Secondary PE Modeling

Banker88's picture
Rank: King Kong | 1,827

I have a 2nd round interview coming up with a secondary PE fund. They do mostly LP secondaries of funds that are majority invested.

I'm still trying to understand exactly how they value these LP interests. In the round 1 interview, they told me that they do a bottoms up analysis on the underlying portfolio companies, and then assume a rate of return on the unfunded portion, which dilutes the value.

Can someone explain this in some more detail? What exactly goes into the bottoms up analysis? Does this mean modeling each company with an LBO, assuming a target IRR for the entire portfolio, and backing into a purchase price for each company, then summing them up? Do they use only equity for the purchase since the portfolio companies will already have debt?

If anyone can explain the mechanics in more detail or perhaps even have a sample model to share, that would be greatly appreciated. I'm also expecting a pen/paper/calculator case study, so if anyone has any insights on that, would be useful. I know how to do a normal paper LBO but not sure what to expect on this one. Thanks in advance!

Comments (92)

Apr 2, 2013

Only slightly related, not really an answer to your question, but you may find this interesting assuming you haven't already watched it: http://www.youtube.com/watch?v=C51On8YmGCw

Good luck

    • 1
Apr 2, 2013

Anyone?

Apr 2, 2013

They're buying LP interests, so think of it as shares of a stock. I don't work in secondaries, but I'm guessing it's something like: value the LP interest of the equity of each portfolio company (I.e if a portfolio company has 1bn of equity and I've committed 10pct of the PE fund's capital, that's worth 1bn), back out management and performance fees, and apply a low rate of return (USTs? LIBOR?) To the unfunded commitments. To value the equity you would use traditional methods -- DCF, comps, LBO, etc...

Apr 3, 2013

Think of it as doing a "mini model" for each of the companies in the fund. Build out a comp set, grow sales, expand margins, pay down debt, etc..; essentially determine the equity value from sale/ipo that the fund would be entitled to. Then combine all those cash flows and remove carry and management fees. Those are the cash flows the fund gets from selling the existing companies. Then apply a return to the unfunded; 1.6x-2.0x gross (Private Equity like returns, not the lower rate mentioned above), adjusting for quality of the manager or asset class. These unfunded net returns would be 1.4-1.75x for example. Unfunded only dilutes the value if your required return is above the net return from the unfunded; for example if you want to return 1.5x from your secondary purchase, and the unfunded returns 1.4x net, then yes it hurts your returns.

The combination of the cash flows from existing companies + unfunded returns are what you would receive in future distributions. Now determine what you'd pay for that. Secondary firms tend to start at 1.5x net and move up based on risk.

Apr 2, 2013
m8:

Think of it as doing a "mini model" for each of the companies in the fund. Build out a comp set, grow sales, expand margins, pay down debt, etc..; essentially determine the equity value from sale/ipo that the fund would be entitled to. Then combine all those cash flows and remove carry and management fees. Those are the cash flows the fund gets from selling the existing companies. Then apply a return to the unfunded; 1.6x-2.0x gross (Private Equity like returns, not the lower rate mentioned above), adjusting for quality of the manager or asset class. These unfunded net returns would be 1.4-1.75x for example. Unfunded only dilutes the value if your required return is above the net return from the unfunded; for example if you want to return 1.5x from your secondary purchase, and the unfunded returns 1.4x net, then yes it hurts your returns.

The combination of the cash flows from existing companies + unfunded returns are what you would receive in future distributions. Now determine what you'd pay for that. Secondary firms tend to start at 1.5x net and move up based on risk.

1.6-2.0x is a ridiculous assumption for unfunded capital. Most PE funds can't even return that in a 7-year life anymore, and most are sitting on too much cash.

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Apr 3, 2013

Also, in terms of a case study; I'd be less concerned on modeling the individual companies. You're expected to know that already. They probably want to see if you can think within a secondary mind-set. Ask yourself questions like, how unfunded is the fund and what does that mean for the risk profile, what vintage is the fund, how levered are the companies in the portfolio, how risky is a buying a venture fund vs. a mega buyout fund vs, a mezz fund, when do you want to trade IRR for multiple returns.

Apr 3, 2013

A 1.6x - 2.0x gross return on new deals?

A 1.6x gross return is ~1.4x net to PE investors after fees and carry. You're telling me that PE doesn't return 1.4x net over 7 years? A 5 year hold with a 10% gross IRR is a 1.6x, 13% is 1.85x. These are mid single digit net IRR returns, quite low for PE. Check your math. You said you don't work in Secondaries, so stop "guessing" and throwing ridiculous statements around.

Apr 2, 2013
m8:

A 1.6x - 2.0x gross return on new deals?

A 1.6x gross return is ~1.4x net to PE investors after fees and carry. You're telling me that PE doesn't return 1.4x net over 7 years? A 5 year hold with a 10% gross IRR is a 1.6x, 13% is 1.85x. These are mid single digit net IRR returns, quite low for PE. Check your math. You said you don't work in Secondaries, so stop "guessing" and throwing ridiculous statements around.

I don't work in secondaries, but I do work in PE and we do track our competitors. Over 3+ years, '09 buyout funds have called 60% of capital and have an MOIC of 1.17x. '08 buyout funds are 70% called with a 1.20x MOIC. And just to prove I get there may be a J-curve effect (though being able to buy at the trough of the recession is a big advantage), even '03-'05 vintage funds are only around 1.5x.

1.4x net returns seems like an aggressive assumption to me. I understand the math; I question the soundness of what is supposed to be a "conservative" assumption. You're assuming an average to above-average return on capital for capital that hasn't been and may never be called. But hey, I get it - just like us, you probably have a lot of money to put to work and principals who want to do deals, so you rationalize them.

Apr 3, 2013

I would imagine that those quoted MOICs are net and are an average across all buyout funds (I could be wrong though). You just proved my point, '03-'05 vintage funds are on average a 1.5x net multiple, right in the range of a 1.6-2.0x gross return. Also, on average, exits tend to be ~25% higher than the most recent value due to GP conservatism, so it depends how much of that is realized. I'm not sure I follow your point on whether or not it gets called? Unfunded returns tend to be either return neutral or dilutive, so if it doesnt actually get called, then the Secondary returns will be even better.

Check out some data (which I know you have, but for others):
http://www.calpers.ca.gov/index.jsp?bc=/investment...

Blackstone V was in shambles during the recession and has recovered to 1.1x. I'd suspect it gets to 1.3x before all is said and done. I'd say that's a pretty solid low case for investments that were made at the height of the bubble.

Apollo VI - 1.4x, '06 vintage.

Now there are obviously some real dogs on that list, and I wouldn't recommend putting a full unfunded multiple on them.

Apr 2, 2013

Thanks m8 - very useful. Can you clarify a few things:

1) So you do not use DCF, comps, etc. to value each portfolio company and apply a percentage ownership to it as mrb87 said above? This did not make sense to me either.

2) How do you remove management fees and carry from the cash flows per company?

3) Can you discuss the trading IRR for multiple returns - aren't multiples useless without a time horizon specified? How do you use multiples (you said 1.5x) to discount if you have cash flows coming in at different intervals - don't you assume an IRR as the required discount rate, and your NPV of the cash flows is the price you would pay?

Best Response
Apr 3, 2013

1) Comps are the main form of valuation for each company. If the Fund owns 10% of a company then take 10% of the equity value at exit. Say for example $10M EBITDA today grows to $20M EBITDA by exit, apply a TEV/EBITDA multiple based on the comp set you built, remove the net debt (which will have been paid down with your EBITDA to FCF calculation), then take 10% of the remaining equity. This is the distribution that gets paid to the fund. You do this for each company. DCF is almost never used.

2) The management fees and carry are removed on a fund level for modeling purposes, so all company cash flows get aggregated first. Take out 1.5% per year for management fees, then 20% of any profit. If $100 was paid-in, and the return from all companies is $150 over the next 2 years, then after fees you have $147. Remove 20% of the $47, and you're left with $137.6 to the fund.

3) It depends really. Use a floor of 15% and 1.5x. Your investor will not want lower on either. So if you have a fund that returns everything next year, generating a ridiculously high IRR but a 1.2x, its not a good deal. Or a longer duration deal generates a 1.7x over 10 years, but only a 10%; would be a tough deal. Secondaries are unique in that you're buying pretty mature assets, so the IRRs tend to be pretty high; but without a solid multiple to go with it, its a tough investment. IRR almost always clears the hurdle, so focus tends to be on the multiple. If the fund generates $150 to me, then I pay $100 for it, getting me the 1.5x. Keep in mind that there is an extra layer of fees in the Secondary as well, usually 1% and 10%. The 1.5x and 15% floor is after those fees, so returns coming into the Secondary are usually 1.6x and ~18%.

    • 11
Apr 2, 2013

Thanks again man - I think this is the most informative thread about secondaries so you're doing the whole community here on WSO a service.

1) Ok yes I understand what you're saying - multiples are used to value the company within the context of an exit. By the way, how does a secondaries firm project out the growth and make all assumptions about these portfolio companies in the first place? Do they receive portfolio-company level information from the GP or from the selling LP?

2) So when valuing the LP interest, you would remove the carry and management fees in aggregate, not on a per company basis when you're modeling? So for a rough estimate, you can just take 2% management fees off the NAV that the LP invested?

3) In your example, if a fund returns 1.2x next year, is that not a 20% IRR? I don't understand how you get a ridiculously high IRR in general with a low multiple, because isn't the multiple calculated off of what the secondaries firm pays? The IRR and the multiple are not mutually exclusive.

4) I'm still having trouble then grasping how a secondaries firm decides what they will pay for an LP interest. Do they discount each portfolio company by the appropriate discount rate given the level of riskiness for the company, and then sum up those NPVs as their offer price? Or do they lay out all the cash flows in one spreadsheet, and then slap a 20% required IRR to everything to determine their offer price?

Apr 3, 2013

1) Almost all portfolio company level information is from GP produced materials. PE has come a long way in the last 5 years in terms of reporting standards. A couple of years of sub-par returns made the industry a whole lot more LP friendly; its pretty rare now for a GP not to produce quarterly one page summaries on each company. These will have all historical information and sometimes includes next years projections. The mega buyout funds in particular provide loads of company data for you to use. In terms of projecting growth, you can look at public comp projections, historical trends, GP commentary, etc...

2) Correct. Although the GP will take carry out of specific companies, the fund in aggregate will only be allowed to take 20% of profits, so for modeling purposes its considered on the fund level. Management fees are charge on commitments for the first 6 years (investment period), and net cost thereafter (cost basis of current investments) If they charged on NAV then GPs would write everything up and generate more fess.... Calculated net cost should be pretty straight forward.

3) That's assuming the full distributions exit all at the end of the year. For $100, if $80 are distributed in 6 months and $40 at the end of the year, the IRR is 32%. Move these around to certain extremes and you can see what I mean. This is certainly meaningful if there is one large company that the GP says will be sold next quarter.

4) You can generate a blended risk profile for the fund, but I think that probably goes beyond an interview. Say for example company A is highly risky and you want to get paid 2x, while company B is fairly straight forward and you want to get paid 1.5x. Weight those on amount of total distributions to generate your fund required return. But in terms of the actual methodology, it tends to be all distributions, then apply the 1.5x or whatever on those cash flows. This purchase price is then quoted as a % of NAV. This last piece is important because it means you have to assess how "fair" the GP's NAV is. All seller's want par, but if the fund in question is written up to crazy levels by the GP, it'll be impossible. Conversely, if a GP is very conservative, you can pay premiums all day and still generate a nice return. This last piece will come up in a case study, so make sure you understand it.

    • 2
Apr 2, 2013

Thanks for clarifying. What did you mean by:

m8:

But in terms of the actual methodology, it tends to be all distributions, then apply the 1.5x or whatever on those cash flows.

So to summarize, this is how you would value a secondaries position? Correct me if I missed anything.
1) Use info on the underlying portfolio companies provided by the GP to model out each one's cash flows
2) Apply a required rate of return or MOIC on each company to calculate purchase price per company
3) Sum up these purchase prices, then apply a conservative multiple on the unfunded portion and add that to the total.
4) Express this number as a % of NAV of the fund. (The actual dollar amount for the LP interest will be whatever percentage the LP owns in the fund multiplied by the aggregate value you got in step 3).

Jan 17, 2017

Awesome - thanks so much - very helpful.

In terms of the modeling, say the portfolio has 3 companies, you would model out those 3 companies in their standalone models. Then for each one, assuming an appropriate exit multiple each, and then targeting say 2.0x for the first two companies and 3.0x for the last company (since the last company is highly risky and you would want to weight out the risk), you would back into the equity the secondaries would be willing to invest in in the first place right? And then sum up what it would be willing to pay for each to get the purchase price for the entire portfolio.
Thanks again,

Apr 3, 2013

Just to clarify the larger picture more, aside from comps mainly, how intensive is the modeling? For the less mature funds, the companies would farther away from their exit years, so in that case, would the pricing of individua l companies be less multiples-based and more dcf based?

I know a lot secondary funds/FoF also do co-investments. Is anyone (perhaps m8 or mrb) familiar with how they do co-investment modeling? Does the PE firm build a model either from scratch or from a sell-side, pursue it after studying it for a bit of time, and then gives the model to the co-investors OR the co-investors get the news and info and build their own lbo model with sources/uses/rest of it to compare to the GP's model? How often do co-investments happen (even though PE firms are sitting on a ton of cash, they still might not want to commit too much in these uncertain times)? Thanks a lot.

Apr 2, 2013

Also- you said the purchase price is expressed as a percentage of NAV. But that is only for the portfolio companies (funded) parts, correct? There is no NAV for the unfunded portion. So how does that piece get expressed in the secondary firm's offer value?

Apr 4, 2013
Banker88:

Also- you said the purchase price is expressed as a percentage of NAV. But that is only for the portfolio companies (funded) parts, correct? There is no NAV for the unfunded portion. So how does that piece get expressed in the secondary firm's offer value?

You don't, when you buy LP interest, you are taking over this LP existing postition and FUTURE commitment into the fund. Future capital call obviously is 1:1 basis there is no discount or premium to that (e.g. After Lexington bought over Calper's stake in KKR, when KKR calls Lexington $1m for new investment XYZ, Lexingto will commit full $1m)

Apr 4, 2013

With regards the question about risk profiles, the individual company cashflows you aggregate should already reflect their perceived riskiness. Many secondary models incorporate some level of scenario analysis at the company level; so for a given company there may be multiple short-form LBO models, the output of which may be probability weighted to give a 'most likely' fund level outcome. This approach to analysis mitigates the need to think about different target returns and purchase prices at the company level. As others have said, purchase price for the fund position will be determined using a target MOIC/IRR for total fund cashflows. This is the most natural, and easiest way to approach things.

Apr 3, 2013
planettelex:

With regards the question about risk profiles, the individual company cashflows you aggregate should already reflect their perceived riskiness. Many secondary models incorporate some level of scenario analysis at the company level; so for a given company there may be multiple short-form LBO models, the output of which may be probability weighted to give a 'most likely' fund level outcome. This approach to analysis mitigates the need to think about different target returns and purchase prices at the company level. As others have said, purchase price for the fund position will be determined using a target MOIC/IRR for total fund cashflows. This is the most natural, and easiest way to approach things.

Exactly. If you think a company is way too risky, highly levered with declining margins and overvalued by the GP, then you write it off in your model and assume no distributions from the company. I would say though that across the full fund its common practice to risk adjust across asset classes; buyout is a 1.5x return, late stage venture is a 1.7x, early venture is a 1.9x, heavy public exposure is a 1.4x.

Apr 9, 2013

Banker88 - Did you have your interview and/or case study? If so, what did the case study for a secondaries interview entail?

Apr 2, 2013
AnacotSteel:

Banker88 - Did you have your interview and/or case study? If so, what did the case study for a secondaries interview entail?

I did not have it yet - will post my experience when I do.

Feb 9, 2016

Banker88: Did you ever do the case study/model? If so, how was it? Thanks in advance for any info that you can share.

Jul 14, 2017

Banker88: Curious as well about the case study/interview

Apr 12, 2013

Just to add that you should check to see if this secondary fund does any non-traditional deals. About 25% of the secondaries market now comes from stuff like team spin-outs, hedge fund side pockets, buying end of life assets etc. So it's not just about buying individual or group LP interests. In fact, returns are probably higher in the non-traditional deals as these tend to be more complex and more like to be proprietary sourced.

Also the secondaries market is growing as a % of the overall PE market (still only about 3% I think). In addition to LPs looking to sell their commitments for liquidity reasons, a lot of financial institutions in particular want to offload PE assets for regulatory reasons. Not a bad area to get into I think. Certainly compared to traditional FoF which is in decline.

Feb 9, 2016

Here are some simple scenarios:

1) Public pension plan is required to liquidate their private equity investments (funds) for some unknown reason. For the sake of simplicity, lets assume they had only had one fund (e.g. Carlyle IV). They sell this fund to another investor for X dollars. This investor now owns that commitment and is required to meet any additional capital calls, etc. The new investor also gets all the distributions, etc...

2) Co-investments allow LPs to invest side-by-side with the GP. LPs look at this as an opportunity to invest in cherry-picked deals. GPs can use it as a way to raise additional capital for their portfolio companies.

These scenarios can get very complex. There are firms that operate FoFs that specialize in buying secondaries --- some even offer co-investment funds.

Feb 9, 2016

Ok, thanks for reply. However I still don't understand what it means that some PE FoF is active in secondary PE market. How does it work? From what I understand now this pension plan can withdraw from the fund and transfer its stake to another investor without really involving the PE fund. I just don't see where the business (money) is here for PE?

Same when it comes to co-investments. Great for LP, but where is the deal for GP?

Thanks in advance for explanations!

Feb 9, 2016

GP's make their money off carried interest (% of absolute returns) and management fees (1-2% of assets under management) charged to their limited partners (pension funds, endowments, etc.) and other restructuring/consulting services offered to the portfolio companies.

Co-investment opportunities can vary, but for the most part LP's won't participate in the management fees, since they are passive, but they would benefit from all returns on their investment. Co-investment deals are more prevalent and encouraged in countries where foreign takeover rules restrict foreign control.. e.g. In Canada, the Madison Dearbon/BCC deal involved a limited partner because canadian rules require that control be kept in the local hands, so a couple of canadian pension funds ended up taking the majority position in Bell Canada, even though Madison Dearborn drove the deal.

Some hedgefunds also have dedicated funds that are active in the co-investment and secondary PE market.

The GP's make money either way, even in the upcoming downturn, when interest rates may force some highly levered portfolio companies into restructuring/recap/bankruptcy phase.

Feb 9, 2016

Ok, IaEU(tm)m getting there... just one more clarification on secondaries.

Say there is PE fund (GP) and pension fund X (LP) that committed to the fund (and invested following the call). 1yr down the road the LP withdraws from the fund and is selling its stake to some other investor (probably firstly some other LPs will be offered this stake).

The point I donaEU(tm)t get: where in this transfer GP has any interest? To my understanding...

Scenario 1: pension funds stays in the business for the whole investment period >> then GP has management fee (1) + carried interest (2)

Scenario 2: pension fund X withdraws after 1yr are sells the interest to insurance company G >> then GP has management fee (3) from pension fund X + management fee (4) from insurance company G + carried interest (2), where (3) + (4) = (1).

So what IaEU(tm)m trying to understand is why is it beneficial to any PE fund to be active in the secondary market? I assume itaEU(tm)s beneficial if there is some extra money in it. According to my understanding (but probably IaEU(tm)m wrong) there is no difference in profit because (1) + (2) = (3) + (4) + (2). If no profit why to complicate your life?

Feb 9, 2016

From a fee standpoint the GP is no better off because the new LP is basically "substituting" in for the original LP.

When a firm claims that it is active in the secondary market, it means that they are operating a fund of fund that is willing purchase commitments when they come up for sale. The market for secondaries is pretty illiquid, so the buyer may have an opportunity to pick up the commitment at a relatively low price.

Does that help?

Here are some links:

http://en.wikipedia.org/wiki/Private_equity_second...
http://www.landmarkpartners.com/page.asp?h=program...

Feb 9, 2016

GP doesn't usually reap any real benefits from a secondary market/transfer of LPs, although they are required to assist in the process of helping an LP transfer its interest because as asset managers as well as limited partners themselves, GPs have a fiduciary duty to their investors.

most of the time, these transfers are a headache for the middle office of the PE firm due to the legal transactions involved.

however, in some occasions, an LP may actually sell out part of their interest at a premium (rather than a discount) due to a need to exit a fund. The new LP sometimes is willing to actually pay more because they believe that the fund is currently in an upward cycle (coming out of the J-curve, e.g.)

Feb 9, 2016

Riemann, PEAnalyst - thanks for replies and links. It clarifies a lot. Last 2 questions if possible:

1) Is it the practice that once LP withdraws it sells its stake at a discount (if it wants urgently to witdraw) or at a premium (if it wants to withdraw and the fund is doing exceptionally well)?

2) Is it fair to say that the key difference between primary and secondary investment is the vintage year (i.e. another factor that plays a role in the diversification strategy)?

Thanks Guys for explanations!

Feb 9, 2016

Riemann, PEAnalyst - thanks for replies and links. It clarifies a lot. Last 2 questions if possible:

1) Is it the practice that once LP withdraws it sells its stake at a discount (if it wants urgently to witdraw) or at a premium (if it wants to withdraw and the fund is doing exceptionally well)?

2) Is it fair to say that the key difference between primary and secondary investment is the vintage year (i.e. another factor that plays a role in the diversification strategy)?

Thanks Guys for explanations!

Feb 9, 2016

Riemann, PEAnalyst - thanks for replies and links. It clarifies a lot. Last 2 questions if possible:

1) Is it the practice that once LP withdraws it sells its stake at a discount (if it wants urgently to witdraw) or at a premium (if it wants to withdraw and the fund is doing exceptionally well)?

2) Is it fair to say that the key difference between primary and secondary investment is the vintage year (i.e. another factor that plays a role in the diversification strategy)?

Thanks Guys for explanations!

Feb 9, 2016

1) Very few LPs liquidate a position unless they are forced by some policy of sorts. In practice, the LP is in it for the "long haul." Some are more active --- but the vast majority are in the fund from start to finish.

2) When an investor purchases a secondary, they will still keep the original vintage for classification purposes. Vintage is usually determined by the date of the first closing or the date of the first cap call (there are some variations here). It's kinda like a wine --- a 1994 bottle of wine is always vintage 1994 regardless of when you purchase it.

I would say that the key difference between primary and secondary investments is that the secondary is a more mature vehicle. The fund is likely to have made a series of investments and it may even be out of the investment period.

Feb 9, 2016

What is a reasonable target return for a PE secondary fund?

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Jun 18, 2013

Banker 88 - Did you ever do the case study/model? If so, how was it?

Feb 9, 2016

Never ever ever triple post. You have turned this entire forum against you.

Feb 9, 2016

And while we're doling out posting suggestions, I would also suggest you refrain from using ALL CAPS in the subject line. It just comes off as shouting.

Contrary to what you may believe, caps lock is not cruise control for cool.

Feb 9, 2016

Wow you REALLY want to have this question answered don't you!?

Pity I know nothing about this subject ....... :P

I second VCmonkey's comment, triple posting is sacreligious

p.s. - people who triple post never get jobs in PE, fact.

Feb 9, 2016

hahaha - I apologize I inadvertently incurred the wrath of the forum. I am clearly a posting noob. I have an interview next week that I just found out about and would greatly appreciate any wisdom.

May 3, 2015

Does anyone have a practice secondaries pen & paper case study?

Feb 9, 2016

Don't work in secondaries. Ever.

Feb 9, 2016

What's so bad about it? I lean towards IBD but I've been try to dip my toes in fund management and it seems like a logical transition

You know you've been working too hard when you stop dreaming about bottles of champagne and hordes of naked women, and start dreaming about conditional formatting and circular references.

Feb 9, 2016

My old roomate used to in 'secondary PE'

Basically, the secondary PE market refers to transactions done at the LP level. In essence, the advising firm will be the sell-side advisor to the LP trying to sell thier stake in a GP's fund. For example,

Let's say you work for a pension fund and you have a 10% stake in a $100MM NAV Carlyle fund. Due to the long-term nature of your $10MM commitment (7-12years usually), it becomes a very illiquid investment. What the secondary market does is provide liquidity to the LP's wanting to buy stakes in funds, or exit stakes in funds. The valuation aspect is based on NAV (net asset value) and buyer's will generally pay a discount to NAV, however if a fund is expected to outperform its current NAV, buyer's will pay a premium.

There is a lot more to this, but i'll expand if there is any questions.

Feb 9, 2016

There is nothing bad about it. I am not sure what a "secondary PE fund" is, however, it is probably a firm that has an advisory side, and an Asset Management side. Regardless, comp is good, and hours a good.

Feb 9, 2016

A secondary PE fund is the one that buys stakes in funds (as described by MoneyKingdom). In fact it is a Secondary PE Funf of Fund (Secondary PE FoF).

PE FoFs can do primary investments (acting as an LP when a new investment vehicle is created by a PE firm), or secondary investments (buying an LP's investment in an existing investment vehicle managed by a PE firm - "Secondaries").
PE FoFs can do primary investments and/or secondaries and/or co-investments (directly into a portfolio company along with the PE firm).
PE FoFs that specialise in Secondaries (ie. do not do Primary investing and co-investments) are sometimes called Secondary PE funds, but technically they are FoFs.

They mostly recruit people with M&A experience. Typically when you acquire an LP's stake in a fund you will value the underlying portfolio companies of the fund. I've been told that it is quite modelling intensive. You also get to develop a very good understanding of the whole PE world (not just the direct-investing-into-companies side).

Hope this helps.

Feb 9, 2016

Some very good secondary firms out there doing interesting work; Coller Capital for instance.

Feb 9, 2016

A lot of them actually work with BB Asset Management or other megafunds like BX or The Carlyle Group, buying funds or parts of a fund from them. Hours seem to be pretty decent and most of the associates I've seen have a lot of M&A experience in whatever BB industry group they were in.

Feb 9, 2016

What are the mechanics behind valuing a portfolio of LP interests? I would assume you do a DCF of future expected cash flows (i.e. liquidity evens, recaps and exits)?

Any insight?

Feb 9, 2016

Sometimes you may do a little direct deal work if the firm does co-invests... but in my experience most of the work will be evaluating PE firms/funds and their management teams/investment professionals and deciding if you want to commit capital to them.

Feb 9, 2016

Some Funds (Coller Capital, Saints etc) will do a great deal of co-investment and will at times and in the case of Saints will be buying secondary portfolios of assets, rather than LP commitments and therefore there will be extensive valuations, modelling etc

Feb 9, 2016

Not really. Secondary funds buy LP commitments in the secondary market. For example, if a LP in a PE fund wants to get out of the fund (usually for liquidty reasons), that LP commitment will be sold on the secondary market, often for a pretty deep discount, to another buyer (in this case, the secondary PE fund).

Feb 9, 2016

tan86, that makes perfect sense.

A follow-up question: Do these funds (I know there are different strategies) scoure the market for distressed LP and take advantage of the deep discount, thus reducing the initial cost of investing in that fund?

If I knew how to award SBs, you would get one.

Thanks

Feb 9, 2016
Working9-5:

tan86, that makes perfect sense.

A follow-up question: Do these funds (I know there are different strategies) scoure the market for distressed LP and take advantage of the deep discount, thus reducing the initial cost of investing in that fund?

If I knew how to award SBs, you would get one.

Thanks

Not entirely sure how the sourcing process works, but usually secondary buyers are insanely profitable for one main reason, which is the lack of the J-curve. When a LP wants to sell its commitment due to whatever reason, chances are its investment has already hit the bottom of the J-curve. The secondary buyer will then pick up the commitment at a discount in addition to the discount the NAV is already priced at due to J-curve effects. When the underlying investments start maturing, the value of the commitment could rise tremendously.

As a multiple of cost, if you buy an investment at a lower cost base instead of the original cost and it returns X amount, you make much more than if you were the investor who invested at cost.

The PE secondary market is relatively young, but is starting to fill up with more competitors who are actively looking for investments since they can be really profitable.

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Feb 9, 2016

Agree with tan, usually for a discount but keep in mind, it is a discount to the net asset value, not the buy-in. For example, let's assume ABC FoF committed $100mm of capital to BX and funded 50% of that...aka BX has used $50mm of ABC FoF cash to purchase the current portfolio.. Also, assume BX's acquisitions have been good ones and BX has marked up the fund's NAV by 10%... that means ABC's original $50mm of funded equity is now worth $55mm. They can sell their $50mm investment (incl. $50mm unfunded commitment) at break-even and it would still be considered a discount as it is a discount to the current value of $55mm.

I would think working at a secondaries FoF has more analytical work to it vs. a regular FoF since entry point is variable and the art of negotiation is a factor, but I don't have any personal experience in secondaries so I can't say with certainty.

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Feb 9, 2016

Keep in mind there is a difference between secondary (purchasing LP interests) and direct secondary investments, where the firm will purchase portfolio companie(s) from the fund.

Feb 9, 2016

PEguy2011, thanks for clearing that up for me. I feel like Alice after she fell down the rabbit hole, a whole new world.

Once again, if I knew how to give you a SB you'd get one.

This seems like real spreadsheet monkey work. Doing your own valuation of companies, in for example BX's fund portfolio. Coming up with your own estimate of a reasonable price of the LPs commitments.

Last follow-up (for now): What is the benefit of investing in a PE fund that operates in the secondary market vs primary market? I assume the primary market fund has the biggest staff of number crunchers, thus taking longer time to analyse and investing the raised capital.

Feb 9, 2016
Working9-5:

PEguy2011, thanks for clearing that up for me. I feel like Alice after she fell down the rabbit hole, a whole new world.

Once again, if I knew how to give you a SB you'd get one.

This seems like real spreadsheet monkey work. Doing your own valuation of companies, in for example BX's fund portfolio. Coming up with your own estimate of a reasonable price of the LPs commitments.

Last follow-up (for now): What is the benefit of investing in a PE fund that operates in the secondary market vs primary market? I assume the primary market fund has the biggest staff of number crunchers, thus taking longer time to analyse and investing the raised capital.

I'd say the main benefits are diversification and returns. PE itself is not as correlated to the market, secondaries even less so. In the secondary market, you can make money even from the poorest performing fund, so the returns can be great. Imagine buying an LP's commitment at 0.1x cost then seeing that rise to 0.5x at the end of the fund life. That's a home run... Even if the PE fund fucked up, the secondary investor won big.

Feb 9, 2016

HarvardOrBust; Ahhh.. didn't think of that. Good point.

BSTN05; would you care to elaborate? Wouldn't direct secondary investments act as another PE fund in the primary market, making the fund management elligble to positions on the board?

Apr 3, 2013

I would just clarify some of the comments about Secondaries generating great multiple returns. Secondary investors (and their LPs), are looking for shorter duration (vs. a typical PE investment) investments, which should generate a higher IRR with a lower multiple. Think of Secondaries as a lower-risk investment, they rarely lose money and return capital quicker than a typical PE investment.

Think of it this way, if you're investing in a portfolio of companies that should be 2-3 years from exit, you probably have a good idea of the exit value. With the lower risk, you require a lower return, and probably underwrite to ~1.5x. But your capital gets returned quicker, so your compensated with IRR. There are a lot of Secondary firms today willing to take a sub 1.5x return with the trade off a 20-30% IRR.

Feb 9, 2016
m8:

I would just clarify some of the comments about Secondaries generating great multiple returns. Secondary investors (and their LPs), are looking for shorter duration (vs. a typical PE investment) investments, which should generate a higher IRR with a lower multiple. Think of Secondaries as a lower-risk investment, they rarely lose money and return capital quicker than a typical PE investment.

Think of it this way, if you're investing in a portfolio of companies that should be 2-3 years from exit, you probably have a good idea of the exit value. With the lower risk, you require a lower return, and probably underwrite to ~1.5x. But your capital gets returned quicker, so your compensated with IRR. There are a lot of Secondary firms today willing to take a sub 1.5x return with the trade off a 20-30% IRR.

They're are multiple ways to play it... all depends on the firm.

Feb 9, 2016

Also, if your investment period is 2-3 years with recycling, and say you have a 7 year fund life, if you can generate 30% IRR, you will be returning >2x at the fund level. That's pretty good if you ask me.

Feb 9, 2016

Benefits are j-curve reductions and discount + its far easier to DD a fund that is is 40% committed than a fund yet to be raised.

In terms of dealflow, there are plenty of intermediaries who are paid by the people selling their stake to find buyers.

(this refers to non-direct secondaries)

Feb 9, 2016

What an ironic username. Do a search.

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Feb 9, 2016
SanityCheck:

What an ironic username. Do a search.

Feb 9, 2016

I think it's more interesting than regular fund investing but it's still FoF - you're evaluating an existing portfolio of investments and deciding what discount (or premium for the best funds) to NAV that you're willing to bid. I have not seen anybody move from secondaries to the direct side.

Feb 9, 2016

Sb'ed, appreciate the insight

Feb 9, 2016

No problem - let me know if you have any other questions or decide to interview for the role. I have some friends in secondaries and know a bit about the strategy.

I will add that with the increasing maturation of the asset class, the secondaries market is expected to grow quite a bit in the coming years.

Feb 9, 2016

Hi,

I have a 2nd round interview with a secondary PE firm coming up and was wondering if you could give me some useful information (since you have some friends in secondaries). All I know is that the first part of the interview will be a case study. Do you have som insight into what kind of case study this might be and/or other general tips regarding the interview.

Any insight is very much appreciated.

Apr 10, 2017

Any update on what happened in the case study?

May 9, 2017

If you buy a portfolio with a cost of 120 that now has a NAV of 100 for a price of 95% of NAV, is the pro forma cost basis 95 which also equals to the pro forma NAV? Just want to make sure I'm thinking about it correctly when modeling distressed portfolio purchases.

Apr 10, 2017

Anyone have a secondary fund lbo model lying around by any chance (long-shot I know) - mainly interested as to how you get to the expected cash flows of the fund

Aug 23, 2017

Did anyone happen to find a Secondary investment model example? Struggling to find anything online. Quite surprising given how much capital is pouring into this strategy and the number of jobs in this area.

Oct 2, 2017

do you have a secondary model?

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