Two cyclists choosing which track to take

05 Sep 2023

Diversification in private markets: funds of funds vs. secondaries funds

Diversification is key when investing in private markets. We look at how funds of private market funds and secondaries funds can help investors to achieve this.


Private market assets can be an excellent tool for high-net-worth individuals to achieve their diversification goals, as we discussed in a previous edition. However, this asset class is characterised by illiquidity, high minimum investments, restricted access, longer investment horizons, and timing mismatches, which can make achieving your diversification goals challenging.

We look at two common strategies to overcome these challenges. One is to invest in a fund of private market funds and the other is what is known as a secondaries fund. Funds of private market funds offer immediate diversification, professional management, access to top managers, and risk mitigation, but come with layered fees and limited transparency. Secondaries funds come with benefits like immediate diversification, increased liquidity and pricing efficiency, but also with limited control and customisation options.

As with any investment, investors should carefully consider their investment objectives, risk tolerance, and preferences to determine which approach aligns best with their overall needs.

Introduction

Investments in private markets are assuming an increasingly important role in the asset allocation process for high-net-worth individuals (HNWIs). Diversification remains a fundamental principle in this process, to reduce risk by spreading investments across different asset classes, sectors, and geographies. In the realm of private markets, where investments are made in non-publicly traded companies or assets, achieving diversification can be particularly challenging.

Challenges of achieving diversification in private markets

Achieving diversification in private markets poses unique challenges when compared with traditional public markets. While diversification is relatively straightforward in publicly traded stocks and bonds, private markets present several hurdles that make diversification more challenging. Here are some reasons why achieving diversification in private markets can be difficult:

  • Illiquidity: Private market investments are typically illiquid, meaning that they are not easily bought or sold on public exchanges. Unlike publicly traded securities, which can be immediately bought or sold, private investments often have lock-up periods, restrictions on transfers, and limited exit options. Illiquidity hampers the ability to rebalance portfolios or reallocate capital quickly, potentially impeding diversification efforts.
  • High minimum investments: Private market investments often require substantial minimum investment amounts, creating barriers to entry for many investors. These high minimums can restrict the number of investments an individual or institution can make, limiting diversification possibilities.
  • Access: Private equity, venture capital, real estate, and other alternative investments are typically available to institutional investors and HNWIs. The restricted access to many investable options may make it challenging to achieve broad diversification across various sectors, geographies, or asset classes.
  • Longer investment horizons: Private market investments tend to have longer investment horizons compared to public market investments. Funds may have lock-up periods of several years, and the full investment cycle, including capital deployment and realisation, can span a decade or more. The longer timeframes involved make it challenging to adjust portfolio allocations swiftly or react to market changes effectively.
  • Timing mismatch: The timing and availability of attractive investment opportunities, specific strategies or fund managers may not be in step with when investors may want to allocate capital to a private market fund.

Funds of private markets funds and secondary funds may assist in achieving efficient diversification

Two common strategies that investors employ to achieve diversification are investing through a fund of funds or a secondaries fund. This article will delve into these two approaches, discussing their advantages and disadvantages in the context of private markets.

Fund of private market funds

A fund of private market funds (FoF) is an investment vehicle that invests in a portfolio of underlying private market funds. The FoF itself does not directly invest in the underlying companies but rather selects and allocates capital to a diversified set of private equity, private debt, real estate, venture capital, or other alternative investment funds. Here are some advantages and considerations associated with FoFs:

Advantages:

  • Diversification: A primary advantage of FoFs is that they provide investors with immediate diversification across multiple private market funds. By investing in a FoF, investors may gain exposure to a broad range of underlying funds, asset classes, strategies, companies, industries, and geographies, which helps spread risk.
  • Professional management: FoFs are typically managed by experienced investment professionals who specialize in selecting and monitoring private market funds. This expertise can be invaluable for investors who lack the time, knowledge, or resources to conduct in-depth due diligence on individual funds.
  • Access to top managers: FoFs often have relationships with top-tier fund managers and gain access to funds that may be difficult for individual investors to access directly. This enables FoFs to capitalise on the expertise and track records of renowned fund managers, potentially generating superior returns.
  • Risk mitigation: FoFs can mitigate risk through their due diligence process and ongoing monitoring of the underlying funds. They can assess the fund managers' strategies, performance history, and risk management practices, thereby reducing the risk of investing in poorly performing or high-risk funds.
  • Smoother cash flows: Having exposure to a spread of funds with different investment and harvest periods may provide for a smoother return profile than a single fund.

Considerations:

  • Additional layer of fees: Investing in an FoF involves paying fees at both the FoF level and the underlying fund level. These layered fees can erode returns, making it important for investors to carefully consider the fee structure and evaluate whether the benefits of diversification outweigh the associated costs.
  • Lack of transparency: Investing through a FoF means that investors have limited visibility into the underlying portfolio companies. This lack of transparency can make it challenging to assess the risks and opportunities of individual investments, as well as impact the ability to make informed decisions.

Secondaries funds

A secondaries fund, also known as a secondary market fund or simply secondaries, is an investment vehicle that focuses on acquiring existing limited partnership interests in private market funds from other investors. These funds provide an avenue for investors to gain exposure to a diversified portfolio of companies or assets that are already established. Here are the advantages and considerations of Secondaries Funds:

Advantages:

  • Immediate diversification: Secondaries Funds offer investors the opportunity to gain instant exposure to a diversified portfolio of underlying companies or assets. As these portfolios already exist, investors can assess the composition and quality of the assets before making their investment decisions.
  • Liquidity: By investing in a secondaries fund, investors benefit from increased liquidity compared to investing directly in primary funds. They can access investments that have already gone through their initial investment period, potentially shortening the time to exit and providing more flexibility in managing their portfolio.
  • Pricing efficiency: Investing in secondary transactions allows investors to capitalize on pricing inefficiencies. By purchasing limited partnership interests from other investors, Secondaries Funds may acquire these interests at discounts to their net asset value (NAV), potentially offering attractive entry points for investors.
  • Reduced J-curve effect: The J-curve effect refers to the period of negative returns often experienced during the early years of a private market fund's life. Investing in secondaries funds can help mitigate the J-curve effect as the underlying assets are typically more mature, potentially offering more stable cash flows and shorter investment horizons.

Considerations:

  • Limited control: Investors in secondaries funds have limited control over the composition of the underlying portfolio. They are reliant on the fund manager's ability to select and manage investments effectively. Investors may not have the same level of involvement or influence over the assets as they would with direct investments. It is important to partner with a trusted and established manager who has the expertise, track record and access to scalable secondary opportunities.
  • Less flexibility in portfolio construction: While secondaries funds provide exposure to a pre-existing portfolio, investors may have limited ability to customize the portfolio to align with their specific investment objectives. The composition of the portfolio is determined by the assets available on the secondary market at the time of investment.
  • Potential dilution: Investing in secondaries funds means acquiring limited partnership interests at a later stage of the fund's life cycle. This may result in a portfolio that is less concentrated in early-stage companies or high-growth opportunities, potentially diluting the potential for significant upside returns.

Conclusion

In the realm of private markets, achieving diversification is crucial for managing risk and maximising potential returns. Both FoFs and secondaries funds offer investors pathways to diversification, each with its own set of advantages and considerations. FoFs provide immediate exposure to a diversified set of funds, professional management, and access to top-tier managers but may come with layered fees and limited transparency. Secondaries funds provide instant diversification, increased liquidity, and pricing efficiency but limit control and customisation options. Ultimately, investors should carefully consider their investment objectives, risk tolerance, and preferences to determine which approach aligns best with their needs.

Receive Focus insights straight to your inbox

Sending...

Please complete all required fields before sending.

Thank you

We look forward to sharing out of the ordinary insights with you

Sorry there seems to be a technical issue

Disclaimer

Although information has been obtained from sources believed to be reliable,  Investec Wealth & Investment International (Pty) Ltd or its affiliates and/or subsidiaries (collectively “W&I”) does not warrant its completeness or accuracy. Opinions and estimates represent W&I’s view at the time of going to print and are subject to change without notice. Investments in general and, derivatives, in particular, involve numerous risks, including, among others, market risk, counterparty default risk and liquidity risk. The information contained herein is for information purposes only and readers should not rely on such information as advice in relation to a specific issue without taking financial, banking, investment or other professional advice.  W&I and/or its employees may hold a position in any securities or financial instruments mentioned herein. The information contained in this document does not constitute an offer or solicitation of investment, financial or banking services by W&I . W&I accepts no liability for any loss or damage of whatsoever nature including, but not limited to, loss of profits, goodwill or any type of financial or other pecuniary or direct or special indirect or consequential loss howsoever arising whether in negligence or for breach of contract or other duty as a result of use of the or reliance on the information contained in this document, whether authorised or not.  W&I does not make representation that the information provided is appropriate for use in all jurisdictions or by all investors or other potential clients who are therefore responsible for compliance with their applicable local laws and regulations. This document may not be reproduced in whole or in part or copies circulated without the prior written consent of W&I.


Investec Wealth & Investment International (Pty) Ltd, registration number 1972/008905/07. A member of the JSE Equity, Equity Derivatives, Currency Derivatives, Bond Derivatives and Interest Rate Derivatives Markets. An authorised financial services provider, license number 15886. A registered credit provider, registration number NCRCP262.