“If you want the secondary greatness of recognized talent, focus first on primary greatness of character.” – Steven R. Covey
My wife, Katie, and I recently went with our neighbors to see the Dave Matthews Band (DMB) at a New Jersey amphitheater. It was a no-brainer concert to say yes to. We love hanging out with our neighbors, were only committing to lawn tickets (so the “seats” were cheap), and – whether or not you like Dave Matthews – you’re guaranteed to get a group of high-quality musicians who know how to put on a good show. Add to that the fact that I grew up in the ‘90s, so I’ve heard like ten-thousand DMB songs during my life, and it’s more fun to go to concerts where you recognize some of the music. And, while I’ve never considered myself a big DMB fan, I really like many of their songs. So, when we were presented with the opportunity, it took us about 2 seconds to agree to tag along. What Would You Say?
Ultimately, the performance blew away my expectations. Why? Because I went there anticipating a straightforward Dave Matthews Band concert – some good songs and a little jamming, which they more than delivered. The first bonus was early in the show when I unexpectedly heard the band playing Led Zeppelin’s “Fool in the Rain” – a song I’ve loved for decades and one that takes an excellent band (especially a great drummer, as it’s one of John Bonham’s trickiest beats) to cover correctly. It was awesome. Then, a few songs before the encore, Dave announced, “Now we’re going to bring out my good friend, Warren Haynes.” I almost lost my mind. I was jumping up and down while Katie laughed at my excitement (we really complement one another), so it was a happy moment for us both.
For those unfamiliar with the name, Warren Haynes played guitar for the Allman Brothers Band (ABB) when they reunited in the late ‘80s, first appearing alongside founding ABB member Dickey Betts and later with the prodigious Derek Trucks. He’s become synonymous with The Allmans over the years and walks amongst guitar royalty. He may also be the hardest-working guitarist on the planet (the David Bahnsen of guitarists if you will 🙂 ). As a lifelong Allmans fan, that moment changed my whole experience. I thought I was there just to hang out and see Dave Matthews, but now I was getting to see a legend. That bonus appearance made me feel I got a lot more value for the ticket price (which is in direct contrast to the ridiculous cost of “Liquid Death” waters and other drinks we bought).
I’ve had So Much to Say without mentioning Alts up until now that you’re probably wondering, “Where Are You Going” with this post? Glad you asked. And if you’re finding my references are becoming more ridiculous than Tripping Billies, making you want to Shake Me Like a Monkey, Crush Me, or Crash Into Me with your car, you’re probably not alone. I’ll Back You Up on that opinion while begging for your Mercy. Too Much? I promise I’ll increase The Space Between my dumb puns and Stay on topic for the remainder of this post starting now!
Bringing this longwinded intro to an abrupt halt, what if I told you some private investments also have this element of offering a “value bonus” to investors? That’s what we’re actually going to cover (sorry – one last pun) today, so I hope you’re as excited about it as I am. Here we go!
Primary school
In the world of private equity, investments are most commonly made in primary funds, or “primaries.” You’re probably at least loosely familiar with the concept, but primaries are where a manager (aka “sponsor”) will raise money from investors to earn a return from a particular investment strategy (I realize that sounds vague). A typical example would be a sponsor using the money to purchase, improve, and sell private companies (ideally at a gain, and likely while using a lot of leverage); that’s plain vanilla private equity. These strategies often come in the form of illiquid funds (limited partnerships) that take years to call (“drawdown”) and invest committed capital and then years to harvest and distribute gains to investors. [For a brief refresher/overview of these structures, see the last few paragraphs of “Framing the Solution” from back in Nov of 2020]
Secondary education
Naturally, one may ask: “If someone has invested in an illiquid fund and absolutely MUST get out of it, what can they do?” The answer is that they very likely cannot get their money directly from the fund manager, BUT they can try and find someone else to buy it from them. In other words, they’ll have to trade the fund in the secondary market; thus, these transactions are known as “secondaries.”
From the buyer’s perspective, I’m a big believer in secondaries. Once a fund is several years into its life, most/all of the capital has been called and invested into a portfolio of assets (and/or loans). As a result, the risk/return profile of the fund is pretty well understood – certainly much more so than when the capital was initially committed.
What’s the bonus element? Selling a fund in secondary markets typically (or always, in my experience) happens at a significant discount to the fund’s value. It’s conceptually similar to a house needing to be sold immediately. Buyers know that these secondary transactions are essentially forced sales, so they have a lot of pricing leverage. That means good deals for buyers. As secondaries have grown in popularity, however, I’d assume that pricing arbitrage will close over time.
The second secondary
The above “private investor forced sale” first comes to mind when I think of secondaries, but there is another type worth mentioning: GP-led secondaries. As primary funds run their course, they can linger in extended harvest periods; i.e., there may be a few investments left behind that – despite potentially being excellent investments – may take several more years to be sold/realized. That means the general partner (GP) can’t free up the remaining invested capital for investors, collect their final fees, or wind down the fund (resulting in ongoing costs for obligations like administration, management, tax filings, etc.). Thus, it can be in the GP’s best interest to offload the remaining assets, even at a discount, to cut the fund life shorter and reinvest in new funds (remember, GPs need liquidity to have “skin in the game” for each of their fundraises). Sometimes those assets can even be sold to another fund under the same GP (note that there is a rigorous third-party valuation process to ensure the integrity of those transactions).
Co-investments
GPs buy many different things (properties, companies, etc.) within their funds. Sometimes they find attractive deals that may be too large for a given fund based on diversification/concentration targets or available capital. Rather than forego an otherwise attractive investment, they have a few options.
One option is to spread that deal over a few different funds, given that it fits within each mandate. Different parts of the deal could also be appropriate for various funds under the GPs management based on the expected risk/return/liquidity.
Another option is to bring in money from outside their funds to participate in a deal, which is known as a co-investment. GPs may first offer these co-investments to their funds’ existing limited partners (LPs). In that case, an LPs primary investment is their ticket to the show, but their bonus is the ability to participate in co-investment opportunities (if they have the additional capital to do so).
And why might we regard co-investments as a “bonus”? Because they a) benefit from the complete due diligence and underwriting process of the primary fund, BUT b) have none of the fees! That’s right. Co-investments circumvent the management and performance fees associated with fund structures, which can mean significantly better returns.
Where do I sign up?
While I am a fan of both secondaries and co-investments, they are but select pieces of the overall portfolio construction puzzle. The attributes of each provide the opportunity for enhanced return vs. typical primary funds; however, unlike primaries, they aren’t as easy to come by (especially for the average investor). Thus, a reasonable option for accessing these parts of private markets is through funds that incorporate them into their overall strategy. More diversified funds may include a mix of direct investments, primaries, secondaries, and co-investments. From my perspective, that can make for an investor-friendly way to obtain pretty robust private-market exposure.
If you only learn only two things today, remember the following: First, the Dave Matthews Band has a lot of songs. And second, if your goal is to save money, Don’t Drink the Water at their concerts. I’m officially punned out now.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
