Risk Associated with Secondary Funds

In our last post, we took a look at the reasons propelling the rise of secondary funds. While a diverse portfolio of secondary interests in a fund can offer attractive returns, it is crucial to be aware of the risks associated with this kind of investment vehicle.

• Information asymmetry: Secondary funds acquire investments from existing investors, and they may not have access to the same level of information as the original investors. Limited information about the underlying investments can make it challenging to assess the risks and potential returns accurately. When acquiring a secondary investment in a private transaction, one should ask the investor (or general partner) whether leverage was used to acquire the initial investment. If so, that alone should trigger a cascade of related questions.
• Valuation risk: Valuing private equity and venture capital investments can be challenging due to the lack of public market data and the subjective nature of valuations. If valuations of the underlying funds are inaccurate or overly optimistic, it can lead to overpaying for investments and negatively impact returns. This can happen if one is not paying close attention to the date of the valuation and the subsequent gap between the date of valuation and the completion of the purchase, which could be a period of months.
• Legal and regulatory risks: Secondary transactions can be subject to legal and regulatory complexities. The transfer of fund interests may require approvals from general partners, limited partners, or regulatory authorities. Legal disputes, tax liabilities, or regulatory changes can introduce uncertainties and affect the fund’s performance.
• Illiquidity: Although secondary funds can help to flatten the J-curve and offer more liquidity compared to direct investments, they are still relatively illiquid compared to traditional public markets. Investors in secondary funds typically have limited opportunities to exit their positions, and the process of selling fund interests can be time-consuming and subject to market conditions.

M&A Insurance: Risk Mitigation

One way to mitigate the inherent risk associated with the investment in secondaries is by way of M&A insurance, an effective approach to assigning a quantifiable value to the risks of transferring an interest in a fund. M&A insurance (also known as reps & warranties insurance) in secondaries plays a pivotal role in the facilitation of a clean exit and entry of partners, as well as the alignment between general partner and limited partners during post-completion. For example, in a GP-led secondary, losses arising from covered breaches of reps and warranties provided by the GP (i.e. the seller) can be limited through insurance coverage. This arrangement allows the new GP/LPs to make claims against the insurer, while concurrently limiting recourse against the seller GP to instances of seller fraud exclusively.

In this secondary fund series, we will continue to explore and highlight different aspects of secondary funds.

We hope to see you again.?

To contact the authors of this article, please reach out to:

Anson Chan????????????????????????????+852 2230 3554????????[email protected]

Natalie Chow??????????????????????????+852 2230 3505????????[email protected]

Scott D. Peterman, CFA????????? +852 2230 3598????????? [email protected]

Sook Young Yeu???????????????????? +852 2230 3591????????? [email protected]

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