Secondaries: The Saviour of Private Equity?

Ever since the origins of the modern private equity industry in the 1940s, the biggest deterrent for investors has been illiquidity. Investors, known as Limited Partners, are typically required to commit capital to funds that are managed by a General Partner for ten or more years. The development of a private equity secondary market that allows investors to sell their positions in a fund during the investment period was therefore both necessary and inevitable. In a typical secondary transaction, the buyer assumes the rights and obligations of the existing Limited Partner within the fund after a price has been agreed.

While the first secondary firm was set up in 1982, private equity secondaries were very much a localised phenomenon until the turn of the millennium, with less than US$3.6 billion raised from 1991 to 1997. It took the dot-com crash of 2000 for the fringe secondary market to develop, as investors looked for an early exit from their commitments and were often willing to accept cents on the dollar. In the following decade, the secondary market transformed from one characterised by distressed sellers and heavily discounted assets to a robust marketplace with steady transaction volumes and an integral part of the private equity industry.

The onset of the global financial crisis led to tighter regulations being imposed on the private equity industry, such as Basel III, and new economic realities for investors, thus prompting many Limited Partners to unload their commitments via the secondary market. As a result, secondaries transaction volume leapt to almost US$38 billion in 2014.

Now, with a record US$24.3 billion in secondary transactions in the first half of the financial year, 2017 has been a very promising year for secondaries. Although the average deal size has remained constant since 2014, the number of transactions has increased year-on-year. There were 874 transactions in H1 2017, representing a 67% increase from H1 2016. This implies that the activity of small and medium buyers has grown to be more significant in recent years as the market becomes more accessible.

The desire for sellers to unload their position in the Limited Partnership is driven almost entirely by the need for liquidity. Most often, this is because of the individual motivations of the seller rather than the quality of the fund or its General Partner. Demand for liquidity may arise from the inability to finance future commitments, desire to reallocate positions within a portfolio or shifts in overall investment strategy away from the private equity space.

The allure of the secondary market for buyers, as opposed to the primary market, lies in the relative speed with which capital is returned – typically three or four years, instead of ten years or more. In addition, secondaries provide a lower risk profile due to the ability to evaluate actual investments in a mature fund, instead of only looking at the General Partner’s track record. This results in a diminished risk of losing capital. The Total Value to Paid-In (TVPI) ratio measures whether a fund has provided a return on investment and a ratio below 1 indicates the fund failed to provide a return. Just 1.4% of secondary funds exhibited TVPI ratios below 1 compared to 22.8% of direct private equity funds. It is important, of course, to note that exceptional returns occur less frequently in the secondary market - the average TVPI of secondary funds is approximately 10% lower than primary funds. That said, it is only reasonable to sacrifice some potential gains for significantly lower risk.

In a portfolio context, mixing secondary investments into a private equity portfolio can allow for a smoother cash flow profile, due to shorter holding periods than primary commitments. Investors are also able to build up private equity exposure and deploy capital much faster and in a diversified manner. Notably, secondary funds provide investors with the means to add vintage year diversity to an existing portfolio by ‘back-filling’ it with historic vintages, which is particularly valuable to investors that are new to the private equity asset class.

Secondaries are seeing unprecedented growth across all scales. The trend towards the most established players raising even larger ‘funds of funds’ continues to be maintained, with Ardian Secondary Fund VII becoming the biggest ‘fund of funds’ when it closed at US$10.8 billion in 2016. In addition, the removal of intermediaries by online platforms is persuading smaller investors to venture into the secondary marketplace. By providing a simple way to generate liquidity for sellers and having a strong risk-adjusted return profile that attracts buyers, the future of the private equity secondary market looks promising.

Citations:-

https://www.capdyn.com/media/1930/capital-dynamics-secondaries-white-paper-3rd-ed-june-2016.pdf

https://www.secondarylink.com/static/files/1a74e00f-a900-4ca5-b26f-8795cedbc5c8/KP/LZ/0f524602789a11e78399874e222c8f50_Setter_Capital_Volume_Report_H1_2017.pdf

https://www.secondarylink.com/static/files/1a74e00f-a900-4ca5-b26f-8795cedbc5c8/L4/4E/a5f723f834c911e7b055d72e8f817b02_Setter_Capital_Volume_Report_FY_2016.pdf

https://www.preqin.com/docs/reports/Preqin-Secondary-Market-Update-Q2-2016.pdf

https://www.collercapital.com/about-secondaries/history-secondaries