New to PE? Try secondary funds, says Cambridge

While some Asian institutions are at the stage of wanting to make direct investments into private equity, many are still looking to make their first move into the asset class, as they seek higher returns than are available in listed markets.

Often investors see fund-of-fund managers as the best way to get started in PE investing, but they may be better off with secondary funds, argues a report by Cambridge Associates.

FoF managers are viewed as a good bet because they allocate to a portfolio of PE funds, providing exposure to private investment managers and helping clients learn about the industry, said the investment consultancy.

Secondary funds – which buy positions, often at a discount, in PE funds that are already active and making investments – can often generate returns more quickly and that are stronger that those from funds of funds.

The main difference between PE secondary funds and FoFs is that the former can start generating returns much faster, said Alex Shivananda, senior investment director at Cambridge and co-author of the report.

Secondary funds typically acquire stakes in PE funds that are already investing in their own right, which enables them to begin generating returns immediately. On the other hand, funds of funds raise capital to commit to PE funds, which themselves are also newly raised and just starting to make investments in portfolio companies.

For example, it typically takes just seven years for distributions to secondary fund investors to match contributions from investors, compared to 11 years for the typical PE FoF, noted the report. And 40% of a secondary fund's capital is usually distributed back to investors within the first five years, while just 13% of FoF distributions typically occur within the first five years.

What's more, returns from secondary funds also tend to be stronger than those from funds of funds. In aggregate, as of June 30, 2016, secondary funds reported stronger results than funds-of-funds on a pooled internal rate of return basis and a total value to paid-in capital basis, which measures the total value created by a fund, said the report.

It explained that one reason for the lower returns from funds-of-funds is that fees are being charged for a longer period before funds are actually put to work in underlying companies.

Nevertheless, funds of funds can still add value for institutions seeking specific private investment exposure, said Cambridge. For example, venture capital funds can be hard to access, and a skilled VC-focused FoF manager can help investors allocate to those hard-to-reach strategies. Funds of funds can also be good for accessing specific geographies, such as emerging markets, added the report.