When the second come first
Michael Granoff of Pomona Capital explains how secondary interests can be used to take advantage of inefficiencies in the private equity industry
First, a simple definition. A secondary interest represents the purchase of an interest in a private equity fund from an existing limited partner who desires liquidity prior to the term of the partnership.
Why would an investor sell an interest in a venture capital or buyout fund? When we started Pomona Capital, many prospective investors said that no one would sell an interest in a good fund. Yet over the past few years, we have purchased interests in most of the better-known venture and buy-out funds in the US, including Kleiner Perkins, Sevin Rosen, Blackstone, Clayton Dubilier, TA, Brentwood, Warburg Pincus and Sprout. The one generalisation that has proven true is that investors usually sell their interests for reasons to do with their own situation and not as a result of their view of the investment itself. These situations can include:
q Mergers or acquisition
q Change in strategy
q Change in personnel
q External reasons for investment not met, eg window on technology for companies, lending business for banks
q Need for liquidity
The sale of an interest provides an investor with liquidity for an illiquid investment, allows reinvestment of proceeds, fixes the rate of return and eliminates the significant administration required to manage private equity investments.
Limited partners in funds sometimes need to sell their interests. The question for a potential investor in a secondaries fund is whether it is a good investment to buy secondary interests?
The foundation for any secondary interest investment is the performance of the underlying private equity funds. The rate of return of private equity funds has outperformed other asset classes by meaningful percentages over an extended period of time. The appeal of the asset class is confirmed by the huge flows of capital into private equity over the past few years.
The hypothesis of secondary interest investors is that it is possible to gain the positives associated with the private equity business while mitigating many of the risks. Our investment strategy is designed to take advantage of the inefficiencies of the private equity industry in three ways:
q First, we typically purchase interests in funds that are largely, if not totally, invested. Buying an interest in a private equity fund well into its life and analysing its assets eliminates much of the uncertainty and risk associated with a blind pool. We are not limited to the marketing presentations of general partners.
q Second, the illiquidity of the market, combined with the liquidity needs of sellers, allows for a price discount from net asset value. We have the opportunity to value the assets and decide what we will pay for them.
q Third, buying into a partnership at a late stage results in a significant time discount, shortening the holding period and resulting in earlier distributions. Ideally we miss the lemons that ripened first and benefit from the successes of the fund. The cashflow dynamic for a secondaries fund is far different from a typical private equity fund. We own interests in hundreds of companies and have made distributions to investors in every quarter since inception.
These factors combine to create a relatively lower risk investment with potentially higher returns. When we do it right, secondaries investors receive a greater absolute return (due to our purchase discount) in substantially less time.
Pomona invests in funds with a range of maturities. An investor therefore also receives instant diversification across vintage years and instant seasoning to a portfolio across economic environments. These are important considerations for those new to the private asset class or those who desire to increase their exposure.
The next question is just how much product is there? The market for secondary interests is a function of only two variables:
q First, the amount of money invested in private equity funds. The current private equity environment is marked by more investors putting more capital into more funds. Existing limited partners are increasing their private equity investments. Many new investors are entering the private equity area. The private equity market is broadening and deepening.
q Second, the rate of turnover. Estimates range from 1% per year to 3% of a fund over its life. Turnover is a function of internal circumstances and overall economic conditions. Additionally, we have detected a noticeable shift in sentiment by limited partners who increasingly consider selling as a regular business decision. Our own sense is that the turnover rate is likely to increase as the economic cycle plays out.
Overall there is a rapidly expanding secondaries market. As an example, Pomona’s deal flow has increased by an average of about 70% for the last three years. Last year we analysed well over $1.2bn of product.
While the secondary interest business is inherently attractive it is very difficult to execute. Many private equity investors are interested in the potential purchase of secondary interests. Few are equipped to do what it takes to operate a successful secondary interest business, which includes:
q Finding sellers of interests. Sellers typically do not advertise. We employ a global, proactive strategy to identify potential sellers. We source transactions from offices in New York and London, and in Japan through a joint venture with The Industrial Bank of Japan
q Analysing transactions. One of the distinct advantages of the secondary interest business is the opportunity to examine the assets of a fund. But the value is only as good as the analysis. It is difficult to analyse a portfolio of early stage private companies in a matter of days and determine whether it contains rocks or gold. We have developed a methodology to analyse every company in every fund we look at. We employ a ground-up strategy based on the direct investing experience of our principals as opposed to the top-down analysis of many fund investors.
q Closing transactions. Sellers are themselves sometimes complicated entities and they require complex and flexible structures. Our advantage is that we get deals done. We have never had a deal not close once we reached an agreement with a seller.
Transfers of fund interests require the consent of general partners and general partners are not always immediately cooperative. The key to our relationships with general partners is confidentiality and trust. We have never been denied consent to transfer an interest.
So who buys secondary interests and how can investors participate? Today the business is dominated by only a handful of dedicated funds with varying amounts of experience and the ad hoc activities of traditional private equity gatekeepers. Although the market is growing rapidly and remains inefficient, competition has increased. Frankly, many secondaries investors are displaying their own version of irrational exuberance, taking higher risks and paying higher prices. Pomona sees itself as a principal investor and not an asset gatherer. We willingly choose price discipline over volume.
Over the past six and a half years, we have striven to create a reputation for honesty, confidentiality and execution. Our strong track record is built on an ability to proactively identify potential sellers, conduct rigorous analysis of opportunities and to structure and close complex transactions quickly. We currently manage over $580m across four secondary interest funds and two primary funds of funds. Our investor group is comprised of well-known institutions including BancBoston, Citigroup, Bank Worms, MIT, Global Asset Management, the Rothschild Family and Wilmington Trust.
Pomona is also a primary investor in many of the best performing venture capital and buyout funds. Our primary fund of funds business provides us an opportunity to deepen our relationships with general partners and better understand portfolios. We want to be a general partner’s or a selling limited partner’s first call.
While there is no publicly available secondary interest fund return data, we delivered to our investors a net return of over 30% over four funds, much of it realised.
In sum, secondary interest funds can provide a diversified, seasoned, lower risk, high return, private equity product to investors. But it is not without risk.
Peter Lynch at Fidelity often says, “know what you own”. Buying an interest in a poor performance fund at a discount is not a bargain. Buying an interest in a quality fund at a high price assumes a great deal of risk. The secondary interest business is attractive but difficult to execute. Investors should choose carefully.
Michael Granoff is chief executive officer of Pomona Capital in New York