Private equity, though a compelling addition to a well-structured portfolio, presents investors with unique challenges in cash flow management, diversification and liquidity. Private equity “secondary funds,” however, can help offset some of these challenges while delivering a favorable potential return. To help determine whether a private equity secondary fund is right for you, let us answer several frequently asked questions:

What is a private equity secondary fund? Secondary transactions, in their simplest form, involve the sale and transfer of an existing limited partnership interest in a private equity fund, or a portfolio of funds, from one investor to another. As a result, sellers receive liquidity for their stake in the fund and are released from any unfunded portion of their capital commitment. The buyer agrees to pay a negotiated price for the seller’s interest, usually at a discount to net asset value (NAV), and to take on future funding obligations. In exchange, the buyer receives future distributions from the fund as it exits its portfolio holdings and returns capital to investors. Secondary funds simply execute this on a large scale. Secondary fund managers raise pools of capital from investors in order to purchase and assemble a diversified portfolio of these secondary interests.

What prompts these transactions? Seller motivations vary, from financial distress to active portfolio management. Motivation of the buyer is likely centered, not surprisingly, on financial gain. But buyers may also make the investment to acquire access to a particular strategy, geography, fund vehicle or investment manager.

What are the benefits of a secondary fund investment? There are several benefits to investors in secondary funds, but three important areas are:

Secondary funds return capital, quickly mitigating the “j-curve effect” that often produces negative performance in the early years of a private equity fund as cash outlays exceed distributions. Secondary funds basically fast-forward through these early years by acquiring interest in seasoned funds, thereby drastically truncating the timeline to distributions.

Secondary funds reduce “blind pool” risk by investing in mature, pre-identified, underlying fund interests and existing assets, unlike primary funds, where investors commit capital to a “to-be-assembled” portfolio. So portfolio risk is more readily identified and can be priced into the transaction.

Secondary funds provide a high level of diversification. The exposure of a single secondary fund commitment typically spans a range of vintage years, geographies, investment strategies and industries, which helps smooth the return volatility associated with primary investing.

How well do secondary funds perform? Secondary funds remove a degree of uncertainty from the investment equation through the acquisition of existing, mature assets. While the upside return potential may be limited relative to top-quartile performance in buyout or venture capital strategies, the downside risk is also muted. In fact, secondary funds have fared well in the context of the broader private equity landscape.

What about fees? Typically, the investor pays a fee to the secondary fund manager who, in turn, pays a fee to the managers of the acquired underlying fund interests. But the burden does not fall squarely on the investor, primarily because when the secondary fund manager underwrites a transaction, its all-in cost, including fees, must meet the fund’s minimum net return objective. Thus, purchase prices are adjusted accordingly, and future management fees are effectively subsidized by the seller.

Secondary funds demonstrate a unique set of private equity portfolio management benefits while providing a stability of return relative to the broader private equity market. They may be worth considering for your portfolio.

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