Pitches to invest in secondary funds and mezzanine funds always strike a chord with certain limited partners, particularly those that are looking for distributions to flow back to them early in the lives of their limited partnerships. Our annual analysis of fund return data also suggests that both strategies provide a less risky way to play the private equity game.
It’s tough to paint secondary and mezzanine funds with a broad brush. But as a general rule, secondary funds are earmarked for the purchases of interests in limited partnerships from buyers who need liquidity before their fund terms—typically 10 years, with extensions possible—expire. By buying into mature funds closer to their harvest phase, or already in it, secondary buyers strive to reduce or eliminate the J-curve effect, in which returns on private equity funds stay negative in the early years of a fund’s term due to fee draw-downs and few exits. Mezzanine funds, by contrast, are earmarked for investments in subordinated debt, typically a combination of fixed-rate debt with a high coupon rate and equity kickers.
So how do secondary funds and mezzanine funds perform compared with conventional buyout funds? Altogether, Buyouts this year gathered return data on 443 U.S. and international buyout funds, 22 U.S. and international secondary funds, and 37 U.S. and international mezzanine funds from nine limited partners—mainly public pension funds that publish return data on their Web sites. (We took out duplicate funds backed by more than one limited partner, as well as funds of vintages 2006 or younger; we also lack investment multiples and IRRs for many funds in our samples; see page 30 for more on our methodology.)
Altogether, the 366 U.S. and international buyout funds for which we had relevant data drew down $30.2 billion from investors, and created total value of $48.5 billion between distributions and an estimate of holding value. That produces an overall investment multiple of 1.60x. By comparison, the overall investment multiple for our relevant pool of secondary funds is 1.49x, and that for our relevant pool of mezzanine funds is 1.40x. This isn’t surprising. Both secondary and mezzanine firms appear to pursue less risky strategies than buyout firms; you’d therefore expect investment multiples to be commensurately lower.
The picture gets more interesting when you look at median IRRs. For our U.S. and international buyout funds the median IRR is 12.10 percent. That’s better than the 9.07 percent median IRR produced by the mezzanine funds in our sample. However, it falls short of the 14.39 percent median IRR generated by our pool of secondary funds. This suggests secondary firms make good on their promise of returning money quickly to investors. IRRs are sensitive to the timing of distributions, and early distributions tend to have a positive, lasting effect on the ultimate IRR of a fund.
Also noteworthy is that bottom quartile, median and top quartile investment multiples and IRRs for secondary funds and mezzanine funds tend to be more tightly clustered than they are for buyout funds. Bottom quartile, median and top quartile investment multiples for our sample of secondary funds are 1.24x, 1.45x and 1.70x, for a total spread of 0.46x. For our sample of mezzanine funds the quartile investment multiples are 1.25x, 1.33x and 1.50x, for a total spread of just 0.25x. By contrast, the quartile investment multiples for our entire sample of buyout funds is 1.18x, 1.50x and 2.00x, for a total spread of 0.82x. These numbers also support the view that secondary and mezzanine investment are safer choices for the risk-averse limited partner. LPs in such funds won’t enjoy as many home-run funds in their portfolios, but neither will they have as many big losers. And given the 14.39 percent median IRR produced by secondary funds, you can make a case that secondary fund LPs are getting higher returns at lower risk.
No wonder industry observers have been predicting big things for the secondary market.