Interest and activity in private market secondary strategies have grown to new heights in recent years. Transaction volumes have set records, year after year. Since the onset of Covid-19, fundraising has also remained robust with larger and mega-funds helping to drive total capital closed in 2020 to more than the prior three years combined (1).
There are clear reasons behind this interest. The benefits of the secondary market apply to both buyers and sellers. For sellers, secondaries transactions offer solutions to systemic needs related to private markets. For buyers, they create entry options and value creation opportunities atop existing assets which have their own strategic potential.
While an established practice today, secondaries were not always so readily accepted, and pockets of scepticism persist.
What is the secondaries market?
Before exploring deeper, a quick primer is in order. Private markets fund managers invest in the various private markets verticals via different strategic approaches. This is highly simplified, but these can generally be distilled down to three modes of entry. Multi-manager investment firms raise funds to invest in other funds. These other funds might follow a direct strategy in that they invest directly into underlying companies. Secondary funds in turn often buy either from the investment managers (general partners or “GPs”) or those investing into their funds (limited partners or “LPs”). In other words, secondaries managers buy their investments from existing investors, whether they’re GPs or LPs.
Secondary transactions: LP-led or GP-led
Peeling the onion further, secondaries can then be divided by transaction type. Included are what are now considered to be a more traditional approach to the space: buying a limited partner single interest or portfolio of interests. Here, one or more LPs sell their interest(s), or share(s), in one or more underlying funds to a secondary manager. In so doing, LPs are offered a way out of an otherwise illiquid investment, and secondaries managers looking for access to that fund are offered a way in. Such investments can entail any number of underlying portfolios, and therefore small to large quantities of underlying assets.
Another, growing type of secondary transaction is GP-led. GP-led transactions can take many forms, but often involve the purchase of existing investments which are placed in a new vehicle. GP-led transactions can have a range of exposures but are usually more concentrated relative to purchasing LP interests. These more complex transactions can present incremental access to underlying assets and offer the opportunity to structure in attractive rights.
As secondary transaction types and the characteristics of assets vary across the board, this mix creates opportunities to build unique portfolios of private market assets and to tailor solutions. The attractiveness of sub-strategies can depend on the portfolio construction of the underlying secondary fund as well as current market views.
Common transaction concerns
While both traditional and complex transaction types are well-known today, secondaries investments took time to become mainstream. In fact, GP-led transactions only began to see widespread acceptance in the past five or so years and continue to face questions. For example, one commonly cited concern over time has stemmed from questions around adverse selection.
For instance, why buy an LP’s interest who no longer desires to be an existing investor? Could the sale indicate an expectation of poor performance?
The question is valid: it could and sometimes does. However, such sales are also initiated for a variety of other factors. Like any investor, LPs who are selling are often continually rebalancing their portfolios, based on both business and investment needs. Motivating sales may be new company-level directives (eg, the disbanding of a corporate venture capital portfolio) or simply fatigue after 13 years in the same fund. While sales may be effectuated to offload less attractive investments, there are plenty of distinctive reasons facilitating the continued need for LP interest liquidity solutions. Manager selection is therefore key to navigating the secondary market. Buyers who are highly focused on the underlying assets see the secondary market as one mechanism to gain access, and can consistently distinguish the wheat from the chaff to continue to create a high investment proposition within secondaries.
Similarly, in a GP-led transaction, the question of adverse selection and impact to brand held both supply and demand back for years. For instance, why has the GP not been able to successfully exit the underlying assets? Could the need for more time and capital indicate a lower performing company or less effective GP? Could a GP-led transaction reflect negatively on that GP’s brand? But such sales also solve for a relatively common timing mismatch in the private markets space. The required timeline to fully harvest assets in a fund sometimes proves longer than anticipated. As such, a fundamental and systemic need is addressed through those with the capabilities to provide GP-led transactions.
Across all of private markets, manager selection remains critical to the successful sourcing and execution of attractive opportunities. The same is true in the secondaries market. Across cycle, secondaries managers with the appropriate knowledge, experience and differentiation are poised to effectively source and select attractive deals while minimising adverse selection.
Potential buyer benefits: Reduction in blind pool risk & initial negative performance
Secondaries are not only beneficial to sellers, but also to buyers: the secondary fund managers and their private markets investors. Typical private markets funds are subject to a number of factors unique to the space besides just long hold periods. As LPs initially commit capital to a private markets fund, typically the fund has not yet made any, or only a small portion of, the investments comprising the portfolio over its lifespan. As such, a multi-manager fund investing into a new underlying direct fund will be subject to blind pool risk - the primary fund manager may have a great sense of the strategy and types of investments which will be funded, but is effectively committing capital upfront to fund to-be-selected assets. Conversely, as secondaries fund managers have greater visibility into the underlying assets and the progress of the GP’s strategy, blind pool risk is significantly reduced.
The more advanced status of the underlying investments offers a host of additional benefits to the investors in secondary funds. As the typical private markets fund begins to invest, early cash outflows typically lead to a j-curve, or initial negative performance early in the fund’s life. This can be particularly daunting for newer entrants building out their first private markets portfolio. Without distributions from longer-tenured funds, years of negative and/or low returns would face the new private markets investor. Including secondary funds in the mix can optimise portfolio construction. By entering later in an investment lifecycle, and therefore closer to or during achievement of value accretion, such an initial dip is lessened in secondaries funds. In other words, by shortening the length and/or lowering the depth of the outflows and hastening inflows, secondary funds can diminish the initial j-curve of a private markets portfolio and offer cash back more quickly to the private markets investor.
The more advanced stages of investments within a secondary fund can also translate to shorter timelines to exit for the underlying assets, and therefore shorter tenures for the secondary funds relative to a primary allocation. Secondary funds can therefore offer entrance into otherwise longer-dated strategies for investors with timeline constraints.
Other potential benefits: Vintage-year diversification and discounts
Secondaries also support vintage-year diversification. Let’s revisit that same example of the private markets newcomer building out a portfolio for the first time. Different vintage funds have been subject to different macroeconomic headwinds and tailwinds and offer different levels of establishment. Diversification here can therefore offer an attractive addition to private markets investors’ portfolios. However, building up significant vintage exposure can take time. There is plenty to be had in certain multi-manager portfolios, although these are constrained by the overlap in their investment periods with those of their underlying funds. For an even broader reach, private markets investors can look to secondaries funds, which are not so constrained.
Finally, secondary investments benefit from pricing dynamics unique to the space: discounts. These provide an early mark-to-market pop for secondary funds and a cushion for incremental downside protection. However, the availability of discounts depends on a variety of factors ranging from the particularities of the seller’s circumstances, to the quality of the assets and sponsors themselves, to the relevant market environment, among other considerations. As acceptance of secondaries has grown, so too has the competition. Today, discounts are no longer a given, and secondary transactions pricing at par or even premium levels are not abnormal. As previously noted, GP-led transactions remained a relatively more nascent sub-segment for quite some time, but have been increasing in popularity in recent years. The growth has been substantial, rising from 8% in 2012 to 44% in 2020, according to Greenhill Cogent.
The bottom line
In the meantime, the various potential benefits of secondaries transactions remain. Whether it’s the solution to the illiquidity of private markets for sellers, or—for buyers—the path toward earlier-returning investments, lower j-curves, greater vintage-year diversification or shorter-dated funds, secondaries transactions remain an integral part of the private markets environment and an attractive area for investor consideration. Based on the relevant market environment and strategy of the secondary fund in question, discounts may provide additional cushion relative to multi-manager or direct approaches.
(1) Source: Pitchbook, 2020 Annual US PE Breakdown Report.
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