Secondaries Investing for Private Investors

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We're going mainstream. Hi, I'm Michael Sidgmore, founder of Volco's Mainstream and co-founder of Broadhaven Ventures. We are live here at SuperReturn in Berlin. I'm here with Jake Elmhirst, Head of Capital Formation at Coller Capital.

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We have a lot to talk about today. I think it's going to be a fascinating conversation. There's so much going on in secondaries.

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Coller is first in secondaries. We'll talk about how secondaries may be coming in first in a number of ways. First, though, I want to get to your background.

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You spent 26 years at UBS. You were on the private funds group working with many of the leading GPs in private markets over a number of years. You were then on the wealth side, helping wealth clients access alternatives, and now you're on the GP side building out Coller's wealth solutions business and heading up capital formation.

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So would love to just hear from you your background and how that's evolved as the evolution of private markets has evolved as well, because I think you've had such an interesting purview in a number of different ways.

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Well, Michael, thanks very much for having me along today and a real pleasure to chat with you. Yeah, look, the description you gave is all accurate. I think my conclusion from that is I'm old.

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But I have seen this industry evolve really from its earliest beginnings and here at SuperReturn, I think this is about my 25th appearance at SuperReturn, so a lot has changed since then. And as you look at that evolution and really my path, it was steeped in the institutional business to begin with, raising money for some of the biggest names, which back then weren't so big.

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I worked with Blackstone, I worked with Apollo, I worked with Ares on their very early fundraisers when they were a few hundred million or a few billion in size. And so clearly, that picture's changed very significantly.

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As the institutional fundraising market evolved, I was based in New York. In 2015, I got a call from my colleagues at UBS Global Wealth, and they were looking to really catch up with their US counterparts. They felt like they'd fallen behind.

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They weren't delivering access to private markets in the way that the US firms were. And I got into a conversation, and they said, "Well, what would you change?" And what started as a couple of ideas over a cup of coffee turned into an email, turned into a business plan, turned into, "Oh, would you just come and do this?"

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And it was a good time for me. I'd moved my family to the US in2000. We had a lot of family back in the UK, so a move back to Europe was something that I wasn't adverse to. And the opportunity arose, so I took the plunge.

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I thought I was going into an investment job. You just go and you've got all this money and wealth, and you just pick a few managers, good managers, and this is going to be great fun.

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But what I discovered almost immediately was that it was a massive operational challenge because building diversified portfolios for wealth clients using the classic drawdown structures that institutions use is almost impossible to do. Impossible to do at scale because you can't use the same tools that are available for stocks, bonds, and mutual funds to execute.

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It's very manual, and where you have manual processes in large organisations, things fall apart pretty quickly.

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You introduce complexity and error.

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So we had to come up with a different solution, and we thought about technology, but we were a relatively small business. The spend just wouldn't have justified the outcome.

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So the next best thing was change the product, and that's what we did. We went looking for funds that gave exposure to private markets that could operate like a mutual fund. And back in the day, this was back in 2016, '17, there were very, very few of these things about. But they started to come to market.

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Early movers, groups like Partners Group were there. Actually, that was the first one that we'd onboarded and a bit of a test case. We had some success with that, and then we engaged in conversations with others, Blackstone, BRE, and what we saw was an explosion in interest.

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It really made the asset class relevant because advisors, for the first time, had a tool that they could use that had the features that they needed to engage with their clients. You could manage the exposure in a client portfolio on a dynamic basis, somewhat.

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You didn't have to relearn the product every two months because the problem with closed end is they're episodic, and they go away. It's hard work for the advisors. The client might not be there when they need to fill in the sub docs. And the sub docs, we used to get complaints.

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Why is it that this foot of paperwork comes through the letterbox and kills the cat every time we need to subscribe to a fund? So much easier execution. And so that was really what happened. That was how the story evolved and my experience evolved.

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I hit 25 years with UBS in2021, and that was the magic number. And home was calling, and for me, home was the north of England and Yorkshire, and my farm. So I stepped out of UBS and went farming.

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It's not just home, though. It's what? 23 generations of farming?

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Yeah. I'm the 23rd generation of my family, a direct line of Elmhirst’s to farm the same piece of land in Yorkshire. In fact, we started farming it in 1348 as owners. Before that, we farmed it as serfs as some would say. We haven't changed much, but I don't think we have really. We're quite grounded.

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But in 1348, the Black Death ripped through the north of England and we survived. We had good genes. So we took over, and we've done nothing since other than marry our neighbours.

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There has to be some sort of really good analogy between secondaries and crop yields, farming. There's got to be some. I'm sure you've thought of this now that you're in the secondaries world.

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Well, I can tell you what. Farming, if you look at the checkbox of what makes a good private equity investment, farming satisfies none of them.

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Yes, that's true. There have been farmland investors.

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It's capital-intensive, it's exposed to commodity prices, it's highly regulated, and it's dependent on the weather.

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You would never do it.

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But something there, being close to the land, being in touch with it, is a strong point.

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But you have to diversify your crop yields if you want to do things well and hedge against seasonality or weather, things like that, right?

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You've got to do that, and you've got to be nimble, and you've got to spot your window and go for it.

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So I think that's a great segue to secondaries. Talk about spotting a window.

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You've ended up at Coller, which was first in secondaries, effectively, the early days of what was a small market at the time, and you were seeing it from the other side, early days, doing things like continuation vehicles with GPs from the PFG vantage point at UBS.

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Where I want to start on the secondary side, though, is in your opening description of your background evolution at UBS, there's a word that I think distils what you talked about, which is your lesson learned from working on the wealth side, which is coming up with solutions.

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We were talking about this earlier. Secondaries are very much solutions, and I think it's an interesting point in time to be thinking about where we are in the evolution of private markets and what secondaries are doing to private markets.

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How do you think secondaries are providing solutions to both GPs and LPs right now?

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So clearly, liquidity is a topic that is very high on the agenda for everybody in private equity, and it impacts LPs who've extended commitments to funds.

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They're running their horizon models. They're thinking about the pace of cash coming back to fund future capital calls. And if something breaks in that model, which it has to an extent, the pace of distributions has slowed down, you've still got the commitments. You've got to fund them somehow.

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And you have a couple of choices. Either you take cash from somewhere else in your portfolio, which maybe results in an imbalance or some sort of variation from your asset allocation, or you sell.

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So it's a solution for LPs who find themselves in that position.

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If you look at it from the perspective of a GP, maybe today the exit environment isn't as favourable if you've got really high-quality assets that you know have a growth path ahead of them. One of the hardest things to do as a GP is to find good assets. Origination, finding good businesses with good management teams, that absorbs 80% or 90% of your energy.

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So if you have the opportunity to hold a great asset longer, ride that growth cycle for longer, why wouldn't you do that? And the secondaries market enables you to do that through continuation vehicles.

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So just for context for people, GP-led secondaries, continuation vehicles are the large part of that, about 100 billion now of total volume. LP-led's the traditional form of secondaries, or the more well-known and larger portion of the secondaries market to date, until the rise of CVs is also 100 billion, so roughly 200 billion, a little over at this point, I think.

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But the rise of CVs, I think, hits on a number of really interesting dynamics as it relates to private markets, market structure.

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So as I hear you talk about providing a solution to GPs, enabling them to hold their assets longer, why would they give up that next 3X, 5X return to the next private equity fund that they would sell to? Instead, they can now hold.

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What does this solution mean for the market structure of private equity as you're also seeing large funds get bigger and more scale, and they need deal flow, and small funds maybe want to hold onto those assets instead of selling them, and they now have another solution?

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Well, let's put this in perspective because there's a limit. There's a threshold in terms of how much of a GP's portfolio LPs will tolerate going into continuation vehicles.

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When really, LPs would prefer to see the traditional model of money coming back to them and seeing assets move on.

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Obviously, and for some LPs, that's key because they have capital that isn't flexible enough to be able to roll into another vehicle for another five years.

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So they have no option but to take cash at that point.

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So I think probably how many assets per fund? A couple of assets per fund is realistic.

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So I don't think this is going to be a substitution for the traditional exit markets. The industry still needs those, but it is an important tool, as you say, a solution for GPs to continue to drive value growth in an asset that they have strong conviction around.

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Now, of course, there are other things that benefit the GPs. If you can get cash back to your investors, or some of your investors in an environment where it's hard to raise money. Probably that's going to help you raise more money.

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And for us as a secondary buyer, one of the things that we have to try and discern when we look at any opportunity is, are we buying from the GP or are we buying with the GP?

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And we prefer the latter to the former.

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So given the dynamics of the market now, where if a firm wants to scale, then presumably they're going to go to the wealth channel, but that's an expensive endeavour, as you know, from building out the wealth business at Coller.

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Does the advent of CVs mean that small funds don't have to go after the wealth channel, and they can now stay small and have a solution? Is that how you see things shaking out over time?
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I think it's always going to be harder for small funds to access the wealth channel in the conventional way. And maybe tools evolve, and technology evolves that makes that viable.

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But realistically, it's not just about the execution, it's also about all the things that go with wealth channels, and you can draw parallels with public equity asset managers. You need scale, you need brand, you need marketing spend to a level which a small private equity firm is not going to be able to achieve.

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So I think CVs are a tool that will help them hold onto assets longer that they have strong conviction around. But I do think that the industry is moving towards, and there's consolidation taking place.

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It's moving towards more of a situation where the big get bigger, and really occupy that territory where brand is super important. There will always be room for niche managers who are doing something a little bit different and delivering alpha because they're so specialised.

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Anything in the middle, probably not an ideal place to be.

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I think that brings us an interesting segue of when I think about there's the large-scale platforms and there's the niche managers from the LP perspective, and you have this purview from your time at UBS as well, thinking about holistic portfolio construction solutions for LPs. LPs now need to think about their portfolio holistically, right?

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And then wealth platforms, whether private banks who've done this historically, and now you see the rise of RIAs in the US, there's this centralisation of the CIO function. So they're really thinking about portfolios holistically.

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Yep.

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Where did secondaries fit in before, and where do they fit in today?

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So if you think about some of the characteristics of secondaries, what do you get if you invest in a secondaries fund? Well, you get lots of diversification.

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Maybe less so going forward than historically, because if a GP is doing more GP leads, that's probably going to lead to some more portfolio concentration, and if all you do is GP leads, you're going to look like a buyout fund.

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But if you are doing LP portfolios and GP leads, you're going to have a lot of diversification. The second thing that you get is when you buy a secondary, you actually can see the assets you're buying.

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In contrast with when you invest in a buyout fund, it's the ultimate trust we trade. You're saying to them, "Here's a commitment. Go out and spend my money. Spend it wisely." So we can actually see what we're buying.

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The third thing is that those assets have already been in that fund for a while, maturing, and they are, by definition, closer to the point of exit. So typically, when we're buying an LP-led portfolio, there's already cash being distributed back. So we get our money back quickly, and that de-risks your position. I think last but not least is we are generally buying these assets at a discount to NAV.

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So there's some advantage to that in terms of an initial pickup in return, but it's downside protection.

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So the outcome from all of this 20 years is that median returns from secondaries have outstripped buyout funds, growth funds, venture funds, and the bands of outcome are much narrower.

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Which important point there, which is that dispersion of returns in private markets is so pronounced, certainly relative to public markets where very tight spreads, and then within each asset class, venture. So manager selection matters, but if you want single solution, median returns, like you say, it's an easy turnkey solution.

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So my next question becomes, how does a newer wealth channel investor who is under or unallocated to private markets, do you think they go into secondaries first?

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And then do you think that becomes their core allocation, or maybe they even skip the primary fund commitments because of all the qualities that you just referenced?

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So I think that you should think about secondaries really as a core holding because you're getting all of those things. You're getting diversification, and we can talk about speed of deployment, but actually, that's more of a function of investing into a perpetual fund that is an existing portfolio you're buying at NAV. So you can get that in different ways today.

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Historically, if you were looking at drawdown structures, secondaries typically got you invested faster.

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It's less of an argument when you're looking at perpetual funds, but you get diversification. You get all of those benefits in terms of the shape of the return. That's a great core holding, and you could stop there, and you'd already have diversification and do nothing else and sleep easy at night.

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But by definition, investors and advisors like to have bells and whistles. So take your core, and put satellite holdings around it to express views and introduce other features to the portfolio.

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I want to make sure we unpack some of the maybe misconceptions around secondary. So is there a better way to invest in secondaries? What I mean by that is, is it better to buy at deep discounts?

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It's the way to drive returns, or is it better to buy high-quality assets at less of a discount, but still at some level of a discount because there may be a forced seller?

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So good example, Yale or Harvard needed to sell for reasons outside of their control, and great portfolios, you could buy them. I don't know what the discount was, but that contrast of deep discount versus high-quality assets, less discount.

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So our preference is to buy quality and to buy it at fair prices. And what do I mean by quality? What we're really saying is we like to buy assets that are growing.

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And the simple reason for that is in a perpetual fund, you can only catch a discount when you're executing.

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So if you go through a period where you have less cash because the pace of subscription slows or possibly even turns negative, your pace of execution, the number of assets you acquire, is going to slow down, and so discount capture slows down.

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And we want the returns from our funds to be sustainable over time, regardless of the pace of subscription. So that's one thought.

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The other is if you think about what you're trying to do by buying a deeply discounted asset, usually if an asset is deeply discounted, it means it's not growing or it's growing slowly.

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So it could be a tail-end portfolio that's end of life, and you can buy them at very wide discounts, and maybe that's a good way to make a return.

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Some groups focus on that as a strategy. It works okay in a closed-end structure. But the risk you have is that if you get the timing of exit wrong, then your returns quickly get impaired.

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Whereas if you buy assets that are growing, if your prediction of when those assets exit is out by 12 months, because the asset continues to grow, you're much less impacted. So it's a nice hedge, in terms of underwriting that timing.

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When I hear you talk about underwriting at the asset level, and this relates to CVs too, with the rise of CVs, that's kind of like underwriting a deal as a primary fund investor would.

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Has the skill set that a secondaries fund requires to be able to underwrite deals, has that changed? Are you hiring more people from the traditional GPs who are doing direct deals themselves?

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Yeah, good question. So Coller, we started in business in 1990. Jeremy really got ahead of this industry, and many view him as the founder of the secondaries industry, hence the first and secondaries moniker.

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But that's all we've ever done. We've only ever done secondaries. So if you look at a lot of our competition, a lot of our competitors grew up as allocators, as fund of funds, where they were making primary allocations, and then they got into secondaries.

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So maybe slightly different DNA and mindset, but we've always been focused on the assets. And so the skill set that exists at Coller is very much an asset-focused skill set where we do fundamental analysis on a bottom-up basis on what we're buying, whether it's a GP-led or an LP-led.

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Do you think the rise of CVs means that LPs need to have a different underwriting skill set capability as they think about underwriting a secondaries firm or now these CV-focused secondaries funds that are being raised, either in drawdown or closed-end structures?

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I think it creates a challenge for some LPs. Many LPs are geared to look at direct investments because they have active co-investment programs. But the burden it places on an LP when a GP comes to them and says, "I'm going to do a CV," all of a sudden that LP has to then analyse that asset and figure out whether this is a good idea or not.

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And this is one of the reasons why GPs will only be given consent to do a couple of these things per firm, because if every single asset went that way, the LPs would blow up. They wouldn't have the resources to process the investment decisions that would be required, or at least some of them wouldn't.

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So, I think there are some constraints there, and it does probably in some cases push some LPs towards taking cash as opposed to rolling. And I'm sure that happens.

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How does the rise of CVs impact the evergreen structure as it relates to secondaries?

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So our portfolio construction is geared around a mixture of the two. We think of LP-led exposure as providing diversification and a highly predictable level of cash flow. We think of the GP-led allocation as bringing a return kicker. These assets tend to be higher returning.

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You're taking more risk, more concentration risk, so they should be.

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And the liquidity is similar to a buyout. So when you underwrite a CV, you should probably assume you're holding that asset for five years. Sometimes we get surprised on the upside, but we don't assume that.

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So our strategy is do them in small bites, do them often, layer them in over time, because then you have a liquidity ladder.

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So actually, the liquidity comes back from your GP portfolio is equivalent to your LP portfolio as the vehicle matures.

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Bear with me on this analogy because it's not going to be perfect, so I want to be cognizant of that. But I think it's instructive as we look back in private markets and the evolution, and then going forward.

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So fund to funds was something that was bigger in the past than it is today, that that's become a tougher model and more challenged model for a number of reasons, not to mention double layer fees. Then you have secondaries.

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What's the next evolution from fund to fund secondaries? What's next in your mind?

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So I think the solutions business and how that evolves, because as you said right at the start, secondaries really is about solutions.

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I think what that means is exactly that. We have to provide solutions, and a solution generally is specific to an LP and their situation. So the ability to create unique setups for individual LPs and to really be able to do that at scale, I think is probably the way that this market is going to evolve.

00:25:12 - 00:25:19
Of course, you can't do that for every single LP, and there's a threshold below which you can do that, but I think that threshold is being pushed down all the time.

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What's the evolution of a solutions-oriented platform?

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So there's a few ways to think about this. One, you have private equity secondaries, now you have CVs.

00:25:33 - 00:25:47
Credit secondaries, which we haven't talked about much, but you have a franchise there, and I believe the growth in that market's been like 30X over the last five years or so. I may be a little bit off on that, but there's been, from a small end, a massive growth-

00:25:47 - 00:25:48
It's grown fast, yeah

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... in the credit secondary space, and you have a franchise there.

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There's the GP stakes world and GP solutions world, which kind of touches a little bit of the secondaries world in a sense. What are some of the ways in which you'd expand a solutions-oriented platform?

00:26:07 - 00:26:22
So I would say you need to be able to address specific problems. So let's start with portfolio allocation. A strategic asset allocation is going to have equity, it's going to have credit, it's going to have real assets.

00:26:23 - 00:26:25
So you've got to be able to do all of those three things.

00:26:25 - 00:26:31
And yeah, we tick two of those boxes today. Watch this space in terms of the third.

00:26:33 - 00:26:59
I think the other aspect is different segments of the market are looking for different things. So take insurance companies as an example. Looking to optimise their balance sheets, it's highly regulated, and thinking about capital efficiency in how they structure their portfolios and the structures that they invest into. So you need to be able to solve for that as well.

00:27:00 - 00:27:10
Is that specific to secondaries? Not really, but I think secondaries can play a very important part in that because of the diversification characteristics of the asset class.

00:27:10 - 00:27:26
So I think looking for those types of situations, saying, "We've got a toolbox here. What solutions can we provide? What problems can we solve for with the toolbox that we have? What do we need to add to the toolbox to be able to provide more solutions?" That's the mentality.

00:27:27 - 00:27:38
So when I hear you talk about having a toolbox and providing a lot of solutions to that toolbox, my mind goes to scale. How important is it to have scale in the secondaries business?

00:27:39 - 00:27:52
I think it's increasingly important. And going back to what I said about consolidation and either being very large or very niche, I don't think that that is in any way not applicable to secondaries. I think scale really matters.

00:27:53 - 00:28:07
When you look at the size of some of the portfolios that are coming to market, there's some efficiency from a seller if you've got a single solution rather than trying to put a mosaic together. It's more execution risk. So I think being large is important.

00:28:07 - 00:28:22
We're one of the largest players. We're not the largest, but we're one of the largest, and I think that's an advantage. In credit, we're again, one of the largest players, and we see that as a distinct advantage in credit secondaries.

00:28:23 - 00:28:28
So you're on the ground seeing everything that's going on in secondaries, ton of growth.

00:28:29 - 00:28:43
What do you think is something that people who are not as close as you are farming the soil, I guess literally, in secondaries, overestimate in the short term but underestimate in the long term?

00:28:46 - 00:29;05
Boy. Well, I think there's an undue focus on discount. So it's often one of the first questions you get is, "How big are the discounts today and how do they compare with yesterday or five years ago? And are the discounts getting wider or are they getting narrower?"

00:29:06 - 00:29:19
The answer is very nuanced, and you have to have a level of understanding of what's really going on in a transaction to understand what discount actually is. We don't really think about how big is the discount or how tight is the discount.

00:29:19 - 00:29:40
What we're doing in our investment process is analysing and forecasting the future cash flow that we expect to come from a portfolio or from an asset. We know what our cost of capital is, and the math informs us the price that we're willing to pay for that future cash flow, which is generally speaking at a discount to NAV.

00:29:40 - 00:3000
So going back to this point about growth, if you've got strong growth in that cash flow going forward, then the discount is going to be much smaller. If you've got very slow growth or no growth, then the discount is going to be wider. So it's nuanced. And then there are other tools that you can use.

00:30:01 - 00:30:20
There are deferrals, which can fundamentally change a discount. You're trying to create a setup where the seller feels good about the price because the discount looks small, and we feel good about the price because actually when we close and part company with the cash, which is the point in time that matters, the return looks attractive.

00:30:21 - 00:30:37
So I think where that brings me to, and I think this is a great way to kind of tie everything together, particularly as both the industry evolves and as Coller evolves as a firm, is really feels like secondaries is now active portfolio management.

00:30:38 - 00:30:51
So there's active ownership on the equity side that certain firms do and say that's part of their core values, including a firm that is very close to you all in EQT.

00:30:52 - 00:31:12
You are effectively active portfolio management in a sense. How do you think about that aspect of secondaries as part of the private markets toolkit? And are more LPs going to think about secondaries as active portfolio management in private markets going forward?

00:31:13 - 00:31:36
I think inevitably they will. And almost the evolution of the consideration vehicle market is forcing them to do it because they have to make decisions. It's forcing them to make decisions where historically the assets would've just run off. So I think increasingly, LPs have to be set up in a way to handle that, and that is going to promote their ability to manage their portfolios actively.

00:31:36 - 00:31:38
So I think we're going to see this growth.

00:31:38 - 00:31:49
I think that's such a great way to wrap this up and kind of bring it all together. We talked about how early the firm was in secondaries. It still feels like early days though.

00:31:50 - 00:32:02
Even though you were first in secondaries, there's probably another first on the horizon. So looking forward to seeing what is the next first thing that you all do while still being steeped to the ground as you have been for 23 generations.

00:32:02 - 00:32:10
So, well, Michael, I appreciate that, and I look forward to coming back and talking to you about the next thing when it is the next thing. So thank you very much-

00:32:10 - 00:32:10
Love it

00:32:10 - 00:32:12
... for indulging me today.

00:32:12 - 00:32:13
Thank you, Jake. Really appreciate it.

00:32:13 - 00:32:13
Thank you.

00:32:13 - 00:32:23
Yeah. We're going mainstream.