A True Alternative: Long/Short Allocations to Health Care
Health care offers unique opportunities for skilled active managers to generate alpha — both long and short — across multiple health-care industries.
Driven by strong returns, private equity has seen unprecedented growth during recent decades. For example, a study by McKinsey & Co. showed that net asset values in private equity have outgrown public equities market capitalization nearly threefold since 2000. And the trend remains unbroken: in our Annual Investor Survey of private equity investors, 60% of them increased their allocations to the asset class in the past 12 months.
However, investing in private equity has its pitfalls. Generating large returns does not come without risks, because there is large dispersion in returns across buyout and venture capital (VC) managers. In a large sample obtained from Preqin, close to 10% of all buyout funds had negative returns, and more than 35% doubled their money. For VC, the loss ratio is much higher, as more than a quarter of VC funds return less than the invested capital and roughly 30% of funds have a multiple over 2x.
Deep knowledge of the asset class and strong selection skills are therefore of utmost importance for an investor that commits directly to buyout and VC funds. With substantial long-term experience, investors can make use of the right-skewed dispersion of private equity returns and benefit from it by generating returns higher than those of public markets.
Fortunately, secondary funds, which provide liquidity by buying the interests of existing funds, offer investors without that long-term experience access to the asset class, with similarly attractive return characteristics but with much lower-risk profiles. To illustrate the point, the following chart plots all of the internal rates of return (IRRs) for funds with vintage year 2015 or older from Preqin, clustered by their strategy. Blue dots below the orange line represent funds with negative IRRs. The rectangles show the lower and upper quartiles as well as the median (line in the middle).
IRR Dispersion Across Strategies
Median DPI and Vintage Year
The IRR for a secondary fund is comparable to that of a buyout fund, and it’s much higher than that of a VC fund. The dispersion, on the other hand, is much narrower: only 3 out of more than 200 secondary funds have IRRs below 0% — and only marginally so. The attractive IRR characteristics for secondary funds are the result of two key factors: First, secondary funds typically build up diversified portfolios of private equity funds — consisting of several dozen underlying assets — compared with much more concentrated buyout and VC funds. And second, as secondaries buy into existing private equity funds, it takes less time for them to receive distributions, which de-risks the funds much earlier.
The latter point is shown nicely by the above chart, which compares the median ratio of distributed to paid-in capital (DPI) for a fund, clustered by strategy and vintage year. As of the most recent valuation date of September 2021, secondary funds have consistently had the highest DPIs for each vintage year — except older vintage years, for which the longer holder period of buyout funds eventually translates into higher realized returns.
Take the vintage year 2016 as an example. A typical secondary fund has already returned more than 40% of the invested capital to its investors, whereas the DPI is less than 0.3x for a typical buyout fund. A typical VC fund has returned only 0.1x.
In summary, secondaries represent an attractive strategy for private equity investors — both experienced ones and investors new to the asset class who can build up their portfolios more quickly. Meanwhile, investors appreciate the mitigated J-curve and can profit from the appealing risk–return profile.
Montana Capital Partners
A secondary private equity manager to provide access to a fast-growing alternative investment opportunity.
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