Private Equity Secondaries… A Rough Exit

“Give us your money and come back in 20 years” is the simple description for private equity investments. PE funds are basically “closed-end funds” that gather cash to invest in a number of private ventures. Once the cash is raised, the investment period can be three to five years or longer, after which the investments remain in the fund until they mature or are sold and the capital returned to investors and the fund liquidate’s. The life of a PE fund can be anywhere from eight to 10 to 20 to 30 years and beyond.

But what if an investor needs his money back earlier? I receive a lot of junk email from brokers and fund promoters in my job, and I have recently detected a sudden emergence in the popularity of secondary private equity transactions. Secondary private equity markets enable investors in PE funds to liquidate their holdings. It is common for a PE fund to strike a net asset value or NAV, but from an investor’s standpoint this is really a fabrication since the fund manager does not allow exit or entry into the fund at the stated NAV. The secondary market has filled this gap.

One interesting email I received quoted 321 PE funds seeking bids from willing sellers. Price indications on average were about 10% less than current NAV for the funds. This is a significant haircut, and compares unfavourably with the average stock exchange listed “closed-end fund” which trades at a 3.5% discount to NAV.

It is often argued that PE investments offer a higher return to compensate for their illiquidity. The evolution of a secondary market should arbitrage this return advantage away. That would mean that PE prices get bid up, to the point that the majority of PE funds should trade at a premium to NAV rather than a discount. This clearly has not happened, and despite the spawning of a number of hedge funds investing in secondary PE, anyone seeking to sell their holdings face a rough exit.