Faced with hundreds of potential deals spanning vintages, structures and strategies, how do we narrow the field? We look for opportunities where we can leverage our strong GP relationships to gain insight into high-quality assets, seeking sales processes with favorable competitive dynamics.
In private equity investing, secondary investors will acquire interests from limited partners seeking liquidity in existing private equity funds. The secondaries market has grown significantly in recent years, with annual transaction volume expanding by more than three times since 2016.1 But as the field of opportunities has grown, so has the complexity of the investment selection process. While many factors play a role when screening for optimal investment opportunities, Pomona believes it is important to focus on three key attributes to mitigate unpredictable outcomes. Below, we explain our process and show how these considerations factored into a recent secondary transaction.
A strong relationship with the GP
The general partner (GP, manager or sponsor) of a particular private equity fund is responsible for identifying investment opportunities and taking an active role in managing each underlying business after its acquisition. As a result, the GP’s ability to discover, evaluate and nurture assets directly influences a deal’s success. As a secondary investor, we believe having deep, long-standing relationships with leading private equity sponsors offers important benefits, including:
- An ability to acquire assets alongside high-performing GPs who have shown they can deliver consistent returns through multiple economic cycles.
- A deeper understanding of the GP’s effectiveness in managing the assets and generating returns across different investment strategies.
- Better insight into the underlying portfolio holdings, enabling a deeper understanding of portfolio company performance, business risks and opportunities, and potential liquidity events.
Access to transactions with limited competition through introductions to limited partners looking to obtain liquidity from their private equity portfolios.
 | Example: Project Verdant2 – Pomona Investment Fund (PIF) committed $45 million to Project Verdant, a LP secondary transaction focused on the acquisition of an interest in a 2016 vintage fund sponsored by a well-established European-based private equity manager with a 50-year track record. – Pomona has been investing alongside this sponsor for more than 15 years and has committed capital on both a primary and secondary basis across several transactions. – This sponsor has delivered consistent returns through multiple economic cycles and has successfully executed its global investment strategy by investing across the capital structure in businesses operating in a variety of sectors. |
High-quality assets with potential for near-term liquidity
There are many ways to define quality. We look at it from three angles:
- Growth: We have found that growth is typically achieved by businesses that successfully venture into new markets, execute novel strategies, or acquire competing or complementary businesses. The underlying growth of these businesses can enhance long-term investment performance.
- Appropriate valuation: While growth is a key attribute that Pomona considers when evaluating investment opportunities, there is a limit to what we are willing to pay for that growth. While a particular portfolio company may have strong growth characteristics, the business may not be able to overcome an excessive valuation, which can lead to subpar returns.
- Near-term liquidity potential: Liquidity plays a vital role in providing flexibility and potential return enhancement for investors. It helps mitigate risks, supplement gains and compound returns. Even in challenging market environments, when merger and acquisition activity is low or the initial public offering market is inactive, high-quality businesses that generate organic revenue growth remain attractive to buyers and provide liquidity for investors.
| Example: Project Verdant2 –The Project Verdant portfolio comprised 20 underlying portfolio companies (predominantly based in the U.S. and Europe) operating in a wide variety of sectors. – The largest assets in the portfolio (85% of NAV) had exhibited strong growth characteristics, from both a revenue and an earnings (EBITDA) perspective, over the three years prior to acquisition. – Given the age of the portfolio and the sponsor’s proven ability to manufacture liquidity in challenging macro-economic environments, we believed there was potential for the underlying assets to generate near-term liquidity. |
Favorable competitive dynamics
Throughout its 30-year history, Pomona has successfully navigated the competitive landscape of the secondary market. While the market continues to grow and evolve, Pomona has remained nimble and strives to identify pockets of inefficiency and to stay away from the crowd. By focusing on narrow processes, where Pomona may have an inside edge, it’s easier to acquire desirable assets at favorable prices. How does Pomona do this?
- Leverage relationships: Maintain strong lines of communication with multiple stakeholders in order to identify transactions where competition is limited (deals not available to the full universe of secondary investors).
- Restrictive sponsors: Obtain “approved buyer status” from high-performing private equity managers who have a history of restricting transfers to select secondary investors. This allows Pomona to pick single fund interests out of a larger portfolio and potentially unlock entire secondary transactions with minimal competition.
- Using its size to its advantage: Unlike bigger funds, Pomona does not have to participate in every big deal. Instead, we have the flexibility to participate in select transactions of varying sizes where there’s less competition. This allows the Firm to move up or down market, seeking out pockets of inefficiency where the fund can capitalize on attractive investment opportunities.
| Example: Project Verdant2 – The Project Verdant GP played an integral role in structuring the transaction on behalf of their limited partners. – Pomona’s longstanding relationship with this sponsor was paramount in getting us a seat at the table with an exclusive group of secondary buyers invited to bid on the assets. |
Staying clear of uncontrollable risks
Even if a deal satisfies these criteria, there are several reasons why a secondaries investor may choose to pass on it. Pomona tends to avoid transactions that have significant exposure to the following:
- Early-stage or venture capital funds: These strategies are typically associated with businesses that have limited proof of concept and/or no profitability, increasing the unpredictability of the outcome.
- Emerging markets: Businesses operating in emerging or frontier markets are more susceptible to political unrest, economic uncertainty and limited rule of law, which can lead to a wide array of potential outcomes.
- Energy assets and other commodity-related businesses: Investments in industries such as energy, and those related to other commodities, are heavily influenced by external factors, such as the price of oil. These externalities are challenging to forecast accurately, making it difficult to determine expected investment results effectively.
PIF seeks to deliver on the fundamental premise of secondaries
Pomona’s investment strategy is designed to address both value and growth, aiming to deliver an appealing risk-adjusted return over the medium and long term. The objective is to build a well-diversified portfolio of mature private equity assets that demonstrate robust growth potential and offer the possibility of near-term liquidity. The firm actively seeks opportunities to acquire assets at below-market prices, providing a margin of safety against potential downside risks.
A note about risk Investing in private equity is a risk and there is no guarantee that an investment in private equity or in a Pomona-sponsored fund will be profitable. The above scenarios are for illustrative purposes only and are theoretical; there is no guarantee an investment in a Pomona-sponsored fund will exhibit any of the above characteristics or return profile. Discussed below are the investments generally made by Investment Funds and the principal risks that the Adviser and the Fund believe are associated with those investments and with direct investments in operating companies. These risks will, in turn, have an effect on the Fund. In response to adverse market, economic or political conditions, the Fund may invest in investment grade fixed income securities, money market instruments and affiliated or unaffiliated money market funds or may hold cash or cash equivalents for liquidity or defensive purposes, pending investment in longer-term opportunities. In addition, the Fund may also make these types of investments pending the investment of assets in Investment Funds and Co-Investment Opportunities or to maintain the liquidity necessary to effect repurchases of Shares. When the Fund takes a defensive position or otherwise makes these types of investments, it may not achieve its investment objective. The value of the Fund’s total net assets is expected to fluctuate in response to fluctuations in the value of the Investment Funds, direct investments and other assets in which the Fund invests. An investment in the Fund involves a high degree of risk, including the risk that the Shareholder’s entire investment may be lost. The Fund’s performance depends upon the Adviser’s selection of Investment Funds and direct investments in operating companies, the allocation of offering proceeds thereto, and the performance of the Investment Funds, direct investments, and other assets. The Investment Funds’ investment activities and investments in operating companies involve the risks associated with private equity investments generally. Risks include adverse changes in national or international economic conditions, adverse local market conditions, the financial conditions of portfolio companies, changes in the availability or terms of financing, changes in interest rates, exchange rates, corporate tax rates and other operating expenses, environmental laws and regulations, and other governmental rules and fiscal policies, energy prices, changes in the relative popularity of certain industries or the availability of purchasers to acquire companies, and dependence on cash flow, as well as acts of God, uninsurable losses, war, terrorism, earthquakes, hurricanes or floods and other factors which are beyond the control of the Fund or the Investment Funds. Unexpected volatility or lack of liquidity, such as the general market conditions that prevailed in 2008, could impair the Fund’s performance and result in its suffering losses. The value of the Fund’s total net assets is expected to fluctuate. To the extent that the Fund’s portfolio is concentrated in securities of a single issuer or issuers in a single sector, the investment risk may be increased. The Fund’s or an Investment Fund’s use of leverage is likely to cause the Fund’s average net assets to appreciate or depreciate at a greater rate than if leverage were not used. The Fund is a non-diversified, closed-end management investment company with limited performance history that a Shareholder can use to evaluate the Fund’s investment performance. The Fund may be unable to raise substantial capital, which could result in the Fund being unable to structure its investment portfolio as anticipated, and the returns achieved on these investments may be reduced as a result of allocating all of the Fund’s expenses over a smaller asset base. The initial operating expenses for a new fund, including start-up costs, which may be significant, may be higher than the expenses of an established fund. The Investment Funds may, in some cases, be newly organized with limited operating histories upon which to evaluate their performance. As such, the ability of the Adviser to evaluate past performance or to validate the investment strategies of such Investment Funds will be limited. In addition, the Adviser has not previously managed the assets of a closed-end registered investment company. Closed-End Fund; Liquidity Risks: The Fund is a non-diversified closed-end management investment company designed principally for long-term investors and is not intended to be a trading vehicle. An investor should not invest in the Fund if the investor needs a liquid investment. Closed-end funds differ from opened management investment companies (commonly known as mutual funds) in that investors in a closed-end fund do not have the right to redeem their shares on a daily basis at a price based on net asset value. |