Private-equity secondary market: What Investors Need to Know

The private-equity secondary market is a complex and often misunderstood space. It's not just for institutional investors, but also offers opportunities for individual investors who are willing to take on some risk.

The secondary market is a platform where investors can buy and sell existing private equity stakes, allowing them to gain exposure to a diverse portfolio of companies. This can be a more efficient way to invest in private equity than going through a traditional fund, with some investors able to achieve returns of 8-10% per annum.

The secondary market is also a great way for investors to gain liquidity, as they can sell their stakes if they need cash.

Private equity is a type of investment where a firm or individual provides capital to a private company, with the goal of eventually taking the company public or selling it for a profit.

Private equity firms typically invest in companies that are undervalued or have growth potential, and they often take an active role in managing the company to increase its value.

Private equity firms can be categorized into various types, including leveraged buyout firms, venture capital firms, and mezzanine capital firms.

Private equity investments can be made through various means, including direct investments, funds, and secondary market transactions.

Private equity firms often use debt financing to supplement their equity investments, allowing them to invest more capital in each deal.

The private equity industry has grown significantly over the years, with global assets under management reaching $1.3 trillion by 2020.

Private equity firms typically hold onto their investments for around 5-7 years, during which time they work to improve the company's operations and increase its value.

Private equity firms often generate returns through exit strategies such as initial public offerings (IPOs), mergers and acquisitions, or sales to strategic buyers.

Private equity firms are governed by a general partner and limited partners, with the general partner responsible for managing the fund and making investment decisions.

The private equity industry is subject to various regulations, including the Investment Company Act of 1940 and the Securities Act of 1933.

Private equity firms often have a significant impact on the companies they invest in, driving growth and innovation through strategic investments and operational improvements.

The private-equity secondary market has seen a significant growth in recent years. The total volume of secondary deals hit a record high of $132bn in 2021, far surpassing the previous record of $88bn set in 2019.

The sector has swelled to three times its size over the past decade, with secondary buy-outs now exceeding the volume of initial public offerings in the United States. This is a major sign of the market's growth.

Private markets are becoming increasingly sophisticated, with a broader range of participants entering the market. Pension funds, sovereign wealth funds, family offices, endowments, and foundations are now part of the secondary market.

GP-led deals, where general partners provide liquidity for their existing LPs, are becoming a significant part of the secondary market. These deals accounted for 48% of the total secondary transaction volume in 2022, up from 30% in 2019.

The secondary market is not just about gaining liquidity, but also about strategic realignment of an institution's portfolio. Secondary transactions can help investors reduce the number of GP relationships, meet regulatory changes, and address shifting allocation mandates.

The private-equity secondary market offers a range of benefits and opportunities for investors. Secondary markets provide liquidity for existing investors, allowing them to exit their investments and realize returns.

One of the key benefits of secondaries is that they give investors access to a diversified portfolio of underlying investments, managed by experienced general partners (GPs). This diversification can reduce overall portfolio risk and provide a more stable return profile.

For those seeking to gain private equity exposure but are concerned about the duration or significant gap between making a commitment and receiving distributions, secondaries offer a mitigated J-curve and a faster return of capital. This can be particularly attractive for investors who need to free up money for other investments or expenditures.

Here are some of the key benefits of investing in secondary private equity markets:

These benefits make the private-equity secondary market an attractive entry point into private markets, offering investors a unique risk and return profile.

A GP-led secondary is a type of private equity transaction led by a fund manager, or general partner. They sell part or the whole of their fund to a secondary investor.

In a GP-led transaction, the existing limited partners, or LPs, in the fund have the option to roll their assets over to the new vehicle or cash out. This can be a complex process, but it allows the GP to hold onto their portfolio of assets while some LPs exit.

GP-led transactions often take the form of a continuation vehicle, which is a new fund that allows the GP to keep their assets and some LPs to retain their investment. This is a popular model, especially for GPs who want to focus on their preferred individual assets.

The total value of GP-led transactions hit $68 billion in 2021, more than double the value in the previous year. This is a significant increase, and it's more than half the total value of secondary fund transactions in 2021.

The secondary market in private equity offers numerous benefits to investors. It provides liquidity for existing investors, allowing them to exit their positions and free up capital for other investments.

One of the key benefits of secondary markets is that they offer cheaper prices due to forced sellers. This discount to net asset value (NAV) is a major appeal to new investors.

Secondary markets also give general partners (GPs) an approved and accepted continuation vehicle. This allows GPs to avoid selling down their assets when they might not want to, and instead continue to manage the portfolio as they see fit.

Investors can access many underlying portfolio investments through secondary markets, which can reduce overall portfolio risk through diversification. This is because secondary markets assume pre-existing commitments in multiple funds, making them more diversified than primary private equity funds.

Here are some of the key benefits of secondary markets in private equity:

These benefits make secondary markets an attractive option for investors seeking to gain private equity exposure with less risk.

The private-equity secondary market has its drawbacks, and it's essential to be aware of them before investing. Illiquidity is one of the main challenges, as private equity investments can be difficult to exit before the fund's completion.

Private equity transactions often lack transparency, making it hard to determine an investment's fair worth. This can lead to investment losses due to improper pricing. High transaction expenses are another issue, with private brokers often charging high fees for their services.

Here are some of the key challenges and risks to consider:

Private equity secondaries can be a great way to gain exposure to private equity investments, but they come with their own set of challenges.

One of the main difficulties is illiquidity. Private equity investments can be difficult to exit prior to the fund's completion, which can make it hard to access your money when you need it.

The secondary market's cash flow profile depends on distributions, which can be uneven. This means that investors need to choose experienced managers who have a keen eye on down-market protection and have a demonstrated record of getting through market cycles.

The valuation of companies in the secondary market can be challenging to determine, and the assets' actual value may differ from the price paid.

Transaction expenses can be high, especially when private brokers are involved. These expenses can eat into your returns and make it harder to achieve your investment goals.

Here are some of the main challenges of private equity secondaries:

Overall, while private equity secondaries can offer unique benefits, it's essential to be aware of these challenges and choose experienced managers who can navigate them successfully.

Blind Pool Risk is a significant concern for investors in primary funds. Investors in primary funds don't know in advance what investments the fund manager will make, which can be unsettling.

This uncertainty is known as blind pool risk. It means investors are essentially betting on the fund manager's ability to make smart investment decisions without knowing the specifics.

Investors in secondaries, on the other hand, can mitigate this risk by investing in existing commitments. This gives them visibility into potential future performance and allows for due diligence, which is crucial in making informed investment decisions.

By knowing which assets they are acquiring, investors in secondaries can make more informed decisions and potentially avoid costly mistakes.

A secondary transaction in the private-equity secondary market involves the purchase and sale of an investor's existing commitment to a PE fund.

The original LP in a fund sells its position in the secondary market, which includes both its current investment in the PE fund and any unfunded future commitments to the fund.

LPs are contractually bound to the fund partnership for at least ten years, providing a consistent source of committed capital to the GP.

The GP requires a consistent source of committed capital to execute on their investment strategy, but LPs may seek to withdraw from their obligation to the fund before the fund's term has ended.

The acquisition of an existing LP commitment, including fair compensation for the value of the investments already made, marks the beginning of a traditional secondary transaction.

Secondary transactions effectively work as an exchange, where the buyer is acquiring another LP's access to the fund, including its exposure to the existing portfolio and commitment to paying off any remaining capital to the GP.

This reduces blind pool risk in secondary transactions because buyers are purchasing existing assets and portfolios, rather than committing capital into a blind pool of future investments.

The private-equity secondary market has seen a remarkable growth in recent years. In 2021, the total volume of secondary deals reached a record high of $132 billion, far surpassing the previous record of $88 billion set in 2019.

This growth is part of a broader trend that has seen private markets swell, with the sector now three times larger than a decade ago. The sheer value of trades in the secondary market is a testament to its increasing importance.

By most measures, the private equity secondary market is a major player, with secondary buy-outs now exceeding the volume of initial public offerings in the United States. This is a significant shift from the 1990s, when the first secondaries funds were formed with tens of millions of dollars of committed capital.

The market's growth is also fueled by the increasing need for liquidity solutions outside traditional routes. In tougher economic conditions, GPs tend to hold assets longer, leading to fewer distributions for LPs and driving further interest in secondary transactions.

The widening of discounts has made secondaries an attractive opportunity for investors to make cheap additional investments in private equity. This, in turn, has increased competition in the market, as many investors look to expand their private equity allocations.

The secondary market has also become more sophisticated, with a wider range of liquidity options and solutions available. This includes access to all strategies, investment types, fund maturities, and funding levels.