Private Equity Indices Based on Secondary Market Transactions (2022)

Posted by Michael S. Weisbach (Ohio State University), on

Tuesday, November 13, 2018

Print E-Mail

Buyouts, Capital markets, Fund performance, Institutional Investors, Private equity, Venture capital firms
More from: Brian Boyer, Keith Vorkink, Michael Weisbach, Taylor Nadauld

Michael S. Weisbachis Ralph W. Kurtz Chair in Finance at The Ohio State University Fisher College of Business, and Research Associate at the National Bureau of Economic Research. This post is based on a recentpaper by Professor Weisbash;Brian Boyer,Associate Professor at the Brigham Young University Marriott School of Management;Taylor Nadauld,Associate Professorat the Brigham Young University Marriott School of Management; andKeith Vorkink,Associate Dean andDriggs Professor of Finance atthe Brigham Young University Marriott School of Management.

(Video) Private Equity Fund Structure

In recent decades, private equity has become an important asset class for institutional investors. A 2017 survey of institutional investors finds that 88% are invested in private equity, with nearly a third having an allocation greater than 10%. A typical private equity investment begins with capital commitments at the fund’s creation and ends with the final distribution, which is often 12 to 15 years after the initial capital commitment. The return on the fund is determined by the returns on the individual portfolio companies in which the fund invests, and is therefore only fully observable following the fund’s final distribution. The underlying value of these portfolio companies fluctuates with firm-specific and economy-wide news in a manner similar to that of public equities, but these fluctuations are usually not fully reflected in the valuations that funds report to their investors. Moreover, since returns are measured at such irregular, infrequent intervals, it can be quite challenging to estimate standard performance parameters such as factor alphas and betas.

(Video) Private Equity Secondaries: Beneficiary Of Rising Distress

While active markets for trading investments in private equity funds did not exist prior to 2000, in the early 2000s, a secondary market developed on which limited partners (LPs) could transact their stakes in private equity funds. In this paper, we use data obtained from a large intermediary in this market to evaluate the risk and return of private equity funds in a similar manner to the way in which investors regularly use public equity markets to understand the risk and return of publicly traded companies. Using these data we construct transaction-based indices for both buyout and venture capital funds, and use these indices to address a number of questions about the private equity market. These indices provide new insights into the performance of private equity as an asset class. In contrast to the existing literature, we find that neither buyout nor venture funds outperform public markets on a risk-adjusted basis. We also find that NAV-based indices, such as the Burgiss index, tend to significantly understate the volatility of private equity as well as its covariance with other asset classes.

The primary difficulty in constructing an index from secondary market data for private equity is accounting for the fact that not every fund trades in every period, and many funds in our sample do not trade at all. In the subsample of funds that could be matched with cash flow data from the Preqin database, there are 1,119 fund transactions for 630 funds (372 buyout and 258 venture) from 2006 through 2017, implying that the average fund in our data trades 1.8 times in our sample. Moreover, the funds that do trade are not random draws, and it is possible that sample selection could affect our estimates. We employ two approaches to construct our indices in light of these challenges.

First, we show that if funds transact at random, we can construct an index that tracks the price of a broad portfolio of funds, even if funds within the portfolio do not transact in our sample every period. Second, we account for the possibility that fund transactions are not random, and that the decision to transact in the secondary market could be related to fund market values or other characteristics. To account for such possible sample selection, we create a hedonic index using the approach of Heckman (1979). Using a broad universe of funds, we estimate the parameters of an econometric model using observed transaction prices and each period create an inferred price for every fund, including those that do not transact. We then use these inferred prices to construct our index. We account for measurement error when estimating performance parameters by applying bias adjustments.

(Video) 2018 Investment Panel Discussion, Secondary Markets

A striking observation about the transactions-based indices is that they are much more cyclical and exposed to market-wide risk than other indices based on reported NAVs. We estimate the beta of the transactions-based buyout index to be greater than two. As emphasized by Axelson, Sorensen and Strömberg (2014), the return on a buyout fund is essentially the return on a portfolio of highly levered firms. Even if the portfolio firms prior to the buyout have unlevered betas slightly less than 1.0, tripling their leverage, as is typically done in a buyout, should lead to a portfolio beta larger than two. For comparison, we estimate the beta of a buyout index that we construct based on the NAVs reported by Preqin using the same set of firms that make up the transaction-based indices, and the beta of a buyout index produced by Burgiss. In contrast to the estimates for the transactions-based indices, the estimated betas for both of these more traditional indices are less than 0.5. These indices based on NAVs have much lower betas than the transactions-based indices because NAVs are smoothed over time and do not reflect the information contemporaneously incorporated into market prices.

An implication of the high estimated betas is that, even though the hedonic buyout index averages a 20% return over the sample period, its estimated CAPM alpha is not significantly different from zero. The relatively high average return, therefore, is just enough to compensate investors for their exposure to market-wide risk. This finding is in contrast to our positive estimates of alpha for the two NAV based indices, which mirror the results from the existing literature.

The betas of transaction-based venture capital indices are also higher than that of the corresponding NAV-based indices. We estimate betas for the transactions-based indices to be about 1.0, and for the NAV-based indices to be about 0.3. Since venture funds usually do not lever up their positions in portfolio companies, there is not a Modigliani-Miller ratcheting of betas as in buyouts, which is why venture capital betas tend to be lower than buyout betas. Nonetheless, the estimated betas of the transactions-based indices are large enough to affect inferences about performance. While NAV-based indices of venture funds have estimated alphas that are positive and statistically significant, the transactions-based indices have estimated alphas that are actually negative, although not statistically significantly different from zero.

(Video) Equity Secondary Market (COM)

Besides altering perceptions of private equity performance, the lack of information from secondary markets can also distort investors’ portfolio decisions. For example, following the Financial Crisis of 2008 a number of investors believed that their portfolio weight in private equity had substantially increased, since NAVs of their private equity positions dropped much less in value than the market values of their stock holdings. Our analysis suggests that at the time of the Crisis, private equity funds’ values had fallen by at least as much as public equities. Therefore, properly measured, the fraction of institutional portfolios made up by private equity did not increase during the Financial Crisis, as was commonly believed.

Finally, our indices also allow us to value individual funds at any given point in time and to estimate the extent to which a NAV for a given fund differs from its value in any particular year. These market-to-book estimates could potentially be used by investors to value stakes of private equity funds in their portfolios. They suggest that the values of private equity stakes sometimes differ substantially from their NAVs. For example, in 2017 NAVs were 44% lower on average than our estimate of market values for some fund vintages. Therefore, investors using NAVs to assess their portfolios are likely to understate the value of their private equity holdings considerably. These understatements could materially affect investors’ portfolio decisions as well as their spending decisions, especially if the organizations set spending levels at a fixed fraction of portfolio values.

The complete paper is available here.

(Video) Constructing Private Equity Benchmarks

(Video) Liquidity and the Secondary Market for Stakes in Private Equity

FAQs

Is there a secondary market for private equity? ›

For the vast majority of private-equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private-equity assets. Buyers seek to acquire private-equity interests in the secondary market for multiple reasons.

What are secondary transactions in private equity? ›

A direct secondary transaction occurs when investors sell a directly held ownership interest in operating companies. LPs will transfer their stakes to an existing investor and not to a new buyer. A direct secondary transaction is an opportunity to sell stock before the entire portfolio of companies has been sold.

How big is the private equity secondary market? ›

Today, private equity secondary buyers collectively manage $300 billion with $127 billion of dry powder. (Display 1) This has resulted in high transaction volumes at limited discounts to net asset value for traditional private equity secondaries. Source: “Volume Report FY 2021”.

What is a secondary fund transaction? ›

Definition: Secondary Stock Transaction (or Secondary) A secondary stock transaction is when an investor buys shares in a company directly from an existing stockholder (typically a founder, employee or existing investor). The funds paid go to the seller, not to the company.

What is the J curve in private equity? ›

The J-Curve in Private Equity

The term J-curve is used to describe the typical trajectory of investments made by a private equity firm. The J-curve is a visual representation of the plain fact that sometimes things will get worse before they get better.

What's the difference between primary and secondary funds in the private equity market? ›

In a primary investment offering, investors are purchasing shares (stocks) directly from the issuer. However, in a secondary investment offering, investors are purchasing shares (stocks) from sources other than the issuer (employees, former employees, or investors).

What is secondary market equity? ›

What Is a Secondary Market? The secondary market is where investors buy and sell securities they already own. It is what most people typically think of as the "stock market," though stocks are also sold on the primary market when they are first issued.

What is a secondary LBO? ›

Introduction. A secondary buyout is a leveraged buyout (LBO) where the private equity sponsor, who had previously taken control of a target through an LBO, sells the target firm to another private equity firm or to a financial sponsor, instead of selling it back to the public market.

What are LP led secondaries? ›

In its most basic form, a GP-led secondary involves existing LPs being given the option to sell all or a portion of their fund interests to the buyer during a binding election period. The fund continues with the buyer as a replacement LP.

Is venture capital a secondary market? ›

Although there is no singular definition of what constitutes the venture capital secondary market, we define it as “transactions involving previously purchased investments, or assets, where the underlying value is in the form of equity value of a privately held venture-backed company (not to include M&A or publicly ...

How do secondary funds work? ›

Unlike primary funds, secondary funds buy interests in funds that have mostly completed their investment periods, containing portfolio companies that are already generating cash flow.

What are single asset secondaries? ›

Single-asset secondaries, the latest GP-led wrinkle, are the sale of a sole investment, usually a company. The best offer access to a portfolio gem, typically from an aging fund where incumbent investors want liquidity.

What is an adviser led secondary transaction? ›

Advisor-led secondary transactions involve advisers offering existing fund investors the option to sell or exchange their interests in a private fund for interests in another vehicle advised by the adviser, such as a continuation fund or special purpose vehicle (SPV).

What are structured secondaries? ›

Structured partnerships are secondary private equity transactions where parties structure deal terms to address the gap in price expectation between buyer and seller through the transfer of distinct, alternative values, which are identified through the synergies created by the convergence of differing parties.

What is a co investment in private equity? ›

Broadly, a co-investment is an investment in a specific transaction made by limited partners (LPs) of a main private equity (PE) fund alongside, but not through, such main PE fund. This is often accomplished through a separately structured co-investment vehicle which is governed by a separate set of agreements.

What is the difference between J-curve and S curve? ›

An exponential growth pattern (J curve) occurs in an ideal, unlimited environment. A logistic growth pattern (S curve) occurs when environmental pressures slow the rate of growth.

What does AJ curve represent? ›

A J Curve is an economic theory which states that, under certain assumptions, a country's trade deficit will initially worsen after the depreciation of its currency—mainly because in the near term higher prices on imports will have a greater impact on total nominal imports than the reduced volume of imports.

What causes the J-curve in private equity? ›

The reason the J-Curve exists is because investment managers charge fees on committed capital prior to making any investments. Furthermore, investments are typically held at cost in the early years of the fund (prior to accounting for fees), as the manager needs time to implement their business plan.

What is the difference between a primary and secondary transaction? ›

Key Takeaways. The primary market is where securities are created, while the secondary market is where those securities are traded by investors. In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).

Is an IPO a primary market transaction or a secondary market transaction? ›

An initial public offering (IPO) is a primary market transaction. A primary market transaction is a transaction where newly issued stock are sold. The transaction here is between the issuing company and the investor.

Why primary market is dependent on secondary market? ›

The primary market aims to raise capital by issuing securities and secondary market opens gateway to trade such securities and bring flexibility. Primary markets help in creating financial assets and secondary market makes it saleable.

What are the four types of secondary markets? ›

Apart from the stock exchange and OTC market, other types of secondary market include auction market and dealer market.
...
Advantages of Secondary Market
  • Investors can ease their liquidity problems in a secondary market conveniently. ...
  • The secondary market indicates a benchmark for fair valuation of a particular company.

What are examples of secondary markets? ›

Examples of popular secondary markets are the National Stock Exchange (NSE), the New York Stock Exchange (NYSE), the NASDAQ, and the London Stock Exchange (LSE).

What is the other name of secondary market? ›

The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold.

What is an MBO acquisition? ›

Also known as an MBO, a management buyout is when a company's existing leadership team works together to purchase either a total or majority stake of a business. This typically happens in private companies when the owner retires and company management coordinates a “buyout” in order to take full control.

What is new SBO? ›

It has been titled the new amended SBO rules as Companies (Significant Beneficial Owners) Amendment Rules, 2019. The amendment rules provides a new definition of SBO, according to which an individual as SBO is now based on direct and indirect holding of right or entitlement in the reporting entity.

Why do PE firms use so much leverage? ›

Why Do PE Firms Use So Much Leverage? Simply put, the use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan.

What does Hamilton Lane do? ›

Hamilton Lane (NASDAQ: HLNE) is a leading private markets investment management firm providing innovative solutions to sophisticated investors around the world.

What is a continuation vehicle? ›

Continuation vehicles are investment funds created in order to acquire a single portfolio company investment, or multiple portfolio investments, of a predecessor fund.

How is price decided in a secondary market? ›

Solution. Financial markets allow for the determination of the price of the traded financial asset through the interaction of buyers and sellers. They provide a signal for the allocation of funds in the economy, based on the demand and supply, through the mechanism called price discovery processes.

What is the difference between secondaries and fund of funds? ›

Private equity fund-of-funds are investment vehicles that create a private equity portfolio by investing in a range of primary private equity funds. Secondary funds are vehicles investing in a range of private equity funds on the secondary market.

Why secondary market is important? ›

Why are secondary markets important? Secondary markets are important because they provide liquidity to investors. Buying and selling securities quickly often reduces the amount of value lost on a trade. These markets also allow smaller investors to get involved with trading securities.

What is a single asset transaction? ›

A single asset deal is in essence a classic GP-led transaction but restricted to one asset. The steps through which it unfolds are very similar to a GP restructuring in that the asset is transferred to a new vehicle funded by secondary investors.

What is a single asset continuation fund? ›

The structure of a Continuation Fund involves the formation of a new fund for the purpose of acquiring one or more assets from an original fund. The same fund sponsor continues to manage those assets as part of the investment objectives of the new fund.

Which industry has the SEC directed a sweeping series of proposed new and amended rules? ›

SEC Proposes Sweeping New and Amended Rules under Advisers Act to Overhaul Private Fund Industry. In the span of two weeks, the US Securities and Exchange Commission (SEC) has proposed rules that would significantly overhaul the regulation of the private fund industry.

What are the features of secondary market? ›

4 Chief Features of Secondary Market
  • (1) It Creates Liquidity:
  • (2) It Comes after Primary Market:
  • (3) It has a Particular Place:
  • (4) It Encourages New Investment:

Why the market for secondhand private equity stakes is thriving? ›

The secondary market attracts big fund managers who want to offer their clients the full range of assets, including private ones. For a start, it looks a lot less crowded than the primary business. “Anyone can set up a buyout fund,” says one fund manager. Funds often compete to buy the same companies.

Which of the following is true of a secondary market? ›

Which of the following is true of a secondary market? It is a market in which preowned securities are traded. Which of the following is true of a dealer market? Buyers and sellers are never brought together directly.

How does carry work in private equity? ›

The private equity carry (or simply "carry") is performance compensation that the partners of a private equity fund receive if they exceed a specific threshold return. This compensation is meant to align the private equiteers with their capital providers, as the majority of their compensation comes from the carry.

Does BlackRock do private equity? ›

Private Equity is a core pillar of BlackRock's alternatives platform. BlackRock's Private Equity teams manage US $23 billion in client assets across direct, primary, secondary and co-Investments.

Why do LP investors typically seek co-investment rights with a GP? ›

GPs believe that co-investments provide a way for them expand and deepen their relationships with their LPs. Because co-investments can be attractive opportunities, GPs typically offer them preferentially to their fund investors (LPs), rather than broadly seeking co-investors.

What is secondary market equity? ›

What Is a Secondary Market? The secondary market is where investors buy and sell securities they already own. It is what most people typically think of as the "stock market," though stocks are also sold on the primary market when they are first issued.

What is a secondary LBO? ›

Introduction. A secondary buyout is a leveraged buyout (LBO) where the private equity sponsor, who had previously taken control of a target through an LBO, sells the target firm to another private equity firm or to a financial sponsor, instead of selling it back to the public market.

What are LP led secondaries? ›

In its most basic form, a GP-led secondary involves existing LPs being given the option to sell all or a portion of their fund interests to the buyer during a binding election period. The fund continues with the buyer as a replacement LP.

What are co investments in private equity? ›

Equity co-investments are relatively smaller investments made in a company concurrent with larger investments by a private equity or VC fund. Co-investors are typically charged a reduced fee, or no fee, for the investment and receive ownership privileges equal to the percentage of their investment.

What are the four types of secondary markets? ›

Apart from the stock exchange and OTC market, other types of secondary market include auction market and dealer market.
...
Advantages of Secondary Market
  • Investors can ease their liquidity problems in a secondary market conveniently. ...
  • The secondary market indicates a benchmark for fair valuation of a particular company.

What are examples of secondary markets? ›

Examples of popular secondary markets are the National Stock Exchange (NSE), the New York Stock Exchange (NYSE), the NASDAQ, and the London Stock Exchange (LSE).

What is the other name of secondary market? ›

The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold.

What is a secondary MBO? ›

Related Content. Where the original private equity fund and the management team (who are the owners of the business) dispose of a group (including the old acquisition group and original target) to a team led by its existing management team with funding provided by a new private equity fund.

What is an MBO acquisition? ›

Also known as an MBO, a management buyout is when a company's existing leadership team works together to purchase either a total or majority stake of a business. This typically happens in private companies when the owner retires and company management coordinates a “buyout” in order to take full control.

What is new SBO? ›

It has been titled the new amended SBO rules as Companies (Significant Beneficial Owners) Amendment Rules, 2019. The amendment rules provides a new definition of SBO, according to which an individual as SBO is now based on direct and indirect holding of right or entitlement in the reporting entity.

What is an adviser led secondary transaction? ›

Advisor-led secondary transactions involve advisers offering existing fund investors the option to sell or exchange their interests in a private fund for interests in another vehicle advised by the adviser, such as a continuation fund or special purpose vehicle (SPV).

What are stapled secondaries? ›

A stapled secondary sees the new buyer purchase fund interests from current investors, while also making a commitment to the new fund of the same general partner. The liquidity offered to the existing investors may then free up amounts for them to invest in the new fund as well.

What is an LP led deal? ›

The LP deal is a decision taken by a single LP based on its own liquidity needs. Some LPs are okay with selling at a discount, others are not. But it is their decision and has no bearing on other LPs or the operation of the underlying fund.

How does carry work in private equity? ›

The private equity carry (or simply "carry") is performance compensation that the partners of a private equity fund receive if they exceed a specific threshold return. This compensation is meant to align the private equiteers with their capital providers, as the majority of their compensation comes from the carry.

Does BlackRock do private equity? ›

Private Equity is a core pillar of BlackRock's alternatives platform. BlackRock's Private Equity teams manage US $23 billion in client assets across direct, primary, secondary and co-Investments.

What does sidecar investment mean? ›

Key Takeaways. A sidecar investment is one made by a third party on behalf of another investor. Sidecar funds exist when a group of investors with differing interests participate in investing together.

Videos

1. Constructing Private Equity Benchmarks
(QuantUniversity Channel)
2. How swaps work - the basics
(Marketplace APM)
3. Private Equity Real Estate: Strategies for Finding Excess Returns
(The University of Chicago Booth School of Business)
4. Equity Capital Market
(Tutorials Point (India) Ltd.)
5. Open-End and Closed-End Mutual Funds
(Khan Academy)
6. Securities Markets and Transactions Pt1
(Larry Byerly)

You might also like

Latest Posts

Article information

Author: Arline Emard IV

Last Updated: 11/06/2022

Views: 6286

Rating: 4.1 / 5 (72 voted)

Reviews: 87% of readers found this page helpful

Author information

Name: Arline Emard IV

Birthday: 1996-07-10

Address: 8912 Hintz Shore, West Louie, AZ 69363-0747

Phone: +13454700762376

Job: Administration Technician

Hobby: Paintball, Horseback riding, Cycling, Running, Macrame, Playing musical instruments, Soapmaking

Introduction: My name is Arline Emard IV, I am a cheerful, gorgeous, colorful, joyous, excited, super, inquisitive person who loves writing and wants to share my knowledge and understanding with you.