Surfing the n-wave
Surf's Up! But watch out for the rocks. And Introducing the Cynical Secondary Circle of Life. Another reason to beware of 40-Act Secondary Funds.
A few years ago, the AltView team attended a marketing presentation by a:
Private Equity Secondary Fund
This Fund did not invest directly in companies, but rather made investments in other private equity funds, buying stakes from current owners (Limited Partners, or LPs) of said funds who, for whatever reason, wanted to sell.
Unlike many secondary-focused funds being introduced today that allow monthly access to new investors, it was a so-called drawdown fund. This meant it sought investors’ capital commitments only once (at the fund’s inception) and drew on investor’s capital as it found attractive investments.
Listening, we thought: even if the manager buys stuff for 70% of Net Asset Value (NAV: the value ascribed to the investments by the respective funds’ General Partner/Manager) turns out not to be worth 100%, but instead, ends up being worth only say, 80-85% of NAV, that’s not nothing, right?
In this secondary scenario, the investor has two ways to win:
1. From increases in the underlying value (NAV) of the investments over time, and
2. From having bought the assets for comfortably less than they were worth (i.e. a discount to NAV).
While buying funds that invested in other funds added an extra layer of fees, by buying at a discount to NAV, there was a possibility of getting better returns than the weighted average of the fund’s investments.
This logic does NOT work the same way for new investors in today’s Secondary Fund NAV-squeezers.
NAV-Squeezing funds—at least those without inflows—and surely this will happen to every fund eventually—offer no prospect of gains via NAV discounts closing. That ship sails when the NAV-squeezers’ assets are purchased and immediately marked up. And of course, this happens-by definition-before the new investor entered the fund.
For this reason, it appears virtually impossible for a new investor buying into a pool of NAV-squeezed secondary assets to outperform the underlying funds the secondary fund owns.
Actually, it is worse than that. In a no-inflow scenario, such funds should underperform the portfolio of funds they own by the amount of the secondary fund’s own fees. It feels like a mathematical identity to us. Given the pressures on PE returns to begin with, this would seem to make them an exceedingly unattractive investment option.
Danger: Curves Ahead
For further context, consider that prospective investors in Evergreen funds are constantly reminded about “J-curve mitigation.”
Brief aside: we think of the “J-curve” as one of many vocabulary words that consultants and financial advisors get to learn as part of their privileged relationship with the Alts Aristocracy. They hear (and understand!) and feel good about themselves, and the wee ego boost that comes from digesting an important insight distracts them from the myriad ways they are getting mistreated (Confession: we have felt this wee ego boost). Listen to a podcast on Alts, especially one geared towards wealth managers that cater to rich dentists, and you’d think J-curve mitigation is the biggest financial innovation since the ATM.
Ok sorry about that. Anyway, the J-curve chart has returns on its vertical axis and time on the horizontal axis. A traditional drawdown fund, when it begins life, shows negative returns; there are no realizations but there are operational costs. Negative returns become positive as the fund begins to realize (aka sell) investments at a profit. The blue line below is illustrative.
Evergreen fund investors avoid the J-curve, getting the benefit of immediate exposure to a large asset pool. What’s more, the assets owned should be closer to sale/realization than for a brand-new fund.
However, new secondary fund investors get exposure sure to a different curve; one that the Evergreen Secondary managers won’t want to talk about: the “n-curve.” The n-curve mirrors the j-curve and describes the typical decline in returns in secondary funds over time, as represented by the blue curve in the below chart from a 2022 Ares whitepaper. Note the “initial write up of an investment” comment. In this context, the authors acknowledge that the fade to returns is a real thing.
Source: Ares
In the case of the traditional drawdown fund, the n-curve is less of a problem. We might call this NAV-marking rather than NAV-squeezing, because a traditional fund doesn’t take in additional capital commitments once launched (1).
The Same, But Different
A traditional private equity secondary fund has three important attributes that today’s new Evergreen secondary funds do not share:
1. They gather assets only once.
2. They pay performance/incentive fees based on realized gains.
3. They have (in theory) relatively sophisticated investors.
These three factors should mean that the traditional PE Secondary investor should understand that initial returns shown in blue above, which will look AWESOME, will fade. Incentive fees are paid on actual realizations, so investors care less about interim marks.
In the Secondary Market of 2025, things have, errr, changed. Now, firms get to:
1. Market on performance that reflects NAV-squeezing, and:
2. Get paid additional management and/or incentive fees based on NAV squeezing, and:
3. Take in more capital based on the performance generated from #1 and #2.
We suspect that many Evergreen Secondary Fund investors don’t know these things.
The Cynical Secondary Circle of Life
NAV-squeezing—on its own—presents problems for current Secondary investors. But in the bitterest irony, today’s NAV-squeezing disadvantages tomorrow’s investors. Of course this won’t become clear until inflows stop. Until then, it’s the best party vibe EVER.
By the way: have a look at the chart showing N-curve above and J-curve. See what happens in the out years? The typical buyout fund outperforms the typical secondaries fund. A simple interpretation: fees matter and adding an extra layer of them doesn’t help. The experience will be worse for buyers of NAV-Squeezed funds.
Finally: what if our friends at AQR are right, and the future real return on traditional PE overall is just 2.8%? Subtract 1.75% for PE secondary fund fees, and t-bills start to look like a good (and less risky, and liquid) alternative.
Returns like that will be challenging for even the most skilled Alts-peddler-propagandists to rationalize. In that case, a potential solution would be to minimize the risk of having to ‘splain, by putting those kinds of investments in a place where they might be ignored.
Hmmm. Let’s just think of a place where the overall weighting to Private equity might be small (making it easier to hide bad performance), but the overall market size is HUGE. Like maybe $12 or so trillion.
How about 401(k) plan target date funds? Just a thought….
NOT INVESTMENT ADVICE. INVEST AT YOUR OWN RISK.
(1) A traditional secondary fund could actually use its interim IRR to market its next fund, which could kind of create a strange dynamic; you’d want to market it super-early, before the IRR drifts down. Alternatively, you could buy a bunch of deeply discounted stuff, mark it to NAV, and then start marketing.
Resources:
Landmark (Ares) white paper:
AQR Capital Market Assumptions:
Can you explain why/how the underlying fund bought are "purchased and immediately marked up" in evergreen structure ? Ain't they entered into the fund at a discount then marked up only afterwards ? In that sense doesnt the LP also get exposure to some of the value/mark up return ?
I am offered Carlyle Secondary Fund recently..perhaps good to give it a miss.
Well written, whether investors can exit before a fire sale rush on liquidity causes discounts will be key. Gating may be likely for some funds.