Demystifying discounts in secondary funds

Secondary funds are private investment vehicles that purchase investments from other investors rather than originating them directly. Secondary funds offer several advantages over primary vehicles and, in our view, remain one of the most interesting and compelling opportunities in today’s market.

One of the most valuable features of secondaries is the discount a buyer often receives when investing in this space; it’s also one of the most widely misunderstood. When a fund purchases secondary positions at a discount to their current fair market value, it must mark them up immediately. This can create an immediate (and, at times, substantial) return that can strike some investors unfamiliar with the space as strange or illegitimate.

Despite their appeal, most investors have never heard of secondary funds, much less invested in one, owing to the comparatively smaller size of the secondary market and the numerous hurdles that can make them difficult to evaluate and incorporate into portfolios.

We sat down with Scott Fellmeth, Westmount partner and senior advisor, to help pull back the curtain on these funds and the discounts they provide so investors can have a clearer picture of what is happening in this asset class.

Scott, why do these funds have big jumps in value? Is this value real?

Yes, the value is real. When a manager buys a position for a discount to its last known value, that manager must immediately mark the position up to its fair market value, which is why the increase happens all at once. While there is no guarantee that we could immediately sell the position for the same price, the value still reflects what the market generally believes the price to be at that time.

If we buy a fund position at a discount, doesn’t the purchase price now become the new price?

Not necessarily, and that’s because secondary transactions are idiosyncratic by nature. Typically, the seller is stressed and in need of liquidity, so they are willing to sell their position for less than it’s worth.

Theoretically, this does not affect the value of positions held by non-stressed owners. For example, if your neighbor sold their house at a steep discount because they needed cash urgently, that transaction would still show up in the Multiple Listing Service (MLS) but it wouldn’t reflect the actual real estate market value in the area. Secondary transactions sold at discounts work in much the same way.

Why would anyone sell something for less than it is worth?

They wouldn’t unless they had to. In many of these transactions, the seller needs liquidity quickly and has no other choice but to sell at a discount to get it. In other words, a seller may find it worthwhile to accept a lower price in exchange for ready cash, especially if they still hold a substantial amount of their net worth in stock. By providing that liquidity, we can capture the extra potential return from the discount.

Why do these discounts exist in the first place? Why does this not happen in public, liquid markets?

The discounts exist because there are information, skill, and relationship asymmetries in the private markets that do not exist on the public side. Put another way, private markets can be extremely inefficient.

On the other hand, public stocks are generally said to be “efficient.” In those markets, one is seldom forced to sell at a discount because the markets are more or less liquid. For example, most public stocks (OTC markets excepted) trade hands constantly over exchanges. They have dedicated market makers who provide liquidity to sellers and buyers, and sellers in the public exchanges do not need to search high and low for buyers like they often do with private assets.

Why doesn’t everyone do this?

These strategies are hard to scale. While it is growing, the secondary private market space is still a fraction of the size of the primary market. There is no easy way to buy deal flow in secondary markets; it has to be created through relationships and negotiations. As a result, it is naturally capacity-constrained.

How does Westmount access the secondary markets for its clients?

Westmount clients can access the secondary markets through the Alternatives segment of our portfolio, and through our private alternatives platform. To learn more, contact one of our advisors, call 310-556-2502, or email info@westmount.com.