By Dillan Pindoria, Hassan Wahba, Nishil Lakhani, Holly Bridges, and Bhav Rambhiya (University of Nottingham)
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.