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Download DataCommentary Return Characteristics of Mature Secondary Fund Investments

3 2015 Preqin Ltd. /www.preqin.comPrivate Equity Spotlight /November 2015

Return Characteristics of MatureSecondary Fund Investments

Prof. Oliver Gottschalg ofHEC ParisFounder, PERACS

Introduction and Methodology

The private equity secondary market has witnessed significantgrowth in the past decade. This is largely due to the sizeable volume

of commitments made to primary funds, combined with portfolio

reshaping by private equity investors. The growth trajectory has

been accelerated in recent years by financial institution asset sales

for regulatory and capital reasons.

Tail-end secondary fund investments have developed over recent

years as a distinctive sub-segment of the secondary market. On

the one hand LPs engaged in active portfolio management look at

corresponding transactions to weed out the mature parts of their

portfolio and trade-in possible future upside for immediate cash

flow and reduced portfolio monitoring complexity. On the other sideof these transactions are often specialized investors who focus

on specific approaches to unlock the value in portfolios of mature

investments. Yet, investors know little about this specific risk and

return profile of such tail-end secondary investments, which led

us to perform some dedicated analyses to better understand their

distinguishing features.

Our study uses Preqins performance data on over 800 globalbuyout funds with 1980 to 2013 vintages. The dataset contains

detailed cash flows and net asset values (NAVs) over time and

for the purpose of our analysis is considered as the universe of

primary funds that secondary acquirers target. Based on this data,we can simulate the performance of a hypothetical secondary

investor buying a given subset of these funds at a given age and

at a given price (relative to NAV), then compare the performance

of these investments to a primary commitment to the same sample

of funds.

We measure performance in aggregate terms through the TVPIof each simulated secondary fund, as well as based on an

annualized performance measure. To avoid the problems with the

traditional IRR measure, which leads to a distortion and often an

overstatement of performance for secondary funds, we applied the

improved PERACS rate of return as our measure of annual returns.

This is defined as: PERACS Rate of Return = (TVPI^(1/Durationin years))-1), and is used in the following whenever we speak of

annualized returns.

Each simulated secondary fund has a typical four-year investment

period, and targets primary funds of different ages (less than

four years old, four to seven years old or eight years and older),of different quality (measured as the actual future performance

quartile of the investment opportunity) and at a specific price

relative to the most recent NAV.

This technique enables us to identify several distinguishing features

of late secondary funds in terms of their return profile. First of all,we show evidence that late secondaries have ceteris paribus (i.e.

simulating the same price and the same available GP quality) a less

attractive return profile for investors in terms of TVPI (see Fig. 1).

Across all eleven simulated secondary fund vintages, the TVPI ofthe late secondaries lies below that of their younger counterparts.

If we replicate the analysis based on our measure of annualized

performance (The PERACS Rate of Return), one would expect

a reduced effect, as the mature secondaries are by design more

advanced along the J-curve and should hence have a more

favourable annual performance. However, it turns out that this is

the case only for simulated secondary vintages from more than 10years ago, while for the more recent vintages, younger secondary

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Early Secondaries Mid Secondaries Late Secondaries

Fig. 1:Secondary Strategies Compared by TVPI (Vintage

2000-2010 Funds)

Vintage Year

Source: Preqin Secondary Market Monitor

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Ear ly Secondaries Mid Secondaries Late Secondaries

Fig. 2:Secondary Strategies Compared by PERACS RoR

(Vintage 2000-2010 Funds)

Vintage Year



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4 2015 Preqin Ltd. /www.preqin.com

Commentary Return Characteristics of Mature Secondary Fund Investments

Private Equity Spotlight /November 2015

investments perform better even on an annualized basis (see Fig.

2).

In a next step we look at the impact of pricing on the attractivenessof mature secondary fund investments. Generally, one observes

that mature funds are often trading at steeper discounts in the

secondary market, which leads to the expectation that the pricing

differential is likely to overcompensate for the aforementioned return

effect. Our results confirm that this is indeed the case. Already at

a simulated 20% greater discount, mature funds outperform theiryounger peers on a TVPI basis and even more so on an annualized

basis (see Figs. 3 and 4).

The last dimension we explore is the quality of the underlying

primary funds, measured as the actual performance quartiles of

each primary fund investment opportunity relative to its peers.Initially going back to an investment at par for all quality categories,

we observe that the initially described underperformance of late

secondary investments is driven only by the funds from lower

performance quartiles. For top-quartile funds, mature secondary

investment (at par) are more attractive than their counterparts, while

the opposite is the case for funds from the lower three quartiles.This is true for TVPI and even more so for annualized returns,

where for the two upper quartiles, the simulated late secondary

funds outperform their younger counterparts (Figs. 5 and 6)

Case Study: Benchmarking Secondary Fund InvestmentOpportunities

The PERACS Performance Benchmark, which allows investors

to benchmark actual secondary investments against the

simulated performance of hypothetical secondary fund investment

opportunities based on the method used for this research, makesit possible to dig deeper into the performance of mature secondary

investments with specific characteristics. Consider the case of

an investor who performs due diligence on two fund managersspecialized in mature secondary funds. Both managers are

specialized in the purchase of mature stakes in US buyout funds,

i.e. funds of at least eight years of age. Manager A acquires stakesin funds of all performance quartiles, with an average discount of

30%, i.e. an entry pricing of 0.7x of NAV. Manager B focuses on

stakes of poorly performing funds, i.e. the lowest two performance

quartiles, with an average discount of 50%, i.e. an entry pricing

of 0.5x of NAV. The track record of the two managers is shown in

Fig. 7.

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Top QuartileAverage

Second BestQuartileAverage

Third BestQuartileAverage

Lowest QuartileAverage


Fig. 5:TVPI for Secondaries Strategies across Underlying Fund

Quartiles


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Top QuartileAverage

Second BestQuartileAverage

Third BestQuartileAverage

Lowest QuartileAverage


Fig. 6:PERACS RoR for Secondaries Strategies across

Underlying Fund Quartiles


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Fig. 3:TVPI Assuming Pricing Discount of 20% for LateSecondaries (Vintage 2000-2010 Funds)

Vintage Year


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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Ear ly Secondaries Mid Secondaries Late Secondaries

Fig. 4:PERACS RoR Assuming Pricing Discount of 20% for LateSecondaries (Vintage 2000-2010 Funds)

Vintage Year



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5 2014 Preqin Ltd. /www.preqin.comPrivate Equity Spotlight /November 2015

Commentary Return Characteristics of Mature Secondary Fund Investments

These two track records are difficult to compare indeed. Considering

likely timing effects, Manager A tends to have higher IRRs and

TVPIs and also a higher PERACS Alpha (an unbiased measureof outperformance over public markets). We can gain further

insight into the actual skills of the two managers by comparing

their performance fund-by-fund to the PERACS Performance of

simulated performance of hypothetical secondary fund investment

opportunities with comparable characteristics. The corresponding

PERACS Benchmarks are shown in Fig. 8.

This makes it possible to compare, fund-by-fund, the actual

secondary investments against the simulated performance of

hypothetical secondary fund investment opportunities with the

exact same characteristics in terms of secondary vintage, strategy(stage, geography and age of the target primary funds), pricing

and the quality of the acquired funds. Such a comparison makes it

possible to identify to what extent a given manager made choices

among theoretically available investment opportunities that

enhanced the returns above the simulated averages. Fig. 9 shows

the results of such a comparison for each of thefive funds that arerelevant to our example.

This analysis shows that the managers differ in their ability to

make such favourable choices. While none of their funds beats

the PERACS benchmark in terms of IRR, both funds of Manager Boutperform this benchmark based on the more relevant PERACS

Alpha and TVPI measures, while Manager A can point to such

outperformance in terms of TVPI for only two of his three funds

and all three of his funds underperform in terms of PERACS Alpha.

As such, this analysis sheds light on two different elements that

investors may want to consider. First, the structural attractivenessof a given investment approach in the secondary space: in our

example this would be the choice between a mature secondary

strategy that maximizes the discount to NAV while accepting poor

quality managers versus a strategy that accepts a lower discount

to obtain a mix of primary funds of all performance categories.Second, the ability of given managers to make choices among

theoretically available investment opportunities that enhanced the

returns above the simulated averages of their chosen strategy.

Fig. 7

Manager A Secondary Vintage TVPI PERACS Alpha IRR

A 2007 2.10 19% 24%

A 2009 1.90 16% 30%

A 2011 1.50 35% 41%

B 2008 1.75 18% 21%

B 2010 1.80 30% 29%


Fig. 8

Secondary Vintage Pricings Min. AgeQuartile

RangeRegion Stage TVPI

PERACS

AlphaIRR

2007 0.7 8 All US Buyout 1.83 20% 25%

2009 0.7 8 All US Buyout 1.79 17% 33%

2011 0.7 8 All US Buyout 1.61 37% 45%

2008 0.5 8

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