In our last article, “The Venture Capital Risk Matrix,” we reviewed targeted return profiles for direct venture capital and fund investments. Since then, the CEO at one of our portfolio companies asked us, “How do secondary funds compare to venture capital returns?” After thinking about it, we decided it made sense to provide an overview of respective return profiles and risks.
Secondary funds typically hold a portfolio of interests acquired from initial limited partnership subscribers (aka “LPs”). Transaction volumes in this market were estimated to be more than $40 billion in 2016, with buyout interests comprising 79%.1 At $3 billion, venture interests represented less than 10% of the total.2 If direct secondary acquisitions – purchases of individual and portfolio stock positions from venture investors – are included, our firm estimates that secondary VC volume was over $10 billion. We believe that sales of unicorns – private market firms worth more than $1 billion – accounted for half of secondary direct market turnover last year.
Based on our analysis below, secondary fund internal rate of return (aka “IRR”) metrics compare favorably with those of VC funds and funds of funds. This stems largely from the fact that most secondary portfolios hold buyout rather than venture LP interests and cash flow quicker than their counterparts. The latter tend to be riskier than the former: among other things, buyers of venture interests typically demand higher multiples, while growth stage VC funds tend to have initial return targets of at least 3.0x for portfolio investments. In addition, secondary funds of all stripes usually acquire J-curve-seasoned interests – that is, five years or older – and exits typically happen sooner than the primary market.
According to Cambridge Associates, secondary funds – both the buyout and venture-focused varieties – have generated 1.44x-1.6x net returns for investors, on average, and 10%-20% internal rates of return (IRR). The double digit IRR and relatively low median multiple reflects a diminished risk of capital loss in comparison to other segments.
The market’s raison d’être
Certainly, secondary trading wouldn’t exist without supply or demand. One question, of course, is “Who is behind the selling?” Motivated by various rationales, those looking to cash in their interests (the supply) might include:
- General partners generating exits for investors through direct asset sales or “GP liquidity solution” programs (discussed below);
- Asset managers repositioning portfolios;
- Family offices reconfiguring portfolio weightings;
- Financial institutions conforming with regulatory requirements or adjusting balance sheet risks;
- Funds of funds reallocating to other managers or terminating their fund;
- Endowments and foundations reducing counterparty numbers or cutting underperforming investments;
- Corporates reorienting their strategic focus or balance sheets;
- Public and private pension funds reducing private equity exposure or freeing up capital for other purposes;
- Limited partners seeking liquidity to satisfy certain obligations.
Both Evercore and Greenhill did a good job of estimating how much seller volume comes from each of these categories last year but came up with slightly different results (charts below).
Source: Evercore Partners
Source: Greenhill Cogent
Transaction type, drivers and returns
As alluded to earlier, direct secondary sales represent around 6% of turnover, according to Evercore; sales of LP interests, in contrast, account for more than 70%. One development that has facilitated this dynamic is the growth of “GP liquidity solutions.” With these programs, general partners work with secondary firms – typically at the end of a fund’s life – to provide investors with access to liquidity rather than leaving it solely in their hands, as with most secondary transactions. This approach affords GPs an opportunity to manage out of remaining positions in an efficient manner.
Source: Evercore Partners 2016 Secondary Market Survey Results
Pricing and demand
Another key question centers on the returns targeted by secondary funds. In general, they seek gross IRRs between 15% and 25% (net IRRs, which take fees and carry into account, are correspondingly lower). Most target multiples of 1.6x-1.8x, regardless of whether venture or buyout interests are involved. Consequently, they anticipate getting their initial capital back in 3-5 years, as opposed to growth- and early-stage funds, where expectations are six and 8-10 years, respectively.
Source: Setter Capital
Intersection of supply and demand
Over time, pricing tends to fluctuate based on any number of factors, including:
- Macroeconomic conditions and market sentiment;
- Distribution pace – cash flow speed – of the underlying funds;
- Exit environment (with respect to both IPO and M&A activity)
- Capital supply-and-demand volume dynamics;
- Relationship between public and private market valuations;
- Broader trend in net asset values.
A timely opportunity?
Secondary funds, especially those raised during the last 12-24 months, have unprecedented amounts of dry powder – $110 billion, according to Greenhill Cogent – helping to bolster pricing. Meanwhile, venture assets, which tend to trade at higher discounts than buyout and other varieties, have notable exposure to the unicorn market. Many unicorns have been overvalued (as seen in many subsequent flat to down rounds) and have yet to exit.
Taken together, these developments suggest that there are some interesting opportunities in the space. For investors seeking to gain exposure to the buyout and venture segments, but who seek a more measured balance between risk, reward and cash flow speed, the secondary market may be worth considering.
1 Setter Capital Inc., Setter Capital Volume Report – FY 2016
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