As the bull market enters its eleventh year, many high net worth investors are looking beyond traditional public market equities for investment returns. Private equity is a natural solution. Before companies like Uber, Lyft, Slack and Beyond Meat went public, they were significant private companies. This trend is especially meaningful since private companies have tended to stay private longer and attain “unicorn” status – that is, valuation exceeding $1 billion. Currently 147 private companies in the US are valued at $1 billion or more, according to a recent report by PwC and CB Insights. The tech sector brought initial public offerings valued at more than $15 billion in Q2/19 alone.
For those investors who don’t have the wherewithal or desire to invest directly in private companies, private equity funds and private equity funds of funds have provided a one-stop solution, particularly among the clients of bulge-bracket private banks. We at Cresset prefer private equity secondaries to private equity funds. Private equity secondaries strategies buy private equity limited partnership shares in the secondary market from investors who either want to reposition their portfolios or simply need the liquidity. The result is a well-constructed, diversified portfolio across a variety of industries and holdings.
Additionally, secondaries buyers have visibility into what they are buying, since they’ll be able to analyze the existing partnership before they bid. Private equity funds, in contrast, typically raise capital before they know what they’re going to buy, leading to “blind-pool risk” for their investors. Because secondaries involve bidding on mature assets, often acquired at a discount to intrinsic value, this strategy mitigates and often eliminates the “J-curve,” where investors’ cash flow is negative for a period as their private equity fund manager calls their committed capital. In private equity, the J-curve effect could last years.
Diversification is another advantage that secondaries strategies offer. Unlike private equity funds that often concentrate in a particular sector or region, secondaries funds are well diversified across industries and geographies. Vintage year concentration, where investments are made during a limited period within a business cycle, represents one of the biggest risks faced by private equity fund investors. Vintage risk is eliminated with secondaries, since limited partnership positions can be accumulated from a variety of vintage years.
Performance of secondaries strategies, like private equity in general, is impressive when gauged against traditional public market benchmarks. Secondaries strategies have been able to keep pace with and often exceed S&P 500 trailing 5-year returns with lower variation in returns. Private equity secondaries substantially outpaced the S&P in the aftermath of the financial crisis, as managers were able to pick up limited partnership shares at distressed discounts at the height of the turmoil.
As a result, private equity secondaries strategies are positioned to build well-structured portfolios from the top down while thoughtfully diversifying across industries, geographies and vintage years. A diversified, direct private equity portfolio can be assembled by an investor with an adequate stockpile of both capital and patience, as well as a high tolerance for risk. However, for those investors less inclined to wait or to worry, private equity secondaries are the way to go.