Insightful Investor Podcast #19 — Michael Bego: Secondaries, Private Markets

Host: Alex Shahidi
Guest: Michael Bego, Founder & Managing Partner, Klein Hill Partners
Date: May 7, 2024

Episode Overview

Main Theme:
This episode dives into the often misunderstood and underappreciated world of secondaries in private markets. Alex Shahidi sits down with Michael Bego, an industry veteran who built Klein Hill Partners into a leading secondary fund manager. They discuss the mechanics, history, and strategic nuances of investing in secondaries—purchasing limited partner (LP) interests in private equity and venture capital funds from existing investors. The conversation covers industry evolution, risk-reward tradeoffs, market inefficiencies, operational challenges, and the future outlook for this niche segment.

Key Discussion Points & Insights

1. Michael Bego’s Investment Journey & Background

• Transitioned from engineering at Cornell to enterprise software, then finance via Columbia Business School.
• Inspired by early exposure to the efficient markets hypothesis and indexing, but preferred private markets for their inefficiencies and potential to add value.
• His engineering and operations research background helped with analytical problem-solving and optimization—skills central to assessing complex private portfolios.
  • Quote: "From an analytical standpoint and fine tuning your numbers muscle and problem solving, it was actually a very good background." (03:21)

2. Why Private Markets over Public?

• Skeptical of some public market practices (e.g. opaque incentives, research-sales connections).
• Believes value-add is greater in private markets due to structural inefficiencies and complexity, which suit his skills and experience.
• Quote: "My potential value add to what I'm doing would be lower with public stocks than what I can contribute in a ... private environment." (05:23)

3. Starting Klein Hill Partners

• Built a reputation in secondaries from 2005-2015 before launching the firm.
• The decision was catalyzed by incoming investor interest following his departure from a prior role.
• Emphasizes real success as actual returns to investors—“how much actual cash you're giving back to investors”—not just AUM. (08:23)
• Early, consistent institutional backing (foundations, endowments, RIAs, insurance) made a significant difference.

4. What Are Secondaries?

a. LP Secondaries

• An investor (LP) in a private equity fund sells their stake to a secondary buyer, often as part of rebalancing or liquidity needs.
• These portfolios can be diverse, spanning many managers and vintages.
• The buyer steps in and becomes the new limited partner, taking over future cash flows.

b. GP-Led Secondaries (Continuation Vehicles)

• The fund manager (GP) initiates a liquidity process for specific portfolio companies, inviting secondary buyers to provide capital and offer liquidity to current LPs, typically retaining management.
• These tend to feature successful, “trophy” companies (>2.5x invested capital).
• • Insight:
    "In each of those cases, LP secondaries and GP LEDs are each just over 1% annual turnover..." (14:57)
    Illustrates how illiquid and infrequent such transactions are compared to public markets.

c. Importance of Liquidity

• Enhanced liquidity increases asset value.
  • Quote: "Having the liquidity actually increases the value of what you own." (16:12)

5. Evolution of the Secondaries Market

• Grew from ~$5B annual volume (2005) to $150B expected in 2024.
• Early days required education—pension funds and foundations didn’t understand the concept.
• New product innovations: GP-leds and single-asset vehicles for nuanced liquidity and higher-quality assets.
• Now, roughly 50:50 between LP and GP-led transactions.
• Secondaries are responsible for about 10% of industry liquidity in recent years.

6. Appeal and Risks of Secondaries

• Discovered secondaries in 2005—liked the superior risk-adjusted return.
  • You buy later in the fund’s life, losers have often been written off, liquidity is nearer.
  • Fast feedback loops for investment decisions and learning.
    • Quote: "We'll do deals here at Klein Hill...we'll have exits from that portfolio in the third quarter of this year...very quick feedback." (21:01)
• Key investor skepticism: are you buying at a discount or just inheriting problems others know better?
  • Persistently positive long-term returns suggest discounts are real, but not outsized (most returns 10–15% IRR for large funds; sometimes leverage-augmented). (22:47)

7. Barriers to Entry and Why Discounts Persist

• High barriers: need for capital, seasoned team, access to proprietary information, and industry relationships.
• Complexity of trades—a single secondary transaction might include dozens of funds/managers.
• Lack of standardized pricing or public information.
  • Quote: "You really need to know what the right price is. Unlike the public stock market, ... the valuations...are based on highly confidential information." (26:12)
• Even big firms struggle to reliably enter secondaries.
• Structural and process frictions—legal transfers, varying terms—slow down industry “public marketization”.

8. Discounts, Pricing, and Deal Sourcing

• Discounts today: high single digits to ~15%; larger discounts in venture after 2021 correction (sometimes 20–70+%).
• Not all "discounts" are created equal—funds can mark the same portfolio company at drastically different values.
  • Quote: "Literally one manager can hold the same company for twice as much as another manager." (31:53)
• Klein Hill focuses on sub-$30M deals, where discounts are ~10–20 points better than large/lumpy deals.
  • Small deal sellers are less economically motivated, and large buyers ignore these, creating a pricing gap.

9. Investment Strategies in Secondaries

• Some secondary buyers focus only on managers they know ("primary platforms"), others buy assets more opportunistically.
• Klein Hill partners with specialists (e.g., Sandana Capital for seed-stage venture) for access/selection edge in venture.
• Sector and size specialization—Klein Hill does smaller deals and has a track record in those segments.

10. Return Decomposition and Quality

• Returns from secondaries have two components:

  • The immediate value unlocked by closing the "discount gap".
  • Ongoing appreciation of the acquired underlying assets.
  • Quote: "If you think of the discount, we're locking in an immediate accretion of value..." (43:26)

• For Klein Hill, both matter—most of their returns actually come from asset appreciation (not just discount harvesting).

11. Risk-Reward of Primaries vs. Secondaries

• Secondaries offer higher IRR, tighter band of returns, and faster payout than primary commitments.

• Lower risk: entering later, after companies have "proven" themselves, debt paid down, or failed ventures written off.

• Secondaries also have more dry powder during volatility—sellers are more willing in downturns, and you can buy high-quality assets at bigger discounts.

  • Quote: "Secondaries do have higher net IRRs on average than primary investments do, whether you're talking about buyout, growth, venture." (45:19)

12. Secondaries in Market Dislocations

• In crashes, discounts widen, liquidity for large trades dries up, but small deals persist.

  • During COVID, Klein Hill did almost a year's worth of deals in a month due to dislocations in small asset sales. (55:14)

• Customized “Factor Investing” Approach:

  • Classified companies by COVID impact to selectively pounce on mispricings (58:22).
  • Similar approach used for interest rate shocks.

13. Maintaining an Edge

• Scale, repeated experience (550+ closed deals), a large team (56+), proprietary information from decades of deal-flow, and high-touch client service are key.
• Investing in AI/ML for information management, though not “button-push” ready yet.
  • Quote: "We're sitting on tons of information based on all of the buying that we've done..." (60:42)

Notable Quotes & Memorable Moments

• On Fundraising & Authentic Success:
  "Success in the industry isn't designed by how much capital you can raise or the size of your firm, but it's really defined in how your funds perform..." — Michael Bego (08:23)

• The Real Returns of Secondaries:
  "If you look at returns in the secondary industry, they've been very strong over a long period of time... almost every vintage ... has delivered double digit net returns..." — Michael Bego (22:55)

• Edge through Complexity:
  "You need a massive investment team that’s highly experienced. ... The information is very difficult." — Michael Bego (25:45)

• On Market Evolution:
  "I've seen a tremendous amount of innovation in the secondary industry over the past number of years..." — Michael Bego (63:50)

• “Why Me?” in Investing:
  "When you're looking at investing ... one thing I like to think about ... is why me? ... If there's not a compelling reason for why you're the right person, it might not be the right approach.” — Michael Bego (65:27)

Timestamps for Key Segments

• [01:39] Michael's early career inspiration and transition from engineering to investing.
• [03:54] Why private markets, not public markets?
• [06:10] The founding story of Klein Hill Partners.
• [10:44] Introduction to secondaries and the mechanics of LP and GP-led deals.
• [17:06] How the secondary market has evolved since 2005.
• [22:18] Discount skepticism: Are secondaries “too good to be true?”
• [25:00] Barriers to entry and sources of persistent discounts.
• [31:53] The reality of NAV vs. "real" value.
• [33:09] Secondary investment strategies and Klein Hill’s niche.
• [37:11] Where the biggest discounts are (venture, challenged funds), and how to find quality.
• [45:19] Statistical comparison: risk, returns, payout speed—secondaries vs. primaries.
• [55:13] Secondaries during COVID and other market dislocations.
• [59:32] Sustaining competitive edge in a more crowded market.
• [62:05] Outlook for private markets and secondaries in future years.
• [64:15] Key risks: macro shocks and regulation.
• [65:27] Bego’s unique insight: the importance of “Why me?”

Further Insights & Final Takeaways

• The secondary market, despite significant growth, remains illiquid and opaque relative to public markets—creating persistent opportunity for those with scale, information, and execution edge.
• Quality diligence—understanding true intrinsic value vs. NAV, sorting for asset quality, and timing purchases—can make a major difference, especially in periods of market stress.
• The future may see further innovation in vehicle structures and increased liquidity—but operational complexity and information advantages will likely continue to favor established, specialized players.
• For investors seeking exposure to private equity, a secondary-focused approach (particularly through a specialist manager) may offer higher returns, more diversification, and greater flexibility than traditional primary commitments—with fewer risks in turbulent times.
• Closing Advice: Before allocating to any investment, always ask, “Why me?” — know your edge, and be honest about when you don’t have one.

[Full episode and show notes available at: insightfulinvestor.org ]