The Alternate Reality of Secondary Funds’ Returns

The US Securities and Exchange Commission is making it easier for everyday investors to access semiliquid funds like interval or tender offer funds that invest in private equity or other private funds. Some of these have produced eye-popping results (that is, multiples more than public markets) in their short lives, particularly secondary funds, which are essentially funds of private funds.

These secondary funds’ returns, however, are largely the function of high relative inflows—that is, when inflows account for a large portion of the fund’s total assets—and an accounting trick. This combination in a continuously offered vehicle produces an effect not seen in any other investment strategy: flow-driven returns.

And let’s be clear off the bat: Fund flows should not directly affect fund returns, though this accounting trick effectively causes that exact phenomenon to occur. Investors should thus not expect high early returns to persist, as returns should level off as flows level off.

How the Accounting Works

To understand how flows can drive semiliquid secondary funds’ performance, at least early in their asset-gathering lives, look no further than the underlying investment strategy. Secondary funds buy shares from investors (limited partners) who own existing private funds and typically purchase these interests at a discount to their net asset values, which is the value that the private fund manager (the general partner) says the fund is worth.

So, for example, a secondary fund manager pays $9 for a share of a private fund that has a NAV of $10. After the secondary manager purchases the share, the manager marks it back up to $10, even before it accretes any value. Right away, that generates an 11% return. Stack that up quarter after quarter by deploying new inflows, and, as shown below, you begin to generate a sizable (paper) return without even needing cash generation from the investments.

This practice is industry-standard. Auditors accept it as a “practical expedient” to valuing the positions using more-complex or time-consuming methods. The method’s defenders claim that secondary funds are liquidity providers and the discounted price reflects the seller’s liquidity preference, not the asset’s true value.

Skeptics claim the price paid more accurately reflects the asset’s fair value (that is, what it can be sold for today), because it was acquired in an orderly—often negotiated—transaction. While the defenders have a bit of a case on the liquidity front, an asset’s fair value is what price it can fetch in an orderly transaction, and it is hard to argue that negotiated deals are not orderly. Sellers of these interests are rarely forced liquidators.

How Flows and Accounting Distort Performance

But perhaps the biggest argument against the practice is this: In continuously offered semiliquid vehicles, immediately marking up asset values creates an environment in which, unlike any other investment strategy, fund flows themselves can dictate performance.

Setting aside the question of the accounting practice’s appropriateness, the combination of high inflows and immediate asset markups distorts a fund’s return picture. The mechanism is simple. When a fund marks up a higher percentage of its portfolio, the better its return for that period. Thus, secondary funds will almost always look good early in their lives because that is when new inflows represent the largest relative amount of the portfolio, and those inflows, once invested, are marked up immediately.

As the fund matures and inflows account for a lower percentage of the fund’s assets, it cannot rely as much on NAV markups for returns, which should flatten out as it relies more on the fundamental performance of its underlying assets.

The early results, though, create a great business opportunity for fund companies selling these new semiliquid funds to everyday investors. They get to sell immediate “good” performance without really generating a real return at all. It is not hyperbole to suggest that, at least early in a semiliquid secondary fund’s life, a fund company’s sales force has greater influence on the fund’s return than the investment team.

This effect cannot occur in traditional public equity mutual funds or exchange-traded funds, though. Their inflows are taken in at NAV and then invested in public securities, but there is no immediate gain to be had simply by deploying inflows, since everything is marked to observable market prices. This flow-induced return phenomenon can only exist when funds can immediately mark up holdings due to subjective valuations.

The only way for public equity managers to replicate this effect would be if they were able to allocate inflows to strictly the stocks they somehow knew beforehand would immediately pop upon purchase. But that level of omniscience is impossible for mere mortal public asset managers. Secondary managers need no such omniscience to experience that pop, just inflows, because they mark virtually everything up upon purchase.

How Higher Flows Lead to Higher Returns

Secondary funds’ returns thus can’t even really be compared with each other, at least early on. The exhibit below highlights how bigger, earlier flows into a fund can result in much better performance than an identical fund with smaller relative inflows.

The exhibit shows four hypothetical secondary funds. Each starts with $100 million invested in the same private funds at the same weights, purchased at a 10% discount in the secondary market. Taking advantage of the accounting rule, they all see an initial 11% gain after marking those holdings back up to their NAVs.

After that, Fund A sees 5% inflows every quarter in its first two years of existence, Fund B sees 15%, and Fund C sees 30%. Fund D starts with a 200% inflow in the first period but then sees the flows cut in half in each subsequent period. The example assumes all four funds immediately put the inflows to work in the same funds, purchasing their new secondary interests at a 10% discount, and then marking them up to NAV immediately. To further illustrate this phenomenon’s impact, the example keeps the valuations of each funds’ holdings the same after their initial purchase and markup to NAV and assumes no distributions.

While this is a highly simplified example, it clearly shows how, thanks to immediate position markups, flows alone can create material performance differences even among secondary funds using the exact same strategy, owning the same funds, and using the same valuation procedures. Without the markup practice, the returns of all four funds would be identical (zero, as no cash was distributed nor were any subsequent valuation changes made to any NAVs).

Because of fewer inflows, Fund A has a smaller percentage of its overall assets to mark up each period than Funds B, C, and D, so it lags for no other reason than its less successful sales team. Fund D illustrates how returns level off as flows begin to account for a smaller percentage of overall fund assets.

In practice, the picture is more complex as funds take time to put inflows to work (cash drag could be more significant in high-inflow funds), pay varying discounts for these interests, experience NAV changes over time, and collect distributions from fund holdings. But this flow-based return engine is still running under the hood regardless.

How Investors Should Approach These Funds

Accounting professors can debate the theoretical appropriateness of the NAV markup practice as a fair value technique, but it ultimately creates a highly distortive flow-based return effect that doesn’t exist in any other kind of investment strategy. Identical public equity funds will deliver the same return regardless of flows. The same does not hold true for secondary funds, and that alone should give investors pause when evaluating a secondary fund’s performance.

Investors should focus on managers who have a track record of generating returns beyond the initial NAV markup, meaning they invest in funds whose NAVs rise after purchase or whose future discounted cash distributions exceed the NAV. Funds that can’t do that essentially just pull forward a future return into the present, meaning they must rely on flows to keep performance going.

All told, this flow-based return phenomenon doesn’t mean a secondary fund can’t be a good investment. But it means investors should not rely on early performance as an indicator of skill, and a fund that has doubled or tripled the S&P 500 in its first year is very unlikely to continue that pace of outperformance going forward.