Secondaries Primer Part 4: Performance
Having previously covered the history of the secondary market, the motivations of sellers, and the characteristics of secondaries that might make it an attractive investment opportunity, I would like to dive into the actual performance of the asset class.
LPs have to make allocation decisions within their portfolio and in order to do so, often compare the risk return profile across a variety of assets. When you look at the return data for secondaries, you quickly notice a very compelling risk/return profile when compared to other asset classes. The data over the last several years shows a risk profile closer to that of public equities but with a return profile closer to that of the venture capital.
Similar Downside Risk Compared to Public Equity Funds
According to a recent report put out by Capital Dynamics, over the last 10 years, the bottom quartile of returns for secondaries is similar to the bottom quartile of US public equity strategies. When compared to public markets in other geographies and fixed income investments, the bottom quartile of secondary funds has outperformed the median and even the top quartile in some instances.
This shouldn’t be much of a surprise. Theoretically, investments into most secondaries consist of late stage private companies about to go public. Therefore, secondary and public funds face similar macro-economic conditions and risks. Furthermore, any equity fund manager looking for growth is likely to invest in the same companies the secondary investors have already invested in once they reach the public markets.
Although the risk profile is very similar, the return profile between the public equity funds and secondary funds is strikingly different. Because secondaries are still an investment into an illiquid asset (albeit theoretically with a short holding period), investors will expect a higher return in exchange for that illiquidity. That indeed turns out to be the case as secondaries have outperformed public stocks by a wide margin on average over the past ten years. As we can see from the chart, secondaries have the potential to generate returns upwards of double those of public equity funds.
In other words, secondaries have similar downside risk, but much greater upside compared to public markets.
Accelerated Cash Back Compared to Venture Funds
In my last post, I claimed that one of the attractive characteristics of secondary investments was much shorter holding periods. In other words, investors should expect to get their money back much sooner than in venture capital. Turns out the data supports that claim.
The graphs below depict the median TVPI and DPI over the last 10 years for both secondaries and venture capital. TVPI stands for “Total Value to Paid-In” and is a measure of the total value (both realized and unrealized) of the investments made compared to the amount LPs have invested. While TVPI captures both realized and unrealized gains, DPI, which stands for “Distributed to Paid-In” measures only the amount of capital that has been returned back to investors (ie: only the realized portion).
Data taken from Pitchbook shows that the median total value of both secondary and VC funds in the 2007 to 2017 vintages has historically been roughly the same (although as we will see later, VC has much wider range of outcomes). Where they differ, however, is the secondary funds have a much higher median DPI. This is because secondary investments have shorter holding periods and thus distribute capital back to their LPs sooner. The majority of secondary funds have returned capital back to their investors while the majority of the value in VC funds is still unrealized. Given the recent vintages of the funds in this data set, this demonstrates the quicker returns from secondary funds.
In other words, secondary funds have distributed the majority of their returns back to their LPs while the majority of performance for VCs in recent years remain as paper gains. Thus, secondary investments can be very attractive to LPs who value liquidity but still want exposure to private markets.
IRR and J Curve Elimination
My last post claimed that secondary funds have higher IRRs due to this shortened holding period, even if total returns are less than venture capital. Data from Pitchbook shows that secondary transactions have consistently outperformed venture capital funds on a net IRR basis in recent years. More importantly, returns have increased in secondary funds in as a number of late stage companies have had successful IPOs.
One thing to notice is the sharp split in performance between the two asset classes in 2016 and 2017. The sharp drop in IRR for Traditional VC is to be expected given how young these funds are. As I explained in my previous post, venture funds go through what is known as the J-Curve where returns start out negative early in the fund’s lifecycle due to the fact that they incur fees and loses before realizing the majority of the gains. What is striking about the split in performance isn’t that Traditional VC performance is going down (it very well could be the case that in a few years the 2016 and 2017 Traditional VC vintages perform quite well and all they needed was a little time to mature), it’s that the secondary funds never experienced a decrease for newer vintages in the first place.
This is exactly the point I was making about elimination of the J Curve effect in my last post. While investors in VC funds have to endure the negative IRR impact early in fund lifecycle, secondary investors see gains much sooner.
Less Volatility
According to data from Cambridge Associates, the returns from secondaries were less volatile on average versus direct private equity and venture capital funds. This analysis is based on the standard deviation on a series of quarterly net returns from Q1 1993 to Q4 2015 (92 quarters) and annualized thereafter. The lower volatility is likely due to investors entering funds at a later stage compared to the original investor, which allows them to identify and adjust buy-in pricing for the assets.
While I do not have the data on volatility for secondaries vs VC only, including private equity in this data theoretically makes the gap between the two asset classes smaller. VC typically has a wider range of outcomes than any other asset class and thus by blending PE with VC, it should reduces the volatility. My assumption is that the contrast between secondaries and VC is actually greater than this graph is showing.
Dispersion of Returns
I also wanted to compare the range of possible outcomes on any given year. Using data from Pitchbook, the graph below shows the range from bottom quartile to top quartile for each vintage dating back to 2003. The dot in the middle of each line represents the median.
There is a lot to digest in this graph so let’s break this down. First, I would like to point out the negative returns for traditional VC in recent years. Same as before, these are young vintages are going through the typical J Curve and likely will show better performance as these funds mature. In contrast however, we again see that Secondary Funds are all showing positive returns, even the bottom quartile of the asset class, at the earliest point in their lifecycle. Secondary funds simply do not exhibit the same J Curve phenomenon that most VC funds do.
Second, lets zero in on the range of outcomes each of these years. In a vast majority of the years, the range between upper quartile returns and lower quartile returns was larger with Traditional Venture Capital.
Lower Risk of Losing Capital
Not only are returns more consistent, but investments in secondaries are far less likely to lose money. According to Prequin, only 1.4% of secondary funds exhibited TVPI ratios below 1.0x compared to 22.8% for direct private equity and venture funds. As with the previous Cambridge Associates chart, this chart is likely conservative because blending PE and VC likely lowers the percentage of funds that returned less than 1x compared to VC on its own.
This greatly diminished risk of losing capital for secondary funds can be attributed to shorter time to liquidity and the acquisition of assets at a discount to NAV.
Case Studies
So far, I have compared data over the last 10 or so years. However, with recent valuations in the private markets reaching record levels, I wanted to know how investments would have done in the last couple years? Would sky high valuations drag down performance of direct secondary investments or would the discounts and public market performance of those companies lead to compelling returns?
In order to answer that question, I gathered data on most of the tech companies that went public in 2017 and 2018 in order to back test what performance would have looked like if a secondary fund had invested in these tech companies. To simplify and standardize the exercise, I made the assumptions about this fictitious secondary fund. The charts below assume that the fund bought in at a 20% discount to the last private valuation of the company and then sold its position immediately following the standard 6-month lockup period after the date of the IPO. Even with lofty private market valuations, the secondary fund would have performed extremely well in recent years.
As we can see from the data, the hypothetical secondary fund would have performed extremely well. But what about time to liquidity? Again, making assumptions to standardize the exercise, I assumed our fund invested 3 months after the last round of financing prior to the IPO and sold immediately following the standard 6-month lockup period after the date of the IPO.
The data shows that the hold period for this secondary fund is significantly shorter than the hold period of a venture fund. The average hold period for both 2017 and 2018 was 2.4 years compared to a 10–12 year commitment on venture funds. Even on the longest hold period for any one company, four and a half years, that’s still roughly only 1/3 of the average hold period for a venture backed company to go IPO today (12 years).
It is pretty clear that the data supports the hypothesis that secondary investments have shorter hold periods, generate higher IRRs more consistently, and offer a very attractive risk reward profile compared to other asset classes.
