More and more institutions are turning to private equity for the first time, in search of investment returns that are increasingly hard to find elsewhere. Commitments to private investment strategies have grown from an estimated USD180 billion in commitments in 2009 to over USD480 billion in 2016.
Many investors believe that private equity “fund-of-funds” managers offer the best way to get started in the asset class, since they invest in a portfolio of private equity funds, providing new investors exposure to private investment managers and helping them learn about the industry in general.
But secondary funds – which buy positions, often at a discount, in private equity funds that are already active and making investments – may be a better first step into private equity than funds-of-funds for institutional investors, according to “When Secondaries Should Come First,” a new report from global investment firm Cambridge Associates.
“The private equity arena can seem overwhelming to new investors, so it makes sense for a newcomer to the asset class to seek a portfolio of private equity managers,” says Alex Shivananda (pictured), Senior Investment Director at Cambridge Associates and co-author of the report. “Secondary funds can help investors establish a foothold in private equity markets faster than funds-of-funds.”
“In this low-return environment, more institutions are seeking the returns that private equity has traditionally offered. At first blush, funds-of-funds may seem like the best entry to private equity, but that’s not necessarily the case,” says Andrea Auerbach, Head of Global Private Investment Research at Cambridge Associates and a report co-author.
The main difference between private equity secondary funds and funds-of-funds, according to Shivananda, is that the former can start generating returns much faster.
Secondary funds typically acquire limited partnership interests in private equity funds that are already investing in their own right, which enables them to begin generating returns immediately. On the other hand, funds-of-funds raise capital to then commit to private equity funds, which themselves are also newly raised and just beginning to make investments in portfolio companies.
“It typically takes less time for secondary funds to put investors’ capital to work in underlying funds that are already partially invested, which means they tend to generate returns much faster than funds-of-funds,” adds Shivananda.
For example, it typically takes just seven years for distributions to secondary fund investors to match contributions from investors, compared to 11 years for the typical private equity fund-of-funds. And 40 per cent of a secondary fund’s capital is usually distributed back to investors within the first five years, while just 13 per cent of fund-of-fund distributions typically occur within the first five years, according to the report.
In addition to occurring earlier, returns from secondary funds also tend to be stronger than those from funds-of-funds. In aggregate, as of 30 June, 2016, secondary funds reported stronger results than funds-of-funds on a pooled internal rate of return basis and a total value to paid-in capital basis, which measures the total value created by a fund, finds the report. One reason for the lower returns from funds-of-funds is that fees are being charged for a longer period before funds are actually put to work in underlying companies.
As with any private investment program, finding the right investment manager is crucial for success. With secondary deals, pricing of the deal is often more important than a particular market or strategy, so investors should evaluate secondary managers based on their ability to effectively underwrite assets, rather than trying to gain exposure to specific funds or asset classes.
The report notes that funds-of-funds can still add value for institutions seeking specific private investment exposure. For example, many venture capital funds can be hard to access, and a skilled and well-networked venture capital-focused fund-of-fund manager can help investors allocate to those hard-to-reach strategies. Funds-of-funds can also be good for accessing specific geographies, such as emerging markets.
“Secondary private equity funds offer the same advantages as funds-of-funds – exposure to a range of private equity managers – but with the potential added benefits of higher returns and faster cash on cash results,” says Shivananda. “Institutional investors interested in exploring the private equity market may want to consider carefully selected secondary funds as a first step.”
