An Investor's Playbook for Private Equity Secondaries

Introduction to Private Equity Secondaries

An equity secondary transaction is when existing investor commitments to equity funds or portfolios of direct company investments are sold. This involves transferring equity interests from one investor to another before the fund or investment reaches its planned end.

The equity secondary market has become a platform for buyers and sellers of these secondhand, private company's equity assets. It offers investors who want to exit a way to access liquidity while allowing new investors to get involved with a portfolio of private companies.

Private equity secondaries funds have gained popularity in years, appealing to both limited partners and general partners. For partners or investors in funds, secondaries provide an opportunity for exits and the ability to rebalance their portfolios.

With large volumes of dry powder capital and high valuations in the private equity industry, secondaries are becoming increasingly crucial. As more investors embrace their advantages and the market infrastructure improves, private equity and secondaries investments are expected to proliferate further.

Types of Secondary Transactions

There are four major types of private equity secondary market transactions:

Sale of Fund Interests

This is the most common and straightforward secondary transaction in private equity investment. Limited partners (LPs) sell all or part of their stakes in a private equity fund to a new LP. The buyer takes over the remaining investment obligations and becomes entitled to potential future returns, providing liquidity to the selling LPs.

Some LPs sell fund stakes to rebalance their portfolio or exit underperforming funds. Others may need liquidity for organizational reasons. Selling fund interests can also allow LPs to avoid management fees and other expenses for the remainder of the fund's duration.

Structured Joint Ventures

In a structured joint venture secondary, a general partner (GP) and one or more LPs partner together. The LPs contribute their fund stakes into a new vehicle managed by the GP. The GP can then sell some or all of the underlying company assets from the contributed fund stakes, providing partial or full liquidity to LPs. Any remaining assets are jointly managed for potential future returns.

Securitization

Securitization involves pooling and structuring portions of private equity fund assets into securitized notes. The notes are then sold to institutional investors to provide liquidity. For example, a GP might bundle interests from 10-15 funds into a collateralized fund obligation (CFO). The CFO issues fixed-income notes secured by the basket of fund assets. This allows LPs early liquidity without finding individual buyers for fund stakes.

Stapled Secondary Transactions

In a stapled secondary, an LP commits capital to a new primary fund from a GP while also selling its stakes in that GP's older existing funds in common secondary transaction. The primary investment fund commitment and secondary sale are negotiated together or "stapled," allowing the LP to optimize liquidity from older funds while maintaining exposure to the GP for future investments.

Participants in the Secondary Market

There are several key players in this niche market of the private equity secondary market:

Limited Partners (LPs)

These investors are usually institutions such as pension funds, endowments, foundations, financial institutions, and insurance companies. They invest their money in equity funds as partners. If an investor wishes to withdraw from a fund to manage their portfolio or gain liquidity, they can sell their partnership stake in the assets of the funds on the market.

General Partners (GPs)

The general partners are the private equity firms that raise and manage the funds. They facilitate secondary transactions on behalf of their LPs. GPs may also initiate secondary deals to generate liquidity and management fees.

Secondary Buyers

These are dedicated secondary funds and institutional investors that purchase secondaries as an investment strategy. Well-known secondary fund managers and buyers include Lexington Partners, Goldman Sachs, Carlyle, Blackstone, and Coller Capital.

Intermediaries

In the market, placement agents and advisors play a role as middlemen connecting buyers and sellers on investment strategies. Their tasks include assessing the worth of fund stakes finding buyers or sellers bargaining on deals and finalizing transactions.

The secondary market enables LPs to exit private equity investments and secondary buyers to make private transactions and take investor capital to purchase these assets at a discount. GPs oversee the transactions, while intermediaries facilitate the deals between buyers and sellers.

Benefits of Secondary Investments

Secondary investments provide an alternative investment with several key advantages to investors compared to traditional private equity fund investments.

Early Liquidity

Unlike primary investments, which often have 10-plus-year fund lifecycles, many secondary investments can provide liquidity and cash distributions much earlier in the fund timeline. By purchasing existing LP stakes, secondary investors acquire more mature assets that are already partially realized. This means earlier exit events and distributions than if investing in a new blind pool primary fund.

Diversification

Secondary funds allow investors to gain exposure to a diversified portfolio of private equity funds and underlying companies through a single secondary fund investment. This provides broader diversification than investing in private equity interests in a single primary fund. Secondary funds can purchase partial stakes across dozens of private equity funds to provide a diversified basket of assets.

Lower Fees

By acquiring existing fund stakes instead of committing to new primary funds, secondary investors can avoid the higher fees and expenses charged in the early years of a private equity fund lifecycle. This cost advantage is very appealing to limited partners.

Risks and Considerations for Secondary Investors

The private equity secondary market comes with certain risks and considerations that investors should keep in mind:

Information asymmetry

In the market for equity funds, it is often challenging to have complete transparency regarding the underlying assets and performance. Investors may not have insight into the company's financials, operations, and other relevant factors. Consequently, accurately determining the value of these assets becomes a task.

Pricing complexity

Valuing illiquid private company stakes is inherently challenging. Traditional valuation methods don't always apply. Factors like projected growth, exit environment, and portfolio company performance add complexity. This can lead to pricing discrepancies between buyers and sellers.

Lock-up provisions

Many private equity funds have lock-up periods that restrict liquidity. Investors who acquire secondary stakes cannot exit or redeem for a certain period, often multiple years. There are also limited options to sell stakes, with drawn-out transaction timelines.

Investors who are considering investments should be comfortable with taking on risks and having a long-term outlook. The limited ability to quickly convert assets into cash and the lack of information may not be ideal for those seeking access to funds.

Conducting research and having expertise in transactions and valuing companies can help reduce the associated risks.

Recent Trends and Growth

The secondary stock market has seen growth over the decade with unallocated funds and secondary transaction volume values hitting record highs. This expansion can be attributed to trends:

Unallocated Funds Increase:

The amount of capital committed to funds but not yet invested soared to over $100 billion in 2020 which is more than triple the 2010 figure.

Emergence of GP-Led Deals:

Deals led by equity partners now represent over half of the transaction volume which is a substantial increase from under 20% in the mid-2000s. GP-led deals provide customized liquidity solutions for limited partners.

Institutional Adoption:

Asset owners such as pensions have been increasingly adopting secondaries to manage their equity portfolios efficiently. Secondaries offer institutions the opportunity to adjust their exposures and improve diversification.

The growth trajectory of the secondary market reflects the maturation and mainstream acceptance of secondaries as an asset class. With LP demand for liquidity increasing, secondary deal flow will likely remain strong in the years ahead as the market evolves.

Valuation and Pricing

Valuing and pricing secondary private equity investments can be complex given the illiquid nature of many private equity international and company assets. Some of the main valuation methodologies used in the private equity secondary market include:

Discounted Cash Flows (DCF)

• A DCF model projects a company's or asset's future cash flows and discounts them back to the present using a required rate of return. This helps determine the investment's net present value.
• DCF requires assumptions on expected cash flows, terminal value, and discount rates and relies heavily on forward-looking projections.
• For private secondary deals, DCFs depend on the quality of data available on the underlying companies and assets in the fund portfolio. Information asymmetry can be a challenge.

Comparable Transactions

• This estimates value based on multiples paid for similar assets and companies in recent transactions.
• Common comparable multiples include Enterprise Value/EBITDA, Price/Earnings, etc. Reliable comps require access to private deal data.
• Comparables help gauge value if a secondary stake holds companies in sectors with robust transaction activity and data availability.

Net Asset Value (NAV)

• NAV reflects the value of a fund's underlying portfolio as marked to market by the fund manager.
• NAV-based valuation requires access to up-to-date valuations. Information lags can make this methodology challenging.
• Some secondary transactions apply haircuts or premiums to reported NAVs to account for timing and information issues.

The interplay of these methodologies and proprietary valuation models gives secondary buyers a toolkit to assess and negotiate deal pricing. Market dynamics ultimately determine the value investors are willing to pay.

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