Private Equity: The Secondary Market

Ten minutes south of Zurich is a little town called Zug. In Zug, we had the opportunity to meet with a few folks at a publicly listed investment firm called The Partners Group, which is one of the major players in what is referred to as the private equity secondary markets. Below are a few things we learned about PE “fund of funds”.

A typical private equity fund is composed of “limited partners” (LPs) and “general partners” (GPs). The limited partners contribute the money to the fund and the general partners go out and find companies to buy and then manage these investments on and active (or passive) basis. Because the GPs are doing all the work to make the LP’s richer, GPs are compensated in multiple ways (e.g. a percentage of assets under management, carried interest, co-investment rights, etc.). The LPs are typically institutional investors, wealthy individuals or another PE fund (called a fund of funds).

A fund of funds is basically a PE fund that, instead of directly acquiring companies, invests in other PE funds that do. Most fund of funds invest in new PE funds. This is called the “primary market”. This process involves LPs analyzing GPs track records and their proposed investment strategies; valuation is rather subjective because there are no assets in the fund yet… it’s very similar to a venture capital investment where the investor is evaluating the management team and their ability to executive their proposed business plan. As the GPs begin to aquire companies, the net value of fund changes in a pattern that is referred to as the “J-Curve”. I won’t get into the details of how the J-Curve works, but I’d highly suggest Goggle for more info.

Now, let’s discuss what happens when an LP (that most likely owns holdings in several funds) decides to liquidate its own portfolio. If it’s a large LP with several investments, it will hire an investment banking firm to conduct an auction process that is very similar to any other sell-side deal (build a book, build a list, call the list). If it’s a smaller LP, it may opt to find a buyer on its own through an independent finder. The finder is simply a match maker and doesn’t conduct an auction process, so they are typically compensated 50-75 bps rather than 1-3%. This process of one LP buying the investments from another LP is what the secondary market is all about. The idea is to buy out other LP interests at an inflection point (hopefully the bottom) on the J-Curve. This provides an opportunity for the secondary investor to achieve a higher IRR because it doesn’t have to wait out the early years of the PE fund when there are no cash distributions to the investors.