The Role of Private Equity Secondaries in Developing Security Token Liquidity

What type of tokenized product will still be an attractive investment in 1, 3, 7 years? Tokenizing an early stage seed round can offer benefits in and of itself, unfortunately, there is a high probability that company will not exist in 7 years. However, some types of investment products provide lower risk profiles and can use tokenization to offer improved liquidity for primary investors + a strong investment opportunity to new investors in year 5.

This article will explore the thesis of improved liquidity for tokenized LP interests in private equity funds. It will illustrate PE’s attractiveness, and risk profile, as an investment product both on the primary and the secondary market.

Part 1: Introduce the current state of the private equity secondaries market. Part 2: Explore how blockchain-based secondaries of LP interests could exist for smaller buyers / sellers.

Note: If you are already familiar with private equity secondaries, skip to Part 2: The blockchain opportunity in private equity secondaries. Please send feedback / reach out with comments — I would like this article to serve as a starting point for discussion.

Part 1: Introduction to private equity secondaries

Private equity managers continue to raise record sums and institutional investors (pensions, endowments, UHNWI) continue to allocate capital to private equity. Why? Because of the private equity asset classes long standing ability to generate alpha. According to a McKinsey report “fully 90 percent of LPs said recently that private equity (PE), the largest private asset class, will continue to outperform public markets.” However, this advantage in performance comes at a cost, your investment is illiquid. Investors generally expect to lock-up their capital for 10 years in exchange for the potential of higher returns. As private markets have grown, not all investors can bear this illiquidity for the full life time of the fund. Today it is increasingly popular for LPs to sell assets before the agreed fund term (around years 5–8) to realize gains and make adjustments to their existing portfolios. This demand for liquidity before fund term created the secondaries market.

Want to understand the current state of primary investment in private equity? Read Bain’s 2019 report.

What are private equity secondaries?

Private equity secondaries are the sale of an investor’s (limited partner) interests in a private equity fund or portfolio of interests in various funds. This happens through the transfer of the investor’s limited partnership (LP) or LLC Member ownership interest in the fund(s) from the selling LP to the buying LP. The buyer takes on all the rights of the associated interest including any commitments to capital. Funds that are 5–10 years old represent the sweet spot for secondary sales.

The following diagram demonstrates how a private equity secondaries transaction currently works.

The private equity secondaries market place has been rapidly growing since the 2008 financial crisis. Today, secondaries is proving as an increasingly popular diversification strategy for family offices, insurers, sovereign wealth funds, endowments, foundations and pensions funds. 2018 saw an all time volume high in closed private equity fund secondaries at $70-$80 billion. This is massive growth from a decade ago when total annual market value was at $16 billion. Not to mention, secondaries have demonstrated lower risk and a higher median IRR by strategy. According to Pitchbook, in 2018 secondaries showed a 21.3% IRR versus 12.5% for private equity and 10.2% for fund of funds. However, despite this 4x growth in secondaries and strong appetite from institutional investors, small investors do not have a way to access this asset class. Blockchain-based private equity shares (security tokens) could prove as a means to allow a new audience access to this attractive investment class.

History of secondaries:

The first secondaries fund was raised by VC for America (VCFA) in 1984 with investor commitments of $6 million. It remained a relatively small industry until the early 2000s (dot com crash). After 2000, secondary fundraising activity began to accelerate alongside the growing private capital industry. The greatest growth occurred after the 2008 financial crash when secondaries developed into what we see today. In the wake of the financial crisis more and more limited partners needed to reduce their capital exposure from the historically illiquid private markets. LPs such as insurance companies or corporate pensions had to meet short-term obligations, which led to forced selling of various fund positions. During the 2008 distress, secondary funds stepped in buying positions at large discounts to net asset value (NAV).

Coller Capital produced a full time line showing secondaries growth from a niche 6 million industry in 1984 to 2018’s record $72bn of global transaction volume. They are recognized as leading the industrialisation of private equity secondaries.

Why become a secondaries seller?

According to Preqin’s Secondary Fund Manager Survey, the number one reason for secondaries sales is portfolio management. This is followed by liquidity. In 2017, fund performance only accounted for 12% of secondaries sales. Overwhelming secondaries sales are not triggered because of what is happening to the fund, they are sold because of what is happening to the LP who owns them.

• Portfolio Management, reallocate assets to a new area as investment objectives evolve
• Cash and liquidity to limited partners
• Avoid future capital calls
• Eliminate or reduce managerial task and overhead costs

Why become a secondaries buyer?

In secondaries, investors come for the liquidity but stay for the returns.

David Jolly, a partner at Coller Capital explained in a Pitchbook interview

“Secondary returns remain strong with less risk than other private equity strategies, LPs may aim to focus on good buyout funds delivering top-end returns, but selecting those is actually more difficult than it sounds, and as you build up a portfolio you can get average returns. Secondaries collectively over time have been able to grow well and maintain a really attractive risk/return profile.”

Data backs up this point even more. Looking at the graph below it is reported that secondaries funds offer a median IRR of 21.3% compared to 12.5% of traditional PE and 10.2% for Funds-of-funds.

• Shorter investment duration, cash back in 3–6 years versus 10 or more
• Improved visibility of underlying assets. Investors can evaluate what is already in the portfolio versus a blind commitment to the fund manager
• Decreased J curve effect (Definition J curve), cash distributions already in place
• Access to new funds / managers

In an interview on Private Equity Wire with Thomas Erichsen, Regional Director EMEA Private Equity & Real Estate, Enrichsen comments on secondaries. He notes that part of the attraction for PE secondaries is that it allows investors to access a fund further into the portfolio’s investment cycle.

“Investors aren’t as close to the beginning of the J curve or too far towards the latter part of the J curve; investments haven’t evened out. There is still growth but the window of opportunity is shorter in terms of how long one’s capital is locked in.

“For some investors, that is a very attractive proposition. They can calculate what their returns are likely to be, over a shorter period of time. If you look at it from a risk perspective, it’s probably a lower risk/return profile.

“It’s an important way for investors to exit certain investments and redeploy their cash elsewhere. I think that is part of what’s driving the growth of the secondaries market,” concludes Erichsen.

How are secondaries priced?

The pricing of secondaries is based on the reported valuations that private equity funds publish, typically on a quarterly basis, and is expressed as a percentage of the reported Net Asset Value (“NAV”). Generally speaking, a Buyer and Seller agree upon a valuation date (sometime also referred to as a “reference date”) at the start of a transaction.

What does the secondaries market look today?

Today, secondaries is continuing to evolve more and more as an active marketplace. Palico, a secondary asset marketplace, spokesman David Lanchner states:

“It’s a culmination of an evolution… We have seen the secondary market utterly transform from a place that was a hunting ground for bottom fishers looking for distressed assets. Now it’s a much more vibrant, continuous marketplace.”

In a January 2019 report, Palico also reported that buyers such as family offices, insurers, sovereign wealth funds, endowments, foundations and pensions funds — investors who historically invested in primary funds, have shown an increase of interest in secondary transactions. This market is expected to continue to expand. An increasing number of diverse portfolios are coming to market and more buyer and seller types recognize that the secondary market is a viable portfolio solution.

CAIA (a leader in alternative investment education) predicts that going forward the secondaries market will continue to grow driven by:

A growing universe of players

• Sellers driven by changing needs, macro forces and normalizing attitudes
• Buyers driven by the search for yield and ample dry powder

A broadening of assets available for sale

• Widening spectrum in terms of quality, asset class and maturity
• Growing asset backlog in the primary PE market

The expanding role of fund of funds managers and general partners

CAIA continues to explain that it is becoming increasingly common for GPs to initiate transactions directly on the secondary market. GPs have begun to proactively offer investors liquidity options. An overall expanding of asset classes within private investment has developed more variety of risk-return profiles, fund structures and investment time frames.

Thanks to secondaries investments ability to remove some of the startup risks of primary fund investing (already know what is in the portfolio, decreased J-Curve impact), secondaries can provide more efficient access to alternative assets. The secondaries market growth can be further demonstrated by the increasing large list of market participants such as Nasdaq Private Market or Sharespost providing liquidity to private companies. Furthermore. additional funds are being raised that are focused on the secondaries strategy.

The blockchain opportunity in private equity secondaries

The problem with today’s secondaries market

Today LPs tend to instigate the majority of the secondary market discussions. Campbell Lutyens 2019 survey states LP led transactions accounts for 61% of the secondaries as a means to take advantage of a growing list of secondaries buyers. They want to secure their returns earlier as an overall portfolio management tool. However, nearly all successful secondaries transactions involve the selling investor to work closely with the GP during the sales process. This is because under the majority of fund agreements require the consent of the GP in order to transfer the interests in the fund. The GP’s participation is also required for a prospective buyer to get access to the due diligence information they need. Due to the requirement for participation of the GP, the GP can refuse to transfer fund interests without reason. Furthermore, GPs generally look to be remunerated for fulfilling their role in the transfer process. This fee is traditionally shared between the buyer / seller. On top of this, GPs tend to have a variety of restrictions in place in terms of when they will consent to a transfer of interests (quarterly, bi-annually, tax related transfer restrictions).

Despite the attractive risk / return nature of a private equity secondary transactions, due to the heavy involvement of GPs and transaction costs, a major problem is created:

High costs and significant GP involvement in the secondaries sales process tends to limit secondaries sales to large LP stakes in large-cap funds. Only institutional investors are able to participate.

This can be highlighted as even though 2018 saw record volume of secondaries transactions, USD 50 billion at the end of 2018, this number is skewed towards mega-deals. Setter’s Volume Report FY 2018 points out 17 large buyers (1 billion+ deployed) represents ~73.7% of total volume.

The blockchain solution

As we can see from Coller Capital’s image below, we have already seen the secondaries market develop in response to increasing liquidity needs. The next stage of this development could be led by GPs who opt to issue part of their primary fundraise via tokenized feeder funds. These feeder funds will appear as a single LP to the GP, but can allow for secondaries market that does not require the direct involvement of the GP. This could create a secondaries market opportunity for smaller investors.

How it [could] work

Capitalizing on the rise of GP led secondaries transactions, moving forward GPs can choose to issue a portion of their primary fund shares via tokenized feeders. This tokenized feeder fund would appear as a single LP to the GP, however would represent a group of smaller investors. These smaller investors could then be able to trade their LP interests within the tokenized feeder based on a set of secondary trading requirements set by the GP during the primary issuance.

Looking at the diagram below, this secondary trading of tokens could fit alongside the larger institutional secondary market for funds. While this is an early possibility, it is a potentially attractive option for GPs hoping to provide a secondaries solutions as:

A. It allows them to access a new investor base during primary fundraising

B. Token investors will continue to look like a single LP during the lifetime of the fund

C. Embedded compliance requirements set during the initial fundraise allows them to be hands-off during secondary trades

Deloitte’s 2019 “Are token assets the securities of tomorrow” report highlights this potential as part of the larger digital assets ecosystem via a practical example:

“At present, investors in private equity, real estate and alternative investment funds (AIF) may find it hard to sell/transfer their holdings owing to a lack of liquidity or of organized markets.

If such fund holdings are converted into digital tokens via DLT then these can be exchanged more easily and transactions can be confirmed or validated in real time (or nearly real time).

An additional benefit for investors is that it will be easier to move shares from one account to another because this will happen via DLT. This will also create an opportunity for custodians to be the agents that transform the physical shares into digital assets. In theory at least, this process could be used on any asset.”

How do tokenized LP interests work?

Tokenized LP interests (frequently referred to as security tokens or digital securities) work by utilizing a transfer manager to override the ERC-20 transfer mechanism. This transfer manager is able to prevent trading until a set of compliance requirements set by the issuer (GP) are passed.

Case study: Secondary trading for Blockchain-based Private Equity Real Estate

While there are a variety of private equity strategies (Venture Capital, Buy Out, Fund of Funds… +), I want to look specifically at a case study around a blockchain-based Private Equity Real Estate (PERE) fund like Leaseum Partners.

Investing in a primary PERE investment, investors base their decisions to allocate capital in the fund primarily off of:

• The market: New York City
• The strategy: Core-Plus & Value Add, Office & Multifamily
• The investment management team: Michael Chetrit, 2M sq ft under management in NYC and David Dahan, former MD at Aviva Investors

What an investor cannot do is know what exactly which assets will be in the portfolio as they have not been purchased yet. On the secondary market, while market, strategy and team remain important — investors get an extra lense. They already know what is in the portfolio.

• The Portfolio: The exact buildings inside the portfolio

A secondary investor gets additional information compared to the blind pool during the primary raise. This works particularly well for real estate. Investors can see the reported NAV of the portfolio and look at prices of recently bought / sold assets nearby. For other PE strategies, such as Venture Capital or Buy Out, information disclosure is more complicated. GPs may not be willing to disclose information about the private companies they own. (More on this later)

A new retail opportunity for secondaries

This model of blockchain based secondary trade automation may fuel a secondaries market that is accessible and an attractive investment for a retail audience. Furthermore, this kind of investment opportunity could fuel the wider secondary market of digital securities.

Michael Granoff, CEO at Pomona Capital, a private equity firm that specializes in secondary investing, commented on the attractiveness of secondary transactions for retail investors in his 2018 Keynote Interview.

“We believe that being a private equity secondaries manager brings us closer to being a good fit with the retail and retirement markets than other private equity strategies. Is it a perfect mouse trap? No, but I would argue that we have come closer than buyout or fund of fund strategies. With secondaries, investors have the ability to mitigate the J-Curve completely and instantly diversify across strategies, GPs and vintages.”

If an investment is attractive and performing well, why would a retail investor sell?

As the main reason for institutions to sell is not fund performance but portfolio management objectives, retail investors will be driven to sell for different motives. Thanks to the diverse set of backgrounds of retail investors, retail investors decisions to sell their fund stakes will likely be driven by their own personal financial objectives. This variety of selling motives indicates that retail investors will at times want to sell funds stakes which will still be good investments for a new set of buyers.

Factors that incentivize a retail investor to sell could include:

What is needed to create a private equities secondaries market for smaller investors?

As mentioned earlier, the sweet spot for secondaries begins around year 5–10 of funds. While currently there are not tokenized funds in that age range, there is potential for it to develop if:

The primary market for digital securities grows in two major ways:

High quality investment products chose to offer a portion of their funds as digital securities

• In order to have a healthy secondaries market, we need attractive investment opportunities on the primary market. For example, while you may be able to get primary investment from an early stage startups vision, a start-up in financial despair does not make an attractive secondaries investment. Furthermore, a fund that has been underperforming is not attractive on a secondary market.

Improved user experience to invest in and hold tokenized assets

• The digital security world as it exists today spun out of the cryptocurrency boom. Unfortunately, from wallets, issuance platforms to custody, digital securities needs a stronger infrastructure to develop a wider ecosystem. This will help onboard more strong investment opportunities and types of investors.

If attractive investment opportunities come to market, then the supporting infrastructure for a secondary retail market must be developed:

Third party due diligence tools / platforms need to support smaller investors

• Diversified buy / sell sentiment can create attractive investment opportunities for small investors to purchase secondaries, however, not every secondary sale is attractive. Small investors will not be able to complete full due diligence of funds existing portfolios as today’s institutional secondaries funds are able to do. Furthermore, GPs will likely not be willing to share confidential information about private companies in their portfolio for very small investors (or potential competitors). Third party rating agencies or due diligence platforms must exist to support small buyers in making their secondary investments.

Secondary market exchanges for digital assets need to become more established

• There are number of secondary digital securities exchanges launching, none have achieved significant trade volume. Whether it is a traditional exchange which begins or supporting digital securities or a new exchange, there needs to be an active secondary exchange / marketplace available for smaller investors. This market does not need to be 24/7, it could be driven by episodic trading.

GPs must set wallet caps for secondary investors

• In order to enable small investors access to attractive deals, GP enforced wallet caps must be embedded in at the digital security level. Creating enforced wallet caps on the secondary market of blockchain-based PE could prove as a means to prevent large secondaries funds from scooping up all the best deals.

Blockchain based private equity secondaries could develop as an attractive investment opportunity for smaller investors as it has for institutional investors — but it won’t happen overnight. Before I conclude, a word of warning on private markets turning public from a June 19th, 2019 passage from Matt Levine’s Money Stuff:

— — —

Here is a simple model for how private stock markets work. I mean, “private stock markets” is not quite the right phrase; private stocks tend not to trade frequently on “markets.” But in the U.S., there are private companies that issue stock in private placements to “accredited investors,” mostly meaning people — roughly 16 million of them — who have more than $1 million of assets or who make more than $200,000 per year. Here is my model:

Some really hot private company wants to raise $100 million. It calls a dozen prominent venture capitalists. They all compete to offer it the best terms and to show off their capabilities in advising and nurturing hot startups. The company chooses the best terms from the best VC and raises the $100 million from one or a handful of them.

Some slightly less hot private company wants to raise $100 million. VCs aren’t fighting to get into the deal, but the company goes around pitching VCs and gets a few of them to believe in its vision. It raises $100 million from perfectly fine VCs on perfectly fine terms.

Some lukewarm private company wants to raise $100 million. It struggles to convince prominent VCs when it pitches them, but is able to find a few outliers: people who left big VC firms and are setting up on their own, people who got rich working at other startups and are now trying their luck as investors, etc. It raises $100 million from a motley assortment of venture-capitalist-ish funders at terms that reflect the riskiness of the operation.

Some ice cold private company wants to raise $100 million. It hires a call center in Florida to dial up all of the dentists in America and ask them to invest $10,000 each. It raises $79.4 million in small lots from dentists, good enough, whatever.

Look look look this is not a perfect model, it is not always right, some tiny startups that are neglected by prominent VCs and raise their money in small lots from dentists end up being huge home runs, and then those dentists get very rich. But in general it seems reasonable to expect a sort of waterfall of private funding, in which most of the clear home-run ideas will tend to get funded by sophisticated professional investors who are able to write large checks and provide useful expertise to young companies, while most of the ideas that get funded by cold-calling dentists will be the ones that sophisticated professionals would pass on.

Not always! And sometimes the sophisticated professionals are wrong! But the point is:

Small-time but accredited individual investors are not generally offered the same private investing opportunities as big sophisticated professional investment funds, and

There might be systematic differences in the quality of those offerings.

— — —

While Matt Levine’s passage is not discussing private equity secondaries specifically, I think he illustrates an important point around access to private deals, both in terms of information and availability.

With private equity secondaries, and all tokenized shares — small investors will not have the ability to complete due diligence to the same extent as large institutional investors. Tools / platforms need to exist to support smaller investors in the “private stock [digital securities] market.”

Smaller investors need access to private investment opportunities which sophisticated investors would also find appealing. Looking ahead — there is little doubt that the private equity secondaries market will continue to grow. The question is, will blockchain technology be used to help fuel this growth and provide smaller investors access?

Please send feedback: This article is a working project and I am open to feedback, counterpoints and areas to explore further. Please let me know your thoughts in the comments. I’m also always open to critical conversations about technology’s impact in the alternative investments space.

About the author: Julianne is an analyst at Leaseum Partners. Leaseum Partners is a blockchain-based Real Estate investment manager.

Sources:

• Venture Capital Funnel Shows Odds of Becoming a Unicorn are about 1%, 2019. CB Insights
• The rise and rise of private markets, 2018. McKinsey
• From Niche to Normal: The Global Private Equity Secondaries Market Demands Attention, 2018. Pitchbook
• Secondary Market Update, Q1 18. Preqin
• History of Secondaries. Coller Capital
• Small PE Secondaries Find Their Place Even as Average Deal Size Increases, 2019. Palico
• Secondary Pricing List — Secondary Funds Sell at Par or Better Despite Falling Stock Prices, 2019. Palico
• Record Cash Pours into Private Equity Secondaries Funds, 2017. Institutional Investor
• Why Technology Can Play a Role in PE Fundraising, 2019. Private Equity Wire
• A Primer for Today’s Private Equity Secondary Market, 2019. CAIA
• Secondaries in Private Equity, 2019. Campbell Lutyens
• Key Issues in Fund Secondaries. Lexology
• Private Equity Secondary Market Pricing and Volume, 2019. MPAG
• The Private Equity Secondary Market, 2019. Coller Capital
• Are token assets the securities of tomorrow, 2019. Deloitte
• Staying nimble in secondaries, 2017. Pomona Capital
• “Demystifying a roaring secondaries market,” 2017. Virtual Roundtable with Navatar
• Secondaries Primer: Parts 1–4, 2019. Brett Munster
• Private Markets Could be More Public, 2019, Matt Levine, Bloomberg