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New isn’t always better
Value in the secondary fund market
Nick Cooney
Investment Partner
We are all familiar with the concept of buying second hand goods, often at much better prices compared with the cost of buying new (eg even very new used cars typically sell at a significant discount to a new car). The price you see isn't the price you get - be careful of headline prices.
With many sellers simply keen to raise some additional money for other purposes. We see the same dynamic in private asset funds (eg private equity, private credit, real estate etc.), typically involving bilateral agreements between the original investor in a closed-ended fund and the new purchaser. It is our view that more investors should explore this opportunity set.
Why invest in secondaries?
- Attractive risk-adjusted returns with limited price volatility, more visibility of underlying assets and typically shorter maturity dates compared with primary investments.
- More diversified portfolios which help to mitigate the risk of underperformance (eg more sectors, vintages, geographies).
- Ability to purchase performing portfolios at meaningful discounts to NAV, (which can result in effective returns even higher than implied by the headline discounts - see below) further enhancing your return potential.
Geography of deals:
Source: LCP
LCP view:
Secondary market investing is attractive, and we believe there are solutions available to meet a range of investor objectives. Sellers are typically more motivated by cash needs than price and are willing to accept meaningful discounts.
Private fund options:
When we think about pricing in the secondary market, the key for buyers is achieving an attractive discount to NAV (net asset value)
Secondary market pricing
When we think about pricing in the secondary market, the key for buyers is achieving an attractive discount to NAV (net asset value – ie the price of the assets in latest valuation statement).
For some asset classes we have seen larger discounts to NAV over the past couple of years compared to history. This has been driven by a number of factors, but one of the most significant is the continued “overallocation” to private assets for many global investors who may now decide to sell in order to achieve greater liquidity. Sellers are typically more motivated by cash needs than price and willing to accept meaningful discounts.
It is our expectation that discounts will be slightly lower in 2024 compared with 2023, but still offer compelling value for those able to take advantage of the current supply-demand imbalance between buyers and sellers.
Price of secondary market assets (as % of NAV)
Source: LCP, Various Secondary Market Advisors/ Brokers, Secondary Buyers. For illustrative purposes only.
Example: Private Debt Secondaries in action
When interpreting the returns on offer, it is crucial to understand the distinction between “headline discounts to NAV” and “effective discounts to NAV”. The former is what a buyer offers the seller, and the latter is the end result after considering transaction structure. The example below illustrates how this works in practice:
The buyer agreed to take over the economics of the deal based on 31 March date based on a headline discount of 5%. However, it did not receive the income distributions ($1.5m + $4m) while the deal was going through the close process.
This is compensated for by adjusting the amount of money paid (ie transfer $5.5m less to seller). But why would this result in a larger effective discount?
When the deal takes place (ie money is transferred from the buyer to the seller), they are only transferring $42m at a time where the portfolio NAV is now worth $48m (due to positive performance).
This means that the discount is larger than it appeared when first negotiated (transferring cash 12% less than reported NAV). This is an illustrative example and it is possible that performance could be negative.
Example of how secondary market price discounts work
For illustrative purposes only.
Accessing the opportunity
We see many larger investors engage with brokers (some of whom prefer to refer to themselves as “advisors”) to access this opportunity set and sellers like using these organisations for better price discovery in the secondary process. The whole process can take around six months but allows buyers to be highly selective around which assets are purchased.
We generally recommend the following process for direct secondary market transactions:
1 – Establishing strategic priorities
- Material due diligence is required on the fund and underlying assets before transacting. Our investment research team covers the market and provides a view.
- Funds are closed-ended and investors will be locked in for the life of the fund. Understanding your strategic requirements is a key consideration.
2 – Selecting the right broker
- Some brokers only deal in large ticket sizes (eg over $50m) and others have little experience in certain asset classes.
- Broker fees can be expensive (in the region of 0.5% - 1.5%). We can help negotiate better deals as a result of exclusive relationship agreements for our investors. We receive no fees from brokers and are not conflicted.
- Selecting the right partner is crucial for achieving a successful transaction.
3 – Diligent project management
- Purchasing assets on the secondary market requires skilled project management and a sensible process framework. We have experience providing this to investors.
For those with more modest capital to allocate or more governance constraints, specialist fund-of-fund solutions have proved popular. While these involve a double layer of fees, it has the advantages of providing much greater diversity to help mitigate idiosyncratic risk.
