Update on Investing in Secondaries
Issues to be addressed in this research paper
In November 2016 we wrote a paper highlighting the opportunities in secondaries. At the time the space was starting to grow, with transaction volume of $40 billion in secondaries the year prior. Then, the majority – approximately 80%, or $32 billion – involved limited partners (LPs) selling their fund interest. The balance was made up of transactions generated by general partners (GPs) through spin-outs, restructurings etc.
Six years have passed. The market has grown, and changed, rather significantly. Secondary transaction volume reached an all-time high of $133 billion in 2021 and, unlike 2015, the majority of transaction volume is now accounted for by GPs rather than LPs. Given these developments, we have reviewed the secondaries space, looking at how the landscape has changed and determining whether secondaries can still provide good investment opportunities today.
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The case for investing in secondaries
Secondaries exist in order to provide selling investors liquidity, while allowing for new investors to purchase investments at attractive entry points. Given that the market is illiquid, new investors are able to purchase these assets at significant discounts to NAV. The existence of discounts can then lead to stronger annualised returns over the longer-term.
Given these discounts, there is also the potential to quickly write-up these new assets. This is part of the reason that secondaries tend not to exhibit a j-curve (initial negative returns driven by fees and expenses until capital has been deployed and investments begin to appreciate). This risk, that secondaries can mitigate, is typically associated with direct private equity or primary funds.
It is also worth remembering that when investing in secondaries, investors are allocating later in the life of the fund or underlying asset. This generally means the transaction will be de-risked to some extent, providing shorter durations as well as increased cash flow predictability. These characteristics remain key objectives for many investors, particularly institutional, across their broader portfolio.
The growth of the secondary market
The secondary market has grown significantly over the last six years. Transaction volume has risen because of the growth of primary private market funds, consistent liquidity needs from investors and increasing demand for secondary transactions because of the various benefits they are able to offer investors e.g. j-curve mitigation.
Back when we first looked at this space, the majority of the market was in LP-led deals. These are generally seen as the least complex transactions in the market. The transactions involve a secondary manager purchasing the LP positions of an institution’s (e.g. a pension fund’s) private equity portfolio.
However, GP-led deals, which generally involve a new structure or fund being set-up to hold the purchased assets, now account for half, and still a growing portion, of the secondary private equity market. This subset has seen the most growth because it is a solution that benefits both the buyers and sellers.
GPs, in older vintage funds, may hold assets with value creation potential. However, they often need more time, and capital in some cases, to realise this potential. GP-led solutions typically extend the holding period of an asset by two to five years and can provide capital to generate value through strategies such as M&A. It also means that GPs can provide a liquidity option for underlying LPs.
Within the GP-led secondaries space, it is single asset transactions that have been rising in popularity. GPs are increasingly looking at this type of deal because it allows them to retain ownership of their highest conviction assets. Additionally, the typical size of these deals has increased towards $1 billion and upwards. This has garnered interest from the larger private equity players with a specialised approach towards secondaries and the ability and willingness to underwrite large, concentrated deals.
The opportunity set
The greatest opportunity lies in the GP-led secondaries space. GP-led transaction opportunities arise as a result of misalignment between GPs and LPs in primary private equity funds. LPs will have been invested for a number of years and are looking for liquidity from their original investment. As a result, the LPs are putting pressure on the GPs to sell the underlying companies. However, for one reason or another, the GP may not be incentivised to sell the assets and would prefer to continue to hold them. GP-led transactions should provide a resolution where both GPs and LPs are happy, in addition to providing a good investment opportunity for the secondary manager.
Asset sales are the most typical GP-led transactions. This type of transaction involves the underlying companies in a private equity fund being sold into a new continuation fund. LPs within the original fund have the opportunity to roll into the new fund, alongside the secondary manager who will also be an LP in the new fund. The original GP is generally retained to continue to manage the underlying companies.
These GP-led transactions are a lot more concentrated than LP-led transactions. The secondary manager is gaining exposure to just one portfolio and the GP may also only agree to execute the deal based on them purchasing a portion of the remaining assets. The secondary manager will therefore generally get exposure to just 5-10 companies through a single transaction, but single asset transactions are also common part of the market.
In fact, single-asset GP-led deals are the fastest growing segment of the secondaries market. This is because GPs are looking to retain strategic assets where there is a strong positive selection bias (vs. selling to third parties), are able to reinvest in what they already know, can pursue value creating strategic initiatives (e.g. M&A), while providing liquidity or re-investment optionality to LPs.
Key risk factors
Key risk factors remain consistent since we originally undertook our work. For example, when a secondary buyer acquires what is – at least at that stage – an illiquid investment vehicle, they are taking a view that they will realise liquidity at some future point.
Whilst managers will do in-depth research on the GP, fund and/or underlying asset(s), they will still get it wrong every now and then. While this is a lesser problem for LP-led deals and traditional GP-led deals, it can be an issue for single asset continuation deals where there will be meaningful concentration risk.
There is also the issue of more competition in this space. Given more managers are entering the market, discounts on entry multiple are decreasing. This is, however, more of a concern in the LP-led space.
With GP-led transactions, the barriers to entry to invest are high i.e. there is usually the requirement of a primary and secondaries platform. This has meant that there is not much competition in the GP-led space and even less in the single asset continuation space where there is usually a need for direct private equity capabilities.
The new risks that pose a threat to this sector, which were not apparent six years ago, are the lofty valuations and higher entry multiples. There is clearly a risk of a pronounced market correction. First, as interest rates rise, the discount rates used to calculate company valuations increase and company valuations decrease. Secondly, as the credit cycle enters a downturn and defaults increase, the cost of financing will increase as lenders become less inclined to lend at a given price. Moreover, inflationary cost pressures and the resulting margin pressure pose a real threat to just about any portfolio company.
Conflicts of interest and reputational risk
GPs involved in these secondary deals have a financial interest on both sides of the transaction, as they are essentially selling to themselves. This can mean that existing investors, which would likely include various pension schemes and other institutional clients, could be worse off. GPs would argue that they offer these existing investors the option of rolling their interests into the new fund or cashing out.
However, setting up a new fund means that the GP gets to restart the management fee process, which becomes more lucrative (private equity fees are typically higher earlier in the fund’s life i.e. the investment period). Also, these transactions would often happen without a competitive sale process, which means that existing investors may not be getting the best possible price (which is somewhat evident from the discount that secondary managers are able to obtain).
With significant dry powder in the market, in combination with the slowdown in IPOs and strategic sales given a potential recession looming, the number of GP-led continuation vehicles will only rise. As this happens, it is likely that a greater number of direct private equity investors will be worse off.
To avoid/lessen the impact of these issues, it is important that GPs disclose all risks and conflicts associated with a transaction and seek opinions from independent, third-party providers. As an obvious example, GPs should look for independent valuers to verify numbers and prices. It would also be reassuring to require Limited Partner Advisory Committees (LPAC) or investor approval of the transaction terms, particularly the sale price.
We still believe that investing in secondaries remains a good opportunity and remain favourable on all of the various underlying types of secondary deals. Both LP and GP-led deals are attractive in their own right and provide different characteristics. The one thing to note is that there is much more competition in the LP-led space, which is resulting in entry discounts that are not as attractive. Therefore, we would favour GP-led deals over LP-led deals.
Having said that, we do believe the greatest opportunity within the GP-led space lies with single asset continuation vehicles. This part of the market has seen the most growth recently and is expected to grow significantly in the next few years.
The number of private equity funds has risen considerably and is likely to continue to do so. This has meant that more GPs have and will want to retain their highest conviction portfolio companies whilst providing the necessary liquidity to LPs. As such, the supply of these transactions will rise while demand is unlikely to keep pace (as deal sizes rise and the barriers to entry to invest in secondaries are high). This could present an opportunity for even better entry discounts in the short to medium-term.
A fund investing in this space may have 10-15 GP-led deals, which is represented by 10-15 single assets/companies. This looks more akin to a typical private equity portfolio, while providing the benefits of discounted entry multiples and high conviction assets, which means greater returns can be generated. However, this comes at the cost of diversification and shorter durations that an LP-led or traditional GP-led portfolio of assets are able to provide.
6 July 2022