Secondary Private Equity Investments: 4 Key Benefits for Insurance Companies
1. Reduced Blind Pool Risk: Secondary funds acquire mature, underlying funded portfolio companies
2. Shortened Holding Period & Mitigated J-Curve: Mature assets may deliver quicker return of capital because of shortened holding period therefore reducing the drag from the J-curve
3. Reduced Cost: Lower cost exposure to private equity
4. Attractive Return Dynamics: Attractive historical capital-adjusted returns with cash flow that is typically more evenly distributed
Overview: Primary versus Secondary Private Equity
Investments in primary funds begin with a commitment of capital to a limited partnership. Over time, that capital is drawn down and used to fund investments in new portfolio companies that fit within the investment thesis of that private equity firm. This means that an investor investing in primary private equity funds is buying the track record of the private equity manager, but does not have transparency into the actual holdings of the fund, since they are yet to be purchased.
In the secondary market, investors can buy into a fund of fund or separate account structure that is constructed from existing limited partner private equity interests. This then creates a pool of private equity interests from a variety of primary private equity funds, otherwise known as a secondary PE fund. Accordingly, the portfolio companies in secondary PE funds are funded, mature portfolio companies (Figure 1).
For insurers, there are four aspects of secondary PE funds that are particularly attractive.
Figure 1. The Differences Between Secondary and Primary Private Equity
Benefit # 1)
Limiting Blind Pool Risk: Secondaries Allow for Greater Transparency into the Risks of Underlying Portfolio Companies
One of the key differences between primary and secondary funds is a manager’s line of sight into the underlying assets. Primary funds lack transparency. In primary funds, investors commit capital prior to investments in the underlying portfolio companies. Investors in primary funds are basing their expectations for each underlying company’s future performance primarily on a private equity manager’s previous success. For example, if a private equity manager has a track record of successful healthcare acquisitions, the logic is that this expertise will translate into future success with subsequent acquisitions of healthcare companies. Accordingly, primary funds tend to be less diversified as managers focus in the geography, sector or industry where they have the most expertise.
Alternatively, secondary funds are formed by combining pieces of existing limited partner private equity interests, meaning the underlying fund has already deployed the majority of its capital to portfolio companies. This structure provides managers of secondary PE funds with better transparency to the underlying companies therefore mitigating some of the uncertainty and risks with blind pool investing (Figure 2). Additionally, the pieces of existing limited partner private equity interests may be sourced from a wide set of primary PE funds. This means that secondary funds usually have broader exposure across vintage years, industries and geographies providing immediate diversification to investors.
Figure 2. The Benefits of a Secondary PE Fund Structure
Benefit # 2)
Mature Assets Deliver Quicker Return of Capital
As Figure 3 shows, investments in secondaries minimize the J-curve effect, with the early years of the fund’s existence representing the capital drawdown and investment period. Given that the entry point of a secondary fund is after the drawdown period, the capital is already invested and at a point of realizing gains (or losses) on those investments. This typically results in more evenly distributed cash distributions in secondary funds. Repayments often mimic those of a bond, as capital is returned quickly over the life of the investment. For insurance companies seeking to identify new sources of income, this feature of secondary PE funds is particularly attractive.
Figure 3. Secondaries Reduce the Drag of the J-Curve
Benefit # 3)
Lower Cost Exposure to Private Equity
Another benefit of purchasing existing limited partner private equity interests is a potential reduction in costs. Primary PE funds have fees and expenses associated with the capital drawdown and investment period. Buying into PE funds later in their life allows investors in secondary funds to avoid these early fees and expenses.
The opportunity set for secondary private equity also continues to grow. Private Equity Assets Under Management (AUM) have grown at a 12% rate since 2000 and over $3 trillion of capital has been raised since 2008.
As private equity activity increases, the inventory of private assets held by investors continues to expand, creating opportunities for secondary buyers as reasons for selling go beyond just liquidity needs and include such factors like portfolio management and exiting non-core relationships.
Benefit # 4)
Attractive Historical Returns
The recent underperformance of non-traditional assets such as hedge funds has led many insurance investors to reconsider their risk budget. In addition to their quick and evenly distributed return of capital, secondary private equity funds have delivered attractive risk-adjusted returns relative to other asset classes (Figure 4).
Alternative investments like secondary PE that can potentially generate efficient returns and more evenly distributed cash flows are particularly attractive as they create opportunities for insurance companies to deploy returned capital more opportunistically. For example, investors in secondary PE can either deploy returned capital back into a subsequent secondary PE fund or use it to take advantage of dislocated opportunities based on the life stage of the credit cycle.
Figure 4. Secondaries have Delivered Higher Risk-Adjusted returns than other Private Capital Strategies
For insurance companies seeking private equity exposure, secondary funds offer many potential benefits, including reduced blind pool risk, a shortened holding period that mitigates the impact of the J-Curve, potentially lower cost PE exposure and historically attractive return dynamics. Additionally, secondary PE funds adapt well in periods of uncertainty due to potential increases in deal flow as a result of market volatility.
However, like any new allocation, effectively adding secondary private equity exposure requires a comprehensive view of each insurer's objectives. With this in mind, insurers should consider the potential impact of the Financial Accounting Standard Board's (FASB) changes to the accounting methodology for public equity. As a strategic partner embedded in a firm with a large general account, Voya Investment Management can walk insurers through our thinking and explain why we think the FASB changes have the potential to make secondary private equity even more attractive on a relative basis.
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Past performance does not guarantee future results.
General Private Equity Risks. Risks that are inherent in private equity investments are generally related to: (i) the ability of each Investment Fund to select and manage successful investment opportunities; (ii) the quality of the management of each company in which an Investment Fund invests; (iii) the ability of an Investment Fund to liquidate its investments; and (iv) general economic conditions. Securities of private equity funds, as well as the portfolio companies these funds invest in, tend to be more illiquid, and highly speculative.
General Risks of Secondary Investments. There is no established market for secondaries and the Adviser does not currently expect a liquid market to develop. Moreover, the market for secondaries has been evolving and is likely to continue to evolve. It is possible that competition for appropriate investment opportunities may increase, thus reducing the number and attractiveness of investment opportunities available to the Fund and adversely affecting the terms upon which investments can be made. Accordingly, there can be no assurance that the Fund will be able to identify sufficient investment opportunities or that it will be able to acquire sufficient secondaries on attractive terms.
Secondaries may also be subject to the following risks: No Operating History Risk, Nature of Portfolio Companies Risk, Co-Investment Risk, Leverage Utilized by the Fund Risk, Leverage Utilized by Investment Funds Risk, Investments in Non-Voting Stock/Inability to Vote Risk, Valuation of Fund’s Interests in Investment Funds Risk, Valuations Subject to Adjustment Risk, Illiquidity of Investment Fund Interests Risk, Repurchase Risk, Expedited Decision-Making Risk, Availability of Investment Opportunities Risk, Special Situations and Distressed Investments Risk, Mezzanine Investments Risk, Small- and Medium-Capitalization Companies Risk, Utilities Sector Risk, Infrastructure Sector Risk, Technology Sector Risk, Financial Sector Risk, Geographic Concentration Risk, Sector Concentration Risk, Currency Risk, Venture Capital Risk, Real Estate Investments Risk, Substantial Fees and Expenses Risk, Foreign Portfolio Companies Risk, Non-U.S. Securities Risk, Structured Finance Securities Risk, Capital Calls / Commitment Strategy Risk, ETF Risk, Unspecified Investments Dependence on the Adviser Risk, Indemnification of Investment Funds / Investment Managers and Others Risk, Termination of the Fund’s Interest in an Investment Fund Risk, Other Registered Investment Companies Risk, High Yield Securities and Distressed Securities Risk, Reverse Repurchase Agreements Risk, Other Instruments and Future Developments Risk, Dilution Risk, Incentive Allocation Arrangements Risk, Control Positions Risk, Inadequate Return Risk, Inside Information Risk, Possible Exclusion of a Shareholder Based on Certain Detrimental Effects Risk, Limitation on Transfer / Shares Not Listed / No Market for Shares Risk, Recourse to the Fund’s Assets Risk, Non-Diversified Status Risk, Special Tax Risk, Additional Tax Considerations / Distributions to Shareholders and Payment of Tax Liability Risk, Current Interest Rate Environment Risk and Regulatory Change Risk. For a complete listing of all the Fund’s risks, with their descriptions, please refer to the “Types of Investments and Related Risks” section of the Fund’s prospectus.
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