By Dillan Pindoria, Hassan Wahba, Nishil Lakhani, Holly Bridges, and Bhav Rambhiya (University of Nottingham)
Photo: Maxim Hopman (Unsplash)
What Is The Secondaries Market?
Private equity funds are typically organised as limited partnerships, where investors - referred to as Limited Partners (LPs) - commit capital throughout the fundraising process. The capital commitments are managed by a General Partner (GP), who is responsible for managing the fund and will have a fee structure that includes both a management fee (generally 2%) and a performance fee (usually 20%). The performance fee is usually paid on profits above a certain threshold, known as the hurdle rate, which helps keep both the GP and LPs interests in line.
Private equity is classed as an illiquid investment due to fund mandates typically lasting between 10-12 years. The secondary market provides LPs with an opportunity to exit early from their investments before the end of the mandate period. If an LP wants to make an early exit, liquidate assets, or rebalance its portfolio, the secondary market is usually its only option. Secondary transactions can be structured in several ways depending on the circumstances and stakeholders involved.
The most common transactions are LP-led (See Figure 1). LP-led transactions are when an existing LP sells its interests to a secondary buyer. The buyer then replaces the LP with all their rights and future obligations, including remaining open commitments. Another transaction type is GP-led transactions, such as single or multi-asset continuation funds. GP-led transactions, which are becoming increasingly popular, involve transferring the portfolio companies to a new fund that enables additional follow-on capacity and, consequently, extended hold periods. The GP then offers its LPs the option to roll over into the new fund or exit by selling their interests to a secondary buyer. GP-led transactions can take several forms, such as tender offers, strip sales, and stapled transactions.
For LPs, secondaries offer an opportunity to manage what would otherwise be an illiquid private equity portfolio. They can create new cash streams ready to deploy into new investment opportunities. Along with the assets and interest, the selling LP also waives any outstanding future capital calls, allowing them to free even more capital for other investments.
The growth of the private equity secondaries market has been accelerating rapidly over the last 15 years, evolving both in transaction size and volume. Between 2019 and 2020, there has been a 23.4% rise in AUM from $243bn to $300bn in the private equity secondaries market. The market has seen a dramatic change, especially after the COVID-19 outbreak. Secondaries flourished in the extreme circumstances of the pandemic because of their flexible and innovative nature. Initially, the market activity in the secondaries was low (concerning the forthcoming jump); however, after the economy started recovering, it raised roughly $87 billion in 2020, which was almost three times the amount raised in 2019.
Investment banks, particularly independents, have supported this market by providing specialist advice to GPs. Firms like Goldman Sachs, Houlihan Lokey, and Jefferies started secondary advisory practices after GP and LP-led deals evened out in volume. Notably, Evercore PCA and Greenhill are the largest advisories, representing $510bn of transactions as of 2021. Evercore PCA acted as the secondary intermediary in a GP restructuring transaction worth $2.5bn between sellers Leonard Green & Partners and buyers HarbourVest Partners and AlpInvest Partners. This trend is a significant contrast to 10 years prior, when transactions such as acquiring an $800 million portfolio by the same buyer, AlpInvest Partners, from seller CalPERS, were considered milestone transactions.
Growth Drivers & Value Creation
With primary markets containing illiquid asset classes, the secondary market provides LPs with early liquidity. Typically, LPs are committed to funds for long periods, receiving returns upon fund liquidation. However, LPs can gain early access to returns by selling their interest in the funds via the secondary market. This allowance lets LPs rebalance and diversify their portfolios in the short run rather than waiting for fund liquidation. Therefore, they can adapt better risk management by reacting faster to market conditions and regulatory changes.
The secondary market also offers buyers many benefits, with the first of these being J-Curve mitigation. The J-Curve describes the typical trajectory of investments made by a private equity firm, where negative returns are typically seen within the initial investment phase (See Figure 2). Given that there is a motivated seller, the secondary market allows LPs the potential to ‘skip’ these outflows, enabling them to benefit from returns seen in the realisation phase, particularly if the interest is acquired at a discount to the net asset value (NAV).
Another benefit is that secondaries hold a more attractive risk/return portfolio than funds. Secondaries reflect a higher IRR while carrying a lower risk of capital invested not being returned (see Figure 3). This higher IRR can be attributed to the shorter holding periods within secondary investments and the recognition of gains if the interest is acquired at a discount to the NAV. Risk levels associated with funds like venture capital are notoriously high; however, secondary investments mitigate this. Typically, by the time an LP secures an interest in a secondary investment, visibility on the financial and operating performance of the underlying portfolio companies is clearer, reducing risk due to increased information.
Challenges Of The Secondaries Market
The most apparent challenge is the time-intensive nature of secondary transactions: initial fundraising, valuing these complex structures and executing the deals. Secondaries transactions are often fast-paced, meaning short time frames for LPs and GPs to complete their due diligence checks. These checks lead to challenges within the secondary market intensified by the ESG involvement, intricate negotiations, and information asymmetry.
ESG integration has become a major factor in decision-making for secondary investments. LPs are increasingly restricting their investments to only transactions aligned with their values and stringent ESG guidelines. Underlying assets are often assessed using ESG Metrics to comply with these strict guidelines. However, this further complicates the due diligence process due to non-standard data and reporting methods. Consequently, ESG due diligence for secondary transactions can be one of the most challenging compared to any other asset class for fund managers.
In addition, there has been an increase in GP minority investments – where GPs invest alongside LPs in GP-led transactions – which can lead to conflicts of interest. This has been a significant challenge for LPs as this transaction type has become more common in the secondary market.
The private equity market is inherently opaque – it is difficult to source the information required for both LPs and GPs to produce accurate valuations. Hence, GPs and LPs have increased their transparency to resolve the challenges above. These partners provide fund agreement provisions and documentation to give more clarity on the execution of transactions and subsequent management of the funds. In addition, we have seen the rise of specialist external advisors to verify valuations which have become more critical to mitigating any conflicts of interest.
As the secondary market continues to grow, the market will naturally become more efficient and resolve many of these challenges by introducing regulation and more standardised processes in what has previously been a relatively niche market within the private equity space.
Although the secondaries market has started to mature and become mainstream amongst private investors, there is significant upside potential that the market will realise over the next few years, especially as GP-led deals have not hit their peak. APAC secondaries fundraising is rapidly evolving and is yet to experience the level of growth that more dominant regions such as North America and Europe have already seen.
In China, institutional investors' demand for alternative liquidity solutions has been high. Government policy, such as the introduction of the Beijing Equity Exchange Centre (BJOTC), has helped meet this demand by acting as an intermediary to transfer fund interests in the secondaries market. Naturally, the effect of a 62% increase in fundraising from H1 2021 compared to the entirety of 2020 (See Figure 4) has attracted more experienced fund managers to the Asia-Pacific. This increase in capacity should translate into increased GP-led deals over future years, as APAC investors become more experienced sellers that use secondaries as a portfolio management tool.
Another area that can become a notable part of the secondary market is the private debt asset class, which has a forecasted market volume of $14 billion by the end of 2024. For the most part, this is being driven by the matured primary private debt market - which has surpassed $1 trillion AUM. However, more recent macroeconomic factors such as the pandemic, easing of government stimulus, and hikes in inflation and interest rates have had a significant effect on the growth potential for secondary private debt. This is because such conditions have created a macroeconomic environment that has incentivised sales of fund stakes by LPs and created stronger liquidity demands by debt managers.