CONTRIBUTORS
Tony Davidow, CIMA®
Senior Alternatives Investment Strategist
Franklin Templeton Institute
In this episode of the Alternative Allocations podcast, I discussed the growth and evolution of secondaries with Taylor Robinson of Lexington Partners. We discussed how secondaries have emerged as a vital piece in the private equity ecosystem, providing much-needed liquidity to institutions. Taylor highlighted the importance of size and scale in executing secondary transactions, and emphasized the importance of acquiring quality assets at reasonable prices to help achieve desired returns.
Taylor and I discussed the changes in the market environment over the last several years. The capital raised leading up to 2021, coupled with slowing exits in recent years, has created a real need for liquidity in the marketplace. Secondary managers have provided much-needed liquidity at discounts to the underlying valuations. Taylor was careful to point out that he’s not buying an asset based solely on their discount. “The discount is really a reflection of what we think the go-forward and terminal value is for the assets we're purchasing and the return we want to earn to take on that exposure.”
We discussed the historical dispersion of returns between public and private market investments. The dispersion of returns between the top and bottom quartile large- and mid-cap funds is roughly 5%; while the dispersion of returns between the top and bottom private equity (PE) fund is over 45%, and nearly 50% for venture capital funds. The dispersion of returns for secondary funds is approximately 22%, eliminating the extreme highs and lows of PE.
Private and Public Market Return Dispersion
As of June 30, 2024.
Source: MSCI Private Capital Solutions, Morningstar.
The returns for US Large and Mid Cap Active Equity Funds reflect the annualized returns for the period January 1, 2005 to June 30, 2024. The returns for Secondaries, Private Equity, Venture Capital (VC), and Private Debt are the Internal Rate of Return (IRR) of the funds with vintage years from 2005 to 2018, as of June 30, 2024. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms available at www.franklintempletondatasources.com.
Taylor emphasized the structural advantages of secondaries—shortening the J-Curve,1 providing distributions sooner, and the diversification benefits (general partners, vintage, geography, and industry). I asked Taylor to discuss how institutions use secondaries. Institutions will often have regularly scheduled secondary programs to diversify their holdings and free up capital for future commitments. They may also use as an “on-ramp” to build positions and/or to maintain exposure.
Taylor noted that, “Secondary sits somewhere between direct private equity and credit in the risk spectrum because it's an equity strategy, but it has broad diversification. You have the benefit of buying assets later in their life, and you can see performance when we buy these portfolios in the companies.”
I shared the Institute’s outlook for 2025, and our views regarding the attractiveness of the secondary market. Taylor added that, “this is an attractive time to invest because I think we are buying really great assets at reasonable valuations.”
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Endnote
- The “J-curve” is the term commonly used to describe the trajectory of a private equity fund’s cashflows and returns. An important liquidity implication of the J-curve is the need for investors to manage their own liquidity to ensure they can meet capital calls on the front-end of the J-curve.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Investments in many alternative investment strategies are complex and speculative, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative strategies may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. Diversification does not guarantee a profit or protect against a loss.
“Secondaries” is the term related to private offerings (typically structured as partnerships, led by investment managers as the General Parter, or GP) where a new investor, or secondary buyer, purchases an existing investor’s commitment to a private equity fund and effectively becomes a replacement investor as a limited partner (LP).
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price. Past performance does not guarantee future results.