Thanks to strong performance over many decades, global private equity (PE) assets have grown to about $3tn under management. Investors in PE mostly gain exposure to underlying companies either via funds, which own them directly, or funds of funds (collectively known as the primary market). Investors can also co-invest alongside PE funds into companies, or even go direct.
The so-called secondary market is another route. It is smaller – less than two per cent of private equity assets are estimated to trade hands each year – but growing fast due to structural changes in the market. Rather than committing money at the outset, secondary capital joins the party several years later, providing liquidity to sellers and creating an active and more transparent market place.
Secondary investing is theoretically attractive because capital can be deployed quickly and diversely, historical fees are avoided, underlying assets are more mature and better funded, and cash is distributed sooner. Returns in secondary funds over the past ten years support the theory.
Traditionally there has been a trade-off when investing via the secondary market. Cash returns have tended to be lower because of less risk, shorter holding periods, reduced scope for valuation anomalies and the fact that often secondary sales are of portfolios that include assets of varying quality. In buying a whole fund position, you get the good with the bad.
However, we believe there is a way to get the best of both direct and secondary investing – to have your PE cake and eat it. What we call Partnership Solutions is a hybrid strategy targeting the alpha of direct PE with the more attractive liquidity and risk profile of the secondary market.
Partnership Solutions focuses on later stage investments within an existing PE fund portfolio. The strategy leverages a dynamic and collaborative approach to satisfy every stakeholder: the incumbent investors, PE fund managers, as well as the underlying portfolio companies. Alpha and superior returns can be created by:
- Maintaining the key tenets of a secondary transaction while tactically identifying individual, attractive assets within an existing PE fund portfolio.
- Prioritising deal creation versus deal sourcing by leveraging strong relationships. This also reduces information asymmetries leading to better underwriting and greater access to managers and underlying portfolio management teams.
- Utilising a bottom-up, asset-by-asset underwriting standard. Such an approach is unrealistic from a time and skill standpoint when assessing large secondary portfolio sales in a minimally invasive manner.
This paper explains why a partnership approach could be attractive to PE investors given recent trends in the private equity market. The value proposition as well as the risks of traditional secondary investing is described in the appendix.
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