May 17, 2019
Secondary Returns: Cobalt's May Chart of the Month
- These days, it seems like everyone loves secondaries for their discounts. After all, what’s not to like about the idea of day-one secondary returns? Further more, the J-curve benefits that come with it? But, success in secondaries depends on more than just love at first sight.
- An underappreciated fact about secondaries: Discounts are generally not the biggest driver of returns. The chart below illustrates this. The orange line represents your secondary return if you had bought the entire universe of mature buyout funds (>=5 years old) at prevailing market prices during each given year. The columns show what portion of this return came from discount versus appreciation.
- As you can see, the majority of secondary returns come from post-close appreciation for almost every purchase year. Over the long run, the discount contributes barely a third of secondary returns. This takeaway only gets stronger if a buyer were to include funds fewer than five years old and/or were to underweight tail-end funds. Both of these command significant discounts but generally entail limited upside and greater risk.
- Discounts have driven the majority of returns in only two purchase years. It is worth touching on these exceptions, one is 2009. Not only were bid discounts uniquely large that year, but those bid discounts turned into even larger closing discounts. This is due to significant market appreciation in the months between bidding and closing. Note, however, that even in a year viewed by many as an outlier, appreciation still accounted for almost half of the return.
- The other exception is 2017. This is a good example of how a discount drives a secondary’s early performance but gives way to appreciation as the secondary matures. One need only compare 2017 to 2014-2016 to see how the discount’s significance tends
to trail off over time.
Secondary Returns: What does this Mean?
- What does this mean for your secondary strategy? For one thing, secondary investors should not place undue emphasis on discount at the expense of quality. The caliber of both the general partner and the portfolio will determine go-forward appreciation. Which, we now know, has been the bigger factor in secondary returns. With respect to the portfolio, buyers should consider not only the growth trajectory of the companies, but also how they are valued. After all, what good is a discount to NAV if aggressive underlying company valuations inflate NAV? Nobody likes a DINO (discount in name only). To assess quality on these dimensions, a secondary buyer must have the relationships and information to know the GPs and truly understand the assets.
- All of this is not meant to completely “discount the discount”. Entry price and appreciation are both keys to success. The relative importance of the two can depend on the individual deal, the point in the cycle and other factors. But as a general matter, investors should know that their experience with secondaries will depend greatly on the substance of what they are buying—not just the discounts that first catch the eye.