The attractive risk-return profiles of secondaries funds will last as long as buyers continue to acquire good-quality assets at significant discounts, according to research from Seine Capital.
Secondaries funds have stood out in the private markets with high returns and comparatively lower risks. While this may seem too good to be true for some investors, a recent paper from Seine Capital examines why the distinct risk-return profile of secondaries funds is reasonable and why it is likely to continue.
The asset class has the lowest percentage of funds with total value to paid-in ratios below 1.0x (2.3 percent), followed by fund of funds (4.9 percent), private debt (8.1 percent) and buyouts (12.5 percent), according to recent research from Seine Capital, shared exclusively with Secondaries Investor.
Separate data also suggests secondaries funds perform well compared with other strategies. According to findings from Bain & Company's Global Private Equity Report 2024, secondaries is the only alternative asset class in which even the fourth quartile of funds have delivered positive returns in the past two decades.
"The perceived mathematical risk in secondaries appears to be much lower and the return appears to be in line or better" than other private capital strategies, which "defies the logic of the efficient frontier", Chad Zidow, a partner at Seine, told Secondaries Investor. In modern portfolio theory, the efficient frontier is an investment portfolio that offers the highest expected return for its level of risk. The anomaly Zidow points out suggests that secondaries funds are yielding higher returns for their risk level than what traditional models would expect, which places them outside this efficient frontier curve.
"The ultimate question is: is this too good to be true? Can it continue? how has it been constructed?" Zidow said.
To find out what's driving the superior returns of secondaries funds, Zidow and François Robey - a former co-chief operating officer at Natixis Corporate, who has held a senior role at Banque Indosuez - simulated the performance of hypothesised secondaries vehicles with varying cashflows, volatility, discounts and other fund characteristics. They changed assumptions about these factors to test by how much they must vary for the funds to start losing their attractive risk-return profiles.
The main takeaway is that investors can expect strong performance from secondaries funds as long as they are going to be acquiring assets of good enough quality at large discounts (typically over 30 percent), according to Zidow. While many secondaries funds can perform well on a risk-adjusted return basis despite transacting at very low discounts, they may rely on financial engineering to achieve this, the paper argues, adding that such funds rarely generate TVPI ratios over 1.7x. For buyers that can obtain significant discounts in secondaries transactions, financial engineering or the use of debt is not required to generate TVPI ratios over 2x, according to the paper.
While the conclusion seems intuitive, it shows how important discounts are in a secondaries deal, especially in a market where discounts vary significantly between the larger and the smaller transactions, according to Zidow. "It's not necessarily that secondary managers are picking assets better than other types of private asset managers… the main thesis here is if you're buying good assets at a really good price, it explains the historical phenomenon that we've observed where your risk of losing capital is virtually null and your potential upside is far greater than with low discounts strategies," Zidow said. Buyers in the smaller end of the secondaries market can acquire assets at more meaningful discounts, Zidow added. Small-cap funds delivered higher mean IRRs and TVPI ratios than their mid-cap and large-cap counterparts from 1987 to 2020, according to the Seine paper.
The paper listed seven reasons to explain the inefficiency of the secondaries market, including a mismatch of supply and demand, information asymmetry, high transaction costs and complexity, limited arbitrage, barriers to entry, liquidity issues and regulatory restrictions. Some of the factors also explain why smaller funds have better returns. For example, the imbalance of capital supply and demand is more evident in the smaller end of the market where buyers have more investment opportunities to choose from.
"There's a lot of capital coming in to try and make this market more efficient," Zidow said. "However, a key part of our thesis… is that it will be a long time, if ever, before small-cap secondaries becomes a truly efficient market. There are so many systemic issues that are going to make it very difficult to standardise small-cap secondaries." Source: https://www.secondariesinvestor.com/are-the-returns-of-secondaries-funds-too-good-to-be-true/
Comments