The secondary private equity market comprises the buying and selling of preexisting investor commitments to private market funds. Secondary funds (secondaries) purchase these existing commitments from limited partners (LPs) seeking to exit primary private equity funds before they are fully liquidated. In recent years, the secondaries segment has grown and matured, and may offer significant appeal to investors.
Exhibit 1: An Overview of Secondary Transactions and Participants
Source: Capital Dynamics. For illustrative purposes only.
An accessible entry point into private markets
Secondaries offer several potential benefits for investors and may represent a particularly attractive entry point relative to primary private equity funds because of their unique risk and return characteristics.
Diversification: Secondary funds are typically more diversified than primary private equity funds (such as growth equity or buyout funds) because they assume preexisting commitments in multiple funds. As such, secondary funds often offer significant diversification across managers, industries, geographies, strategies, and vintage years. This diversified approach has the benefit of offering private equity exposure with less risk compared to an investment in a single primary private equity fund.
Shorter duration and faster return of capital (mitigated J-curve): In primary private equity funds, it typically takes five to six years to deploy capital, and it can be several years before investors start receiving distributions. By contrast, secondary strategies deploy capital faster and distributions typically begin quickly – in some cases as soon as the fund’s inception – because they are investing in mature underlying funds. This mitigates the private equity J-curve, in which primary private equity funds typically have “negative” returns in the first few years (as investors have to pay management fees and initial investment costs from day one), that then turn into positive returns as the underlying investments mature and start to generate returns that significantly outweigh the fees and expenses. Exhibit 2 illustrates the typical return profile of a primary private equity fund versus a secondary fund.
Exhibit 2: Typical Return Patterns of Primary and Secondary Private Equity Funds
Source: iCapital Network. For illustrative purposes only.
Discounted access to private equity funds: The ability to exit private equity funds early has historically come at a price to sellers – secondary fund managers would buy preexisting interests in funds at a discount to their net asset value (NAV). As the market has become more competitive, that discount has declined but secondary portfolios today still trade at an average of 93% of NAV.1 Investors benefit immediately from this discount as well as any value creation that takes place subsequent to the investment.
Limited blind pool risk: Investors in primary funds don’t know in advance what investments the fund manager will make. This is known as blind pool risk. Secondaries mitigate blind pool risk by investing in existing commitments. In other words, they know which assets they are acquiring before they invest, enhancing the potential for due diligence and providing visibility into potential future performance.
The state of the market: challenges and opportunities
In recent years, the secondary market has matured and become more competitive. This translates into tighter pricing for its assets. Many secondary portfolios are now purchased at cost, or even for a premium. Large buyout funds are selling at a record-high 100% of NAV. The use of leverage has also increased, whether through credit lines, deal-specific structuring, or other third-party leverage. In fact, since 2013, the number of leverage providers within secondaries has more than doubled.
Elevated pricing levels have, in turn, led to compressed return expectations. Overall, those managers who succeed in identifying assets outside of competitive auctions or in proprietary situations—or where they benefit from an information advantage—are likely to outperform.
Another element for investors to consider is that, while secondaries can provide a mitigated J-curve and faster return of capital, the cash flow profile of secondary funds is reliant on distributions. If distributions slow (as they might in a recessionary market environment), return profiles could lower. Therefore, it is important to select disciplined managers who are keenly focused on downside protection and incorporate such scenarios into their modeling assumptions.
For high net worth investors, the secondary private equity market offers several potential unique portfolio benefits. For investors seeking to gain private equity exposure through a primary fund but concerned about the duration or significant gap between making a commitment and receiving distributions, secondary funds may be an attractive option. As with any private equity investment, manager selection is critical to realize the benefits of these strategies.
1) Source: Triago Quarterly October 2019.
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