Commentary

Return Characteristics of Mature Secondary Fund Investments

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Return Characteristics of Mature

Secondary Fund Investments
Prof. Oliver Gottschalg of HEC Paris
Founder, PERACS
Introduction and Methodology
The private equity secondary market has witnessed significant
growth in the past decade. This is largely due to the sizeable volume
of commitments made to primary funds, combined with portfolio
reshaping by private equity investors. The growth trajectory has
been accelerated in recent years by financial institution asset sales
for regulatory and capital reasons.
Tail-end secondary fund investments have developed over recent
years as a distinctive sub-segment of the secondary market. On
the one hand LPs engaged in active portfolio management look at
corresponding transactions to weed out the mature parts of their
portfolio and trade-in possible future upside for immediate cash
flow and reduced portfolio monitoring complexity. On the other side
of these transactions are often specialized investors who focus
on specific approaches to unlock the value in portfolios of mature
investments. Yet, investors know little about this specific risk and
return profile of such tail-end secondary investments, which led
us to perform some dedicated analyses to better understand their
distinguishing features.
Our study uses Preqins performance data on over 800 global
buyout funds with 1980 to 2013 vintages. The dataset contains
detailed cash flows and net asset values (NAVs) over time and
for the purpose of our analysis is considered as the universe of
primary funds that secondary acquirers target. Based on this data,
we can simulate the performance of a hypothetical secondary
investor buying a given subset of these funds at a given age and
at a given price (relative to NAV), then compare the performance
of these investments to a primary commitment to the same sample
of funds.

Fig. 1: Secondary Strategies Compared by TVPI (Vintage

2000-2010 Funds)

We measure performance in aggregate terms through the TVPI

of each simulated secondary fund, as well as based on an
annualized performance measure. To avoid the problems with the
traditional IRR measure, which leads to a distortion and often an
overstatement of performance for secondary funds, we applied the
improved PERACS rate of return as our measure of annual returns.
This is defined as: PERACS Rate of Return = (TVPI^(1/Duration
in years))-1), and is used in the following whenever we speak of
annualized returns.
Each simulated secondary fund has a typical four-year investment
period, and targets primary funds of different ages (less than
four years old, four to seven years old or eight years and older),
of different quality (measured as the actual future performance
quartile of the investment opportunity) and at a specific price
relative to the most recent NAV.
This technique enables us to identify several distinguishing features
of late secondary funds in terms of their return profile. First of all,
we show evidence that late secondaries have ceteris paribus (i.e.
simulating the same price and the same available GP quality) a less
attractive return profile for investors in terms of TVPI (see Fig. 1).
Across all eleven simulated secondary fund vintages, the TVPI of
the late secondaries lies below that of their younger counterparts.
If we replicate the analysis based on our measure of annualized
performance (The PERACS Rate of Return), one would expect
a reduced effect, as the mature secondaries are by design more
advanced along the J-curve and should hence have a more
favourable annual performance. However, it turns out that this is
the case only for simulated secondary vintages from more than 10
years ago, while for the more recent vintages, younger secondary

Fig. 2: Secondary Strategies Compared by PERACS RoR

(Vintage 2000-2010 Funds)
0.25

2.0
1.9
1.8

0.20

1.7
1.6

0.15

1.5
1.4

0.10

1.3
1.2

0.05

1.1
1.0
2000

2001

2002

2003

Early Secondaries

2004

2005

2006

Vintage Year
Mid Secondaries

2007

2008

2009

2010

Vintage Year
Late Secondaries

Source: Preqin Secondary Market Monitor

0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Private Equity Spotlight / November 2015

Early Secondaries

Mid Secondaries

Late Secondaries

Source: Preqin Secondary Market Monitor

2015 Preqin Ltd. / www.preqin.com

Commentary

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Return Characteristics of Mature Secondary Fund Investments

Fig. 3: TVPI Assuming Pricing Discount of 20% for Late

Secondaries (Vintage 2000-2010 Funds)

Fig. 4: PERACS RoR Assuming Pricing Discount of 20% for Late

Secondaries (Vintage 2000-2010 Funds)

2.0

0.40

1.9

0.35

1.8
0.30
1.7
1.6

0.25

1.5

0.20

1.4

0.15

1.3
0.10
1.2
0.05

1.1
1.0
2000

2001

2002

2003

Early Secondaries

2004

2005

2006

Vintage Year
Mid Secondaries

2007

2008

2009

2010

0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Late Secondaries

Vintage Year
Mid Secondaries

Early Secondaries

Late Secondaries

Source: Preqin Secondary Market Monitor

Source: Preqin Secondary Market Monitor

investments perform better even on an annualized basis (see Fig.

2).

where for the two upper quartiles, the simulated late secondary
funds outperform their younger counterparts (Figs. 5 and 6)

In a next step we look at the impact of pricing on the attractiveness

of mature secondary fund investments. Generally, one observes
that mature funds are often trading at steeper discounts in the
secondary market, which leads to the expectation that the pricing
differential is likely to overcompensate for the aforementioned return
effect. Our results confirm that this is indeed the case. Already at
a simulated 20% greater discount, mature funds outperform their
younger peers on a TVPI basis and even more so on an annualized
basis (see Figs. 3 and 4).

Case Study: Benchmarking Secondary Fund Investment

Opportunities

The last dimension we explore is the quality of the underlying

primary funds, measured as the actual performance quartiles of
each primary fund investment opportunity relative to its peers.
Initially going back to an investment at par for all quality categories,
we observe that the initially described underperformance of late
secondary investments is driven only by the funds from lower
performance quartiles. For top-quartile funds, mature secondary
investment (at par) are more attractive than their counterparts, while
the opposite is the case for funds from the lower three quartiles.
This is true for TVPI and even more so for annualized returns,
Fig. 5: TVPI for Secondaries Strategies across Underlying Fund
Quartiles

The PERACS Performance Benchmark, which allows investors

to benchmark actual secondary investments against the
simulated performance of hypothetical secondary fund investment
opportunities based on the method used for this research, makes
it possible to dig deeper into the performance of mature secondary
investments with specific characteristics. Consider the case of
an investor who performs due diligence on two fund managers
specialized in mature secondary funds. Both managers are
specialized in the purchase of mature stakes in US buyout funds,
i.e. funds of at least eight years of age. Manager A acquires stakes
in funds of all performance quartiles, with an average discount of
30%, i.e. an entry pricing of 0.7x of NAV. Manager B focuses on
stakes of poorly performing funds, i.e. the lowest two performance
quartiles, with an average discount of 50%, i.e. an entry pricing
of 0.5x of NAV. The track record of the two managers is shown in
Fig. 7.

Fig. 6: PERACS RoR for Secondaries Strategies across

Underlying Fund Quartiles
0.5

2.5

0.4

2.0
0.3

1.5

0.2
0.1

1.0

0.0

0.5
-0.1

0.0

-0.2

Top Quartile
Average

Second Best
Third Best
Lowest Quartile
Quartile
Quartile
Average
Average
Average
Early Secondaries
Mid Secondaries
Late Secondaries

Source: Preqin Secondary Market Monitor

Private Equity Spotlight / November 2015

Top Quartile
Average

Second Best
Quartile
Average

Early Secondaries

Third Best
Quartile
Average

Mid Secondaries

Lowest Quartile
Average
Late Secondaries

Source: Preqin Secondary Market Monitor

2015 Preqin Ltd. / www.preqin.com

Commentary

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Return Characteristics of Mature Secondary Fund Investments

This analysis shows that the managers differ in their ability to

make such favourable choices. While none of their funds beats
the PERACS benchmark in terms of IRR, both funds of Manager B
outperform this benchmark based on the more relevant PERACS
Alpha and TVPI measures, while Manager A can point to such
outperformance in terms of TVPI for only two of his three funds
and all three of his funds underperform in terms of PERACS Alpha.
As such, this analysis sheds light on two different elements that
investors may want to consider. First, the structural attractiveness
of a given investment approach in the secondary space: in our
example this would be the choice between a mature secondary
strategy that maximizes the discount to NAV while accepting poor
quality managers versus a strategy that accepts a lower discount
to obtain a mix of primary funds of all performance categories.
Second, the ability of given managers to make choices among
theoretically available investment opportunities that enhanced the
returns above the simulated averages of their chosen strategy.

These two track records are difficult to compare indeed. Considering

likely timing effects, Manager A tends to have higher IRRs and
TVPIs and also a higher PERACS Alpha (an unbiased measure
of outperformance over public markets). We can gain further
insight into the actual skills of the two managers by comparing
their performance fund-by-fund to the PERACS Performance of
simulated performance of hypothetical secondary fund investment
opportunities with comparable characteristics. The corresponding
PERACS Benchmarks are shown in Fig. 8.
This makes it possible to compare, fund-by-fund, the actual
secondary investments against the simulated performance of
hypothetical secondary fund investment opportunities with the
exact same characteristics in terms of secondary vintage, strategy
(stage, geography and age of the target primary funds), pricing
and the quality of the acquired funds. Such a comparison makes it
possible to identify to what extent a given manager made choices
among theoretically available investment opportunities that
enhanced the returns above the simulated averages. Fig. 9 shows
the results of such a comparison for each of the five funds that are
relevant to our example.
Fig. 7
Manager A

Secondary Vintage

TVPI

PERACS Alpha

IRR

2007
2009
2011
2008
2010

2.10
1.90
1.50
1.75
1.80

19%
16%
35%
18%
30%

24%
30%
41%
21%
29%

A
A
A
B
B

Source: Preqin Secondary Market Monitor

Fig. 8
Secondary Vintage
2007
2009
2011
2008
2010

Pricings

Min. Age

Quartile
Range

Region

Stage

TVPI

PERACS
Alpha

IRR

0.7
0.7
0.7
0.5
0.5

8
8
8
8
8

All
All
All
<3Q
<3Q

US
US
US
US
US

Buyout
Buyout
Buyout
Buyout
Buyout

1.83
1.79
1.61
1.70
1.75

20%
17%
37%
17%
28%

25%
33%
45%
24%
38%

Source: Preqin Secondary Market Monitor

Fig. 9

Manager A
A
A
A
B
B

Secondary
Vintage

TVPI

PERACS Alpha

IRR

Outperf. in
Terms of TVPI

Outperf. in
Terms of
Peracs Alpha

Outperf. in
Terms of IRR

2007
2009
2011
2008
2010

2.10
1.90
1.50
1.75
1.80

19%
16%
35%
18%
30%

24%
30%
41%
21%
29%

TRUE
TRUE
FALSE
TRUE
TRUE

FALSE
FALSE
FALSE
TRUE
TRUE

FALSE
FALSE
FALSE
FALSE
FALSE

Source: Preqin Secondary Market Monitor

PERACS is a provider of quantitative analytics for the private equity industry. It offers specialized consulting services to institutional
and other sophisticated investors by providing detailed insight into the key aspects of private equity investment performance.
The PERACS Secondaries Benchmark is available through Preqins Secondary Market Monitor. Create benchmarks for
secondaries strategies, varying the age of underlying investments (early, mid and late secondaries), price paid for the funds as a %
of NAV, quartile of the underlying funds and fund types (buyout, venture capital and fund of funds).
For more information, or to arrange a demonstration, please visit:
www.preqin.com/smm

Private Equity Spotlight / November 2015

2014 Preqin Ltd. / www.preqin.com