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Accessing private markets through primary fund investing: The path to capital appreciation and IRR

June 25, 2024 | 10 min read

The world’s largest, leading, and most sophisticated institutional investors use primary fund investments as the foundation of their private market portfolios. More recently, family offices, high net worth individuals (HNWI), and retail investors have been actively adding primary private market strategies to their quiver. But what are primaries and how do they provide investors access to potential capital appreciation and alpha?

What are primary investments?

Primaries are investments in a fund in which a limited partner (LP) is the source of capital and a general partner (GP) is the investor of capital into underlying portfolio companies. A single fund typically invests in 10-30 companies over 2-5 years. Diversified primary portfolios typically consist of 20-40 funds leading to a portfolio of 500+/- underlying companies across venture capital, growth equity, and buyouts.

Private equity primaries offer investors early access to companies that are not available in public markets. The private market opportunity available through a primary multi-manager strategy can provide investors access to innovative companies at the earliest stage of company creation, known as venture capital; companies in need of value-added expansion capital, referred to as growth equity; or companies ripe for transformation or optimization which are classified as buyouts. See glossary below for more private markets definitions.

Scott Voss

Managing Director,
Chair of Primary Investment Committee

 

Source: HarbourVest. For illustrative purposes only. While some of the companies listed have been companies invested in by HarbourVest in the past, or may be in the future, the reference does not constitute a recommendation to invest in any of the aforementioned companies or General Partners.

Why primaries? The three Cs

A primary investment strategy can provide investors with several potential benefits, including complementary diversification, compelling long-term performance, and curated portfolio construction.

Complementary diversification: Accessing the other 99%

Focusing exclusively on public markets can greatly limit the opportunity set available to investors. In the US, the number of publicly traded companies has declined by almost 27%1 over the past two decades and now accounts for less than 1% of all active companies.2 Over that same time period, private capital investing in private companies — the other 99% — is playing a larger role in the global capital markets and offering access to more flexible, cost effective, and efficient business models.

Borrowing from the public markets, primary investment strategies allow investors to allocate in much the same way as a public market portfolio (yield, value, growth, and hyper-growth) but with a unique, and much larger, universe of companies. In this way, primary investment opportunities provide access to complementary diversification across different strategies, geographies, and time periods.

Strategy: The global private equity market can be segmented into several distinct strategies, including venture capital, representing 30-40% of the market; growth equity, accounting for 10-15%; and buyouts, the largest segment, capturing 50-60% of the market. Within these broad definitions, strategies are often further refined by sector, industry, or transaction.

Geography: The largest private equity markets in the world include the U.S., U.K., France, Germany, China, Japan, and Australia. Other developing economies throughout Southeast Asia, Africa, the Middle East, and Latin America have seen private equity become vital to their capital markets over the past 2-3 decades. Broadly, global assets across geographies are broken down as follows: North America (50-60%), Europe (25-30%), Asia (15-20%), and Emerging Markets (<5%).

Private equity breakdown by strategy and geography

Strategy

Geography

Source: Preqin, data as of March 31, 2024.

Some marquee examples of venture capital and private equity investments that exemplify the transformational potential of the asset class include:

SpaceX

Founded in 2002 by Elon Musk with the goal of reducing space transportation costs and colonizing Mars, SpaceX has proven to be one of the most disruptive and innovative companies in any venture portfolio. The company’s earliest institutional investors included Founders Fund and Draper Fisher Jurvetson, which gained their initial ownership in 2009 when the company was valued at $60 million.3 In December 2023, a sale of secondary shares valued SpaceX at $180 billion.4

LeasePlan

In 2016, a consortium of buyers including Dutch pension fund ATP, a subsidiary of Abu Dhabi Investment Authority, and TDR Capital completed a €3.7 billion complex corporate carve-out of LeasePlan from parent company, Volkswagen. LeasePlan, one of the world’s largest vehicle management companies, was best positioned to grow as an independent company during a period where Volkswagen needed to focus on its core business.5 In 2023, ALD Automotive, a subsidiary of Societe General, acquired the company for €4.8 billion.6

Dell

Nearly 30 years after its founding and rise to market leadership, Dell lost its competitive positioning and was in need of radical change to maintain relevance. In 2013, Silver Lake led a consortium of lenders that undertook a $25 billion take-private to undergo this transformation including business rationalization, product innovation, strategic acquisitions, and reverse IPO.7 In 2023, subsequent to the spinout and IPO of Dell subsidiary, VMWare, Broadcom acquired VMWare for a record $69 billion, making it the largest takeover deal in the technology industry,8 and one of the most notable value creation events to occur under private equity ownership.

Toshiba

In 1939, Tokyo Denki (founded in 1890) and Shibaura Seisaku-Sho (established in 1875) merged to form Tokyo Shibaura Denki, which was taken public on the Tokyo Stock Exchange in 1949.9 The company was renamed Toshiba Corporation almost four decades later in 1984.10 Recognizing the opportunity to undergo its own transformation and the importance of a local financial partner to do so, this iconic company partnered with Japan Industrial Partners to delist in the largest private equity deal in Japan’s history, a $15 billion take-private completed in late 2023 that moved the 148-year-old conglomerate into domestic hands as a private company.11

Compelling long-term performance: Seeking alpha

Primary fund investing has proven to generate impressive performance for investors that allocate consistently over the long-term. Primary investing offers investors access to young companies that are pioneering new technologies, implementing new business models, and creating entirely new categories. These investments provide distinct opportunities for outperformance on both an absolute and risk-adjusted return basis.

Institutions with access to upper quartile managers or the ability to successfully source and identify new, emerging managers that ultimately prove to be top performers can potentially generate IRRs (Internal Rate of Return) of 20% or greater over the long-term. These primary funds have the potential to generate alpha of 500 basis points against private market indices, which have averaged 15%, and 1000 basis points of outperformance over comparable public market indices, which have averaged 10%.12 To ensure outperformance across private markets strategies, and particularly within private equity primaries, it is important that investors target funds and managers that produce consistent returns in the top two quartiles.

Global private equity 10-year IRR

Source: Burgiss, data for private markets and public market equivalent (PME) as of September 2023. For illustrative purposes only. Past performance is not a reliable indicator of future performance.

Private equity, when compared to other asset classes — most notably public equities, but also including fixed income, hedge funds, private debt, real estate, and infrastructure — has the greatest dispersion by a meaningful amount. This is most dominant for venture capital, followed by growth equity and buyouts. So, when done well, there are outsized benefits. When done poorly, it can lead to significant underperformance and require extra time and attention.

US private vs. public equity 10-year return* dispersion comparison

* Chart compares private equity index IRRs versus public market time-weighted returns. Returns are 10-year IRRs for private assets and 10-year annualized compound returns for public equity.

Source: MSCI, data as June 30, 2023, and Refinitiv, data as of December 11, 2023. Public equity reflects Refinitiv screening of 1,941 US-domiciled US equity mutual funds. Past performance is not a reliable indicator of future results.

Curated portfolio construction: Mixing the art and the science

Once an investor commits to building out a primary private equity strategy, it can take as many as five years to build out a 20-40 fund portfolio diversified by vintage, strategy, geography, and investment theme. At the outset, it is common for investors to invest in well-known, proven GPs. These firms play the role of giving an investor access to the largest, most notable deals in the private markets.

Investors often then complement their core investments with more tactical or specialist funds. These portfolio completion strategies can be put in various categories including sector-focused funds, emerging managers, seed funds, regional-focused funds, and spinouts, among others. In many cases these tactical funds will have outperformance potential but may also have greater dispersion in performance, putting more importance on manager selection.  

Building beyond the core

Sector specialists

Category leaders

Regional specialists

Category leaders

Diversified seed

Category leaders

Next gen

Category leaders

Spinouts

Category leaders

Source: HarbourVest. For illustrative purposes only.

There are a few added considerations with respect to implementation and execution that can help optimize the investment outcome. 

  • The build vs. buy decision

    Primary investing is a people-intensive process, requiring significant time and resources. Success necessitates active sourcing, evaluating, selecting, executing, and monitoring of investments over their lifecycle. The most important consideration in the build versus buy decision is access. For those that outsource to a service provider, access can be more immediate given the investor can step into a serial relationship that may have existed with the service provider for decades. When considering service providers (buy decision), access should be a key area of due diligence, given it is one of the most important areas of value add in private equity primary investing.

  • Using data for better decision-making

    Established and sophisticated private equity investors with a data advantage are using insights to enhance decision-making around asset allocation, portfolio construction, manager selection, active portfolio management, and transaction pricing. Data-informed decision-making is providing a growing advantage to those that have the largest and most relevant datasets. This is also an area where partnerships with leading service providers tied to information sharing or knowledge transfer can bring additional value.

  • Complementing the primary portfolio

    Investors will often add secondary and direct co-investment exposure to enhance various aspects of the portfolio. By adding these different transaction types, investors can benefit from backward vintage year diversification, accelerated funding, and J-curve mitigation. (See glossary below for more private markets definitions) These attributes complement the primary portion of the portfolio, which will drive long-term capital gain while enhancing money multiple and IRR. Many commingled primary-focused strategies already incorporate both secondaries and direct co-investment (30-50%) strategies in their portfolio construction.

  • Active portfolio management

    Primary funds typically have a 10-year fund life and can sometimes extend well beyond. Over the past decade, the secondary market has expanded and matured, offering various liquidity solutions to investors that are actively looking to divest and recycle capital when their investment moves beyond the initial value creation phase, or when the investor has idiosyncratic liquidity needs. Though a sale into the secondary market often comes at a discount to net asset value (NAV), if the seller is not a forced seller and can be patient, the exit can be timed to sell into positive market sentiment to optimize on price. When partnering with a service provider, their approach to active portfolio management should also be assessed.

Key takeaways: Putting a bow on it

As investors contemplate adding private markets exposure to their current portfolio, primary investments serve as the foundation of a private markets strategy, offering many compelling attributes including:

  • Access to a large investible universe not available through public markets
  • Potential for significant outperformance (500-1000 basis points) over comparable public market portfolio13
  • Flexibility that allows investors to be intentional in how they allocate to various sub-strategies and investing themes

For several decades, large, well-known institutions have been successfully investing in private markets through primary funds. Their success is proof that positioning a primary portfolio at the core of a private markets strategy is potentially one of the most efficient ways to access the companies that define the private markets today and, in the future, while driving capital appreciation and IRR in underlying portfolios.

Private markets glossary

Venture capital

Venture capital is a form of private equity financing provided by firms or funds to startup, early-stage, and emerging companies, which have been deemed to have high growth potential. Venture capital focuses on high growth areas that are ripe for innovation, including information technology and life sciences.

Growth equity

Growth equity is a type of private equity investment, usually a minority interest, where private capital partners with company founders to help scale and professionalize the business. In most, but not all cases, the private capital is the first institutional money invested in the company.

Buyouts

Buyout is an investment transaction where one or more private equity investors takes a majority or controlling interest in a private company. Buyout investors often take an active role in the underlying company by sitting on the board and guiding the long-term strategic direction of the company as well as the day-to-day operations. Buyouts have different profiles ranging from growth to value.  

J-curve

J-curve refers to the typical pattern of returns for private equity investments – where early in a funds life as capital is drawn to fund investments in portfolio companies and it pays management fees, the funds performance is typically negative. But over time, as portfolio companies increase in value and are sold at a profit, the negative performance turns positive.

Backward vintage year diversification

Backward vintage year diversification is a characteristic of secondary investing where a new buyer steps into a portfolio of existing, developing funds or assets thereby giving the secondary buyer diversified exposure to deals in prior vintage years.

Accelerated funding

Accelerated funding refers to how capital is typically drawn down from investors in secondary and direct co-investments at the time those commitments are made, with capital for fund primary commitments often drawn over a longer period of time, typically 3-5 years, as primary GPs builds out their underlying portfolios.

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Footnotes
  1. https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/reports-of-corporates-demise-have-been-greatly-exaggerated
  2. https://businessreview.studentorg.berkeley.edu/why-your-favorite-companies-are-privately-held/
  3. https://www.buyoutsinsider.com/dfj-jurvetson-propel-spacex-funding/
  4.  https://www.cnbc.com/2023/12/13/spacex-value-climbs-to-180-billion-higher-than-boeing-verizon.html
  5. https://www.leasinglife.com/deals-dashboards/alds-e4-8bn-acquisition-of-leaseplan-gets-the-green-light/
  6. https://www.leasinglife.com/deals-dashboards/alds-e4-8bn-acquisition-of-leaseplan-gets-the-green-light/
  7. https://www.forbes.com/sites/connieguglielmo/2013/10/30/you-wont-have-michael-dell-to-kick-around-anymore/?sh=48b99d422a9b
  8. Broadcom plans to close $69bn VMWare deal after China approves takeover: https://uk.finance.yahoo.com/news/broadcom-plans-close-69bn-vmware-145937301.html
  9. https://www.global.toshiba/ww/ir/corporate/helpful-info/faq/faq-his.html
  10. https://www.global.toshiba/ww/ir/corporate/helpful-info/faq/faq-his.html
  11. https://bspeclub.com/toshiba-a-japanese-buyout-thriller/
  12. Burgiss, data as of September 30, 2023.
  13. Burgiss, data as of September 30, 2023.
Disclosure

This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

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Professional Investor Definition

“Professional Investor” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”) and its subsidiary legislation) means:

(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

(b) any intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong;

(c) any authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(d) any insurer authorized under the Insurance Ordinance (Cap. 41 of the Laws of Hong Kong), or any other person carrying on insurance business and regulated under the law of any place outside Hong Kong;

(e) any scheme which-

(i) is a collective investment scheme authorised under section 104 of the SFO; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

(f) any registered scheme as defined in section 2(1) of the Mandatory Provident Fund Schemes Ordinance (Cap. 485 of the Laws of Hong Kong), or its constituent fund as defined in section 2 of the Mandatory Provident Fund Schemes (General) Regulation (Cap. 485A of the Laws of Hong Kong), or any person who, in relation to any such registered scheme, is an approved trustee or service provider as defined in section 2(1) of that Ordinance or who is an investment manager of any such registered scheme or constituent fund;

(g) any scheme which-

(i) is a registered scheme as defined in section 2(1) of the Occupational Retirement Schemes Ordinance (Cap. 426 of the Laws of Hong Kong); or

(ii) is an offshore scheme as defined in section 2(1) of that Ordinance and, if it is regulated under the law of the place in which it is domiciled, is permitted to be operated under the law of such place,

or any person who, in relation to any such scheme, is an administrator as defined in section 2(1) of that Ordinance;

(h) any government (other than a municipal government authority), any institution which performs the functions of a central bank, or any multilateral agency;

(i) except for the purposes of Schedule 5 to the SFO, any corporation which is-

(i) a wholly owned subsidiary of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(ii) a holding company which holds all the issued share capital of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong; or

(iii) any other wholly owned subsidiary of a holding company referred to in subparagraph (ii); or

(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

(A) in respect of the trust corporation; and

(B) within 16 months before the relevant date;

(ii) as ascertained by referring to one or more audited financial statements, each being the most recent audited financial statement, prepared-

(A) in respect of the trust or any of the trust; and

(B) within 16 months before the relevant date; or

(iii) as ascertained by referring to one or more custodian (see below) statements issued to the trust corporation-

(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

(l) any individual, either alone or with any of his associates (the spouse or any child) on a joint account, having a portfolio (see below) of not less than HK$8 million or its equivalent in any foreign currency at the relevant date or-

(i) as stated in a certificate issued by an auditor or a certified public accountant of the individual within 12 months before the relevant date; or

(ii)  as ascertained by referring to one or more custodian statements issued to the individual (either alone or with the associate) within 12 months before the relevant date;

(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

(iii) the most recent audited financial statement prepared-

(A) in respect of the corporation or partnership (as the case may be); and

(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

(i) a trust corporation that falls within the description in paragraph (k);

(ii) an individual who, either alone or with any of his or her associates on a joint account, falls within the description in paragraph (k);

(iii) a corporation that falls within the description in paragraph (m);

(iv) a partnership that falls within the description in paragraph (m).

For the purposes of paragraphs (k) to (n) above:

  • “relevant date” means the date on which the advertisement, invitation or document (made in respect of securities or structured products or interests in any collective investment scheme, which is intended to be disposed of only to professional investors), is issued, or possessed for the purposes of issue;
  • “custodian” means (i) a corporation whose principal business is to act as a securities custodian, or (ii) an authorised financial institution under the Banking Ordinance (Cap. 155 of the Laws of Hong Kong); an overseas bank; a corporation licensed under the SFO; or an overseas financial intermediary, whose business includes acting as a custodian; and
  • “portfolio” means a portfolio comprising any of the following (i) securities; (ii) certificates of deposit issued by an authorised financial institution under the Banking Ordinance (Cap, 155 of the Laws of Hong Kong) or an overseas bank; and (iii) except for trust corporations, cash held by a custodian.

Institutional Investor / Accredited Investor Definition

An institutional investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(a) the Singapore Government;

(b) a statutory board as may be prescribed by regulations made under section 341 of the SFA, as prescribed in the Second Schedule of the Securities and Futures (Classes of Investors) Regulations 2018;

(c) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is —

(i) to manage its own funds;

(ii) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or

(iii) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country;

(d) any entity —

(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and

(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);

(e) a bank that is licensed under the Banking Act 1970;

(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;

(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;

(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;

(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;

(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;

(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;

(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;

(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.

An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —

(BA) a deposit as defined in section 4B of the Banking Act 1970;

(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(ii)  a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —

(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

(iii) A trustee of a trust which all the beneficiaries are accredited investors; or

(iv) A trustee of a trust which the subject matter exceeds S$10 million; or

(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or

(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).