Secondaries do not make the J-curve shallower, they make it shorter, and the arithmetic shows by how much and when the effect disappears.
Secondaries do not make the J-curve shallower; they make it shorter. On illustrative cash flows, a primary commitment of 100 calls 92 over six years, bottoms at minus 58 and only gets its cash back in year 7. A mid-life secondary bought at 88 for a reported NAV of 100 puts all 88 to work on day one, but has its cash back in year 3. Per unit of capital, it carries 2.25 capital-years of exposure against 2.67 for the primary.
Worked in full in The Private Equity Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Secondaries mitigate the J-curve" is said in almost every allocation paper. It is true, but for a specific reason and only for a specific kind of secondary, and both become clear once the cumulative cash flows are set side by side.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Primary: calls | 0 | 22 | 24 | 20 | 14 | 8 | 4 | 0 | 0 | 0 | 0 |
| Primary: distributions | 0 | 0 | 2 | 6 | 14 | 22 | 28 | 32 | 26 | 18 | 12 |
| Primary: cumulative | 0.0 | −22.0 | −44.0 | −58.0 | −58.0 | −44.0 | −20.0 | 12.0 | 38.0 | 56.0 | 68.0 |
| Secondary: net cash flow | −88 | 18.0 | 30.0 | 40.0 | 40.0 | ||||||
| Secondary: cumulative | −88.0 | −70.0 | −40.0 | 0.0 | 40.0 |
The secondary is a mid-life buyout fund interest offered at 88 against a reported NAV of 100, a 12 per cent discount, expected to return 130 over four years. Its year-1 flow is a distribution of 20 less a remaining call of 2. The primary calls 92 of its 100 commitment and returns 160, a 1.74x multiple; it is the same illustrative fund as in how to calculate a private equity J-curve, so the two curves can be read together.
Cumulative net cash flowt = Σ (distributions − calls) up to year t
Trough = the most negative cumulative value; cash-back year = first year the cumulative reaches zero
Capital-years at risk = Σ |cumulative| over the years it is negative, divided by capital paid in
In Excel, with net flows in row 4: =SUM($B4:B4) copied across for the cumulative, =MIN(B5:L5) for the trough, and =-SUMIF(B5:L5,"<0")/Paid_In for capital-years per unit.
Measured by depth, the secondary's curve is worse: the whole cheque is out on day one, where the primary never has more than 63 per cent of its calls outstanding at once. Measured by length, it is far better: cash back four years earlier, and each unit of capital at risk for 2.25 years against 2.67, about 16 per cent less. That is what mitigation means in practice, and it does not come free: the primary's IRR, 15.47 per cent, is higher than the secondary's 14.76. By the end of year 3 the secondary's DPI is 1.00x; the primary's is 0.12x, 8 distributed on 66 called, and still only 0.50x at the end of year 5.
The reported J-curve disappears faster still. Bought at 88 and carried at the manager's NAV of 100, the interest shows a TVPI of 1.14x, a 13.6 per cent unrealised gain, at the first quarter end. Nothing has happened to the companies. That gain is the 12 points of discount, 30 per cent of the 40 points this deal creates, recognised the day the books close. The split between discount and appreciation is worked in how much of a secondary return comes from the discount.
| Investment | Paid in | Trough | Cash back | Capital-years per unit | MOIC | IRR |
|---|---|---|---|---|---|---|
| Primary commitment of 100 | 92.0 | −58.0 | Year 7 | 2.67 | 1.74x | 15.47% |
| Late-life secondary at 92 | 92.0 | −92.0 | Year 3 | 1.70 | 1.14x | 7.47% |
| Mid-life secondary at 88 | 88.0 | −88.0 | Year 3 | 2.25 | 1.45x | 14.76% |
| Young secondary at 60, 25 unfunded | 85.0 | −85.0 | Year 5 | 3.76 | 1.35x | 7.43% |
The late-life interest mitigates most, 1.70 capital-years per unit, but at a 1.14x multiple there is little return to protect. The young interest, bought at 60 for a NAV of 70 with 25 still to be called, carries 3.76 capital-years per unit, more than the primary's 2.67: its calls arrive after the purchase price, much as a primary's do, but on a cheque that was large from day one. The J-curve benefit belongs to the age of the fund bought, not to the word secondary.
The common mistake is to cite the reported TVPI or since-inception IRR of a secondaries programme in its first year as proof of J-curve mitigation. The day-one mark-up of 1.14x is a discount being booked, and it reverses if the reported NAV was too high; a buyer who has not rebuilt the NAV bottom-up does not know which. The cash curve is the one that funds capital calls and is the one to plan around, as the primary J-curve calculation also concludes. The second mistake is to ignore unfunded commitments: they bring the primary's J-curve with them.
A mid-life secondary bought at 88 has its cash back in year 3 against year 7 for a primary, and keeps each unit of capital at risk about 16 per cent less time, 2.25 years against 2.67. It does that with a full cheque on day one, and only if the fund is old enough. The free workbook for this case models the interest's distributions and calls year by year and stresses their timing.
Because the buyer enters after the fees and the investment period have been paid for by the seller, and the portfolio is already close to distributing. In the illustrative mid-life case, 88 is paid on day one and distributions of 18, 30 and 40 return it by year 3, where a primary commitment that calls 92 over six years only gets its cash back in year 7.
Because it is bought at a discount and then carried at the manager's reported NAV. An interest bought at 88 and marked at 100 shows a TVPI of 1.14x, a 13.6 per cent unrealised gain, before any company has changed in value. It is an accounting effect of the discount, not performance, and it accounts for 12 of the 40 points of value the case creates, 30 per cent.
No. A young interest with unfunded commitments behaves much like a primary. In the illustrative case an interest bought at 60 with 25 still to be called gets its cash back in year 5 and carries 3.76 capital-years per unit paid in, more than the 2.67 of the primary commitment. The mitigation comes from buying late in a fund's life.
The mid-life interest here is the worked case of Chapter 9 of The Private Equity Secondaries Investor; the free companion workbook models its distributions and calls year by year. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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