Secondary funds have excelled in the private markets by offering high returns and comparatively low risks. While this may seem too good to be true for some investors, a recent study by Seine Capital examines why the strong risk-return profile of secondary funds is reasonable and why it is likely to stay that way.
The asset class has the lowest percentage of funds with a total value to paid-in funds ratio below 1.0x (2.3 percent), followed by funds of funds (4.9 percent), private debt (8.1 percent) and buyouts (12.5 percent), according to a recent study by Seine Capital, conducted exclusively with Secondary investor.
Separate data also suggests that secondary funds perform well compared to other strategies. According to findings from Bain & Company Global Private Equity Report 2024Secondaries is the only alternative asset class in which even the fourth quartile of funds has achieved positive returns over the past two decades.
“The perceived mathematical risk in secondary market transactions appears to be much lower and the return appears to be in line or better” than other private capital strategies, which “contradicts the logic of the efficient frontier,” said Chad Zidow, partner at Seine, secondary investor. In modern portfolio theory, the efficient frontier is an investment portfolio that offers the highest expected return relative to its risk. The anomaly identified by Zidow suggests that secondary funds generate higher returns relative to their risk than traditional models would expect, placing them outside this efficient frontier.
“The crucial question is: Is this too good to be true? Can it continue like this? And how was it constructed?” said Zidow.
To find out what’s behind secondary funds’ above-average returns, Zidow and François Robey – a former co-chief operating officer at Natixis Corporate who held a senior position at Banque Indosuez – simulated the performance of hypothetical secondary funds with different cash flows, volatility, discounts and other fund characteristics. They changed the assumptions about these factors to test how much they need to vary for the funds to lose their attractive risk-return profiles.
The key conclusion is that investors can expect strong performance from secondary funds as long as they acquire assets of sufficient quality at large discounts (typically above 30 percent), according to Zidow. While many secondary funds can perform well on a risk-adjusted return basis despite very small discounts, they may rely on financial engineering to achieve this, the paper argues, adding that such funds rarely achieve TVPI ratios above 1.7x. For buyers who can achieve significant discounts in secondary transactions, financial engineering or the use of credit is not necessary to achieve TVPI ratios above 2x, the paper says.
While this conclusion seems intuitive, Zidow says it shows how important discounts are in a secondary market deal, especially in a market where discounts vary considerably between larger and smaller transactions.
“It’s not necessarily the case that secondary managers are better at picking assets than other types of private asset managers. The main thesis here is that if you buy good assets at a really good price, that explains the historical phenomenon we’ve observed that your risk of losing capital is virtually zero and your potential gain is far greater than with low-discount strategies,” Zidow said.
Buyers in the smaller segment of the secondary market can acquire assets at more significant discounts, Zidow added. Small-cap funds achieved higher average IRRs and TVPI ratios than their mid-cap and large-cap counterparts from 1987 to 2020, the Seine report said.
The paper cites seven reasons for the inefficiency of the secondary market, including a mismatch between supply and demand, information asymmetry, high transaction costs and complexity, limited arbitrage opportunities, barriers to entry, liquidity issues and regulatory restrictions. Some of these factors also explain why smaller funds generate better returns. For example, the imbalance between capital supply and demand is more pronounced at the smaller end of the market, where buyers have more investment options to choose from.
“There is a lot of capital going into the market to make it more efficient,” Zidow said. “But a key part of our thesis is that it will take a long time, if ever, for small-cap secondary markets to become a truly efficient market. There are so many systemic problems that will make standardization of small-cap secondary markets very difficult.”
