploy capital throughout market cycles at attractive buy-in prices.
For purposes of this analysis, we grouped fund sizes into three categories:
Small Cap: <$500m Mid Cap: $500m - $2.5b Large Cap: >$2.5b
Smaller secondary funds can take advantage when a small number of employees and/or investors want to sell their stock ($5-20m). Source: CAIA, Introductory Guide to Investing in Private Equity Secondaries, 2018 This leads to the ability to move faster, work with fewer parties and getting better pricing. 12 There is a gap in the market
During 2004 - 2006, most venture funds Micro VC funds created in 2004-2006 weren’t willing to write checks smaller than $5m because of the size of their fund. At the same time, the cost of starting a company had decreased dramatically requiring less capital to release an initial product. There were a handful of new VCs that recognized this trend and raised what is now know as a “Micro VC Fund.” These funds went on to be some of the best performing venture funds of all time.
Today, the secondary market is in a similar position as the venture market in 2006. More employees and early investors are looking for liquidity but either don’t have or don’t want to sell hundreds of millions of dollars worth of shares that the large secondary funds require. Hence there is a great opportunity for a “mico secondary fund” to fill this void in the market today.
Uncork Capital was launched as SoftTech VC and rebranded in 2017 13 Case Study: 2017 Backward Looking Gains from Tech IPOs in 2017 Assumes bought secondary at 20% discount to last private valuation and sold after lockup ended
We gathered data on many of the tech companies that went public in 2017 in order to back test what performance would have looked like if a secondary fund had invested in these tech companies. To simplify, we made the assumption the fictitious secondary fund bought in at a 20% discount to the last private valuation of the company and then sold its position immediately following the standard 6 month lockup period after the date of the IPO. Even with lofty private market valuations, the secondary fund would have performed extremely well due to the discount paid.
Source: Pitchbook
14 Case Study: GitHub
When Microsoft acquired GitHub for $7.5bn, there was a lot written about the returns Andreessen Horowitz and Sequoia Capital made. However, one piece of information that few realize was that Thrive Capital very quietly invested a total of $150 million into GitHub, of which $120 million was via secondary purchases from early employees, for just under a 10% stake. It is reportedly the largest investment and largest return in Thrive Capital's 9-year history.
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