Institutions look to co-investments, secondaries to mitigate 'J-curve' effect
Limited partners (LPs) are showing growing interest in co-investments and secondaries, prompting private equity (PE) and venture capital (VC) fund managers to adopt such strategies and, at the same time, address a few investing challenges.
“GPs are increasingly utilising secondary markets to retain their best assets for an extended period while also providing liquidity at scale for LPs seeking it,” said Dominic Goh, managing director at HarbourVest, a private markets firm.
One significant concern for LPs who typically prefer steadier cash flows is known as the J-curve, characterised by initial negative returns as costs precede investment maturity.
HarbourVest
By integrating approaches such as secondary funds and co-investments, general partners (GPs) can mitigate the impact of the J-curve and provide early liquidity options while retaining high-performing assets.
Kelvin Yap, another managing director at HarvourVest, added that the co-investment market has also benefited as GPs engaged co-investors to reduce the size of capital contributions per deal.
It also enables portfolio diversification and helps to maintain a consistent pace of exits and distributions.
Industry data from Preqin showed that global PE secondaries reached nearly $93.8 billion in transaction volume in 2023. Meanwhile co-investment activity also surged.
According to Pitchbook data, total capital raised for co-investments with PE investment managers increased from $4 billion in 2010 to $10.3 billion in 2022.
Jimmy Phoon, executive director and CEO of Seviora Holdings, also expects “the secondary market in Asia to continue to deepen due to both GPs and LPs seeking liquidity events.”
Seviora has used secondaries to add more mature assets to its portfolios and mitigate the funds’ J-curves. The firm also looks to secondaries to provide vintage diversification to LPs.
Phoon noted: ”Some interesting secondary opportunities are being driven by GPs seeking to generate liquidity in their portfolios in this period of fewer exits.”
Seviora
On co-investments, “increasingly, LPs are looking at [them] as a must-have component/add-on to their commitment,” he said.
STILL DEVELOPING
Stil, Dean Collins, Singapore managing partner at the law firm Dechert, highlighted challenges present in the Asian secondary market.
“Only about five deals happened in 2023, but we’re working on three more that should close by year-end, and there are others in the market.
"There’s some movement, but it’s not nearly at the level of more developed markets,” he said, indicating that the market is still developing compared to more established ones in other regions.
Regarding co-investments, Collins noted that he does not see a surge in demand although he acknowledged the strategy remains important for many LPs.
“GPs use them to help larger LPs tackle the J-curve by letting them invest large amounts without the usual fees and carry, which cuts down on overall costs as a proportion of the portfolio,” he noted.
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HASTENING DISTRIBUTIONS
In response to LP demand, GPs are adopting other approaches to accelerate early returns.
GPs are “getting creative to speed up early returns and soften the J-curve impact,” Collins added.
Dechert
For example, they have targeted companies that can offer faster liquidity options, and adopted strategies such as short-term financings and secondary buyouts.
PE managers have also employed financial engineering methods, including dividend recapitalisations and NAV financings, to create earlier distributions for investors.
Dividend recapitalisations involve a company taking on new debt to pay a special dividend to shareholders, while NAV financings are loans secured against a company's assets, typically used to provide liquidity without selling the assets.
HarbourVest’s Yap noted that some GPs have increased the proportion of capital deployed in preferred equity, which typically consists of equity instruments that are senior to common equity.
Seviora’s Phoon emphasised the role of financial engineering in this landscape: “GPs use subscription lines before calling capital, deferred payment structures, and structured investments” which allow them to incur debt at the portfolio or fund level, generating early distributions for LPs before exit events occur."
Dechert’s Collins noted that GP’s management fee structures as well are evolving to address the J-curve.
“For example, starting with a lower base fee that ramps up in later years can reduce fee drag [for LPs] during the fund's initial phase,” he said.