Secondaries Investor

Introduction to Secondaries Investors

Secondaries investors play a crucial yet overlooked function within private equity. While many are familiar with equity funds directly investing in companies, secondary investors specialize in acquiring existing stakes and assets from private equity funds.

Secondary investors bring liquidity to the equity market by purchasing interests from partners and investment portfolios from other fund managers and asset owners. This allows fund managers and investors to exit positions, adjust their portfolios, and secure capital for supporting investments.

Over the decade, the secondary market has experienced growth transitioning from a niche sector to a substantial part of the private equity landscape with assets under management exceeding $100 billion. With the maturation of this market, institutional investors are increasingly drawn to investing for diversification and higher returns.

This piece delves into the intricacies of the mechanics, participants involved, and evolving business trends that shape investors' environments. It offers an in-depth exploration of this vital yet often misconstrued aspect of equity and alternative investments.

Defining Secondaries Investors

Private Equity Funds and Private Equity Secondaries

Secondary investors have a role in the equity domain as specialized entities that acquire pre-existing fund interests and assets from limited partners (LPs) seeking liquidity.

Secondary investors differ from equity funds as they acquire LP stakes in various funds, such as private equity, venture capital, real estate, infrastructure, and private debt. They aim to profit by purchasing these market assets below their net asset value.

Several key characteristics define secondary investors:

• They are professional investment firms that actively seek and source secondary deal opportunities from LPs across the globe. Their dedicated in-house teams have deep expertise in valuing and underwriting secondary assets.
• They aim to provide liquidity to LPs seeking an exit before a fund's term ends. This enables LPs to rebalance and optimize their private market portfolios.
• They have a medium to long-term investment horizon, often holding secondary assets until the underlying funds mature. This contrasts with traditional private equity's 10-12 year lock-up periods.
• They utilize leverage and specialized strategies to enhance returns. Investment strategies like tail-end funds, GP-leds, co-investments, and direct secondaries are commonly used.
• To mitigate risks, they focus on building diversified portfolios across vintages, sectors, regions, and asset classes. Portfolio construction and active management are key.

Secondary investors specialize by offering liquidity in an otherwise highly illiquid market while aiming for favorable risk-adjusted returns. Their capital enables LPs to meet their portfolio objectives and drives efficiency for the overall private markets.

The Role of Secondary Investors in Providing Liquidity

Secondary investors play a part in providing liquidity within private markets. In contrast to the public markets, private equity investments are illiquid, and capital is typically locked up for 5-10 years or longer. This creates a challenge for limited partners (LPs) like pension funds, endowments, and sovereign wealth funds, which have ongoing liquidity needs.

This is where secondary investors can provide a solution. Secondary investors inject liquidity into private markets by acquiring LP interests and portfolios containing established equity assets. They enable LPs to exit investments adjust their portfolios, and raise capital for ventures. With this liquidity support, it would be easier for LPs to actively manage allocations across funds and vintage years within the private market space.

General partners (GPs) also provide liquidity options through GP-led transactions. This allows GPs to right-size portfolios, crystallize value earlier, and roll assets into new continuation vehicles. Ultimately, the secondary market plays a role in fostering the operation and expansion of the broader private market ecosystem. Dedicated secondary buyers and funds have been largely driving the growth of private equity over the past decade.

Key Differences from Private Equity 

Private equity funds and secondary investors have different investment focuses and strategies leading to variations in time horizons, risk profiles, and return expectations.

Private equity funds typically adopt a long-term approach by building and enhancing portfolio companies over 5 to 7 years or more. They aim to improve operations and drive business transformations while taking on risks to achieve returns.

On the other hand, secondary investors concentrate more on shorter-term purchases and sales of existing private equity assets. Their investment horizon is 2-4 years as they seize valuation discrepancies and arbitrage opportunities. Secondaries investors take on less risk and leverage. Their expected returns are lower than private equity but higher than public markets.

While private equity creates value by building businesses, secondary investors unlock value by providing liquidity and facilitating asset transfers.

Secondaries Funds and Managers

Secondaries funds are private equity vehicles that focus on acquiring existing private equity fund interests from limited and general partners in the secondary market.

Similarly to traditional private equity funds, secondary funds are structured as limited partnerships where investors contribute capital that is managed by a fund manager or general partner (GP) in charge of sourcing deals, evaluating opportunities, executing transactions, managing assets, and eventually distributing proceeds to limited partner (LP) investors.

Some key aspects of secondary fund structures include:

• Closed-end funds: Secondary funds typically have 10-12-year lifecycles. Capital is locked up for the duration with no redemption rights.
• Blind pools: Investors commit capital upfront before the manager deploys it into deals. The manager has discretion on investments.
• Management fees: In most cases, GPs charge an annual ~1-2% management fee on committed capital to cover operating expenses.
• Carried interest: In most cases, GPs earn a 20% cut of fund profits once a hurdle rate is cleared, aligned with LP performance.

The GP has a critical role in secondary funds, leveraging expertise to source proprietary deal flow, conducting diligence to value assets accurately, negotiating competitive bids, and managing assets post-acquisition. 

Top-tier GPs have extensive secondary experience, networks, and data to identify opportunities and execute transactions that meet their return targets. Their reputation and relationships provide access to unique deals.

Secondaries Transactions 

Secondaries transactions involve the transfer of existing private equity fund shares between a buyer and a seller.

key parties involved in secondary transactions:

• Sellers: These are typically limited partners (LPs) such as pension funds, endowments, family offices, and other institutional investors who want to sell their stakes in a private equity fund. Common reasons for selling include portfolio rebalancing, obtaining liquidity, or exiting an underperforming fund investment.
• Buyers: The buyers are secondary investors or specialized secondary funds who acquire secondary assets. Potential buyers could be firms, other LPs interested in joining a fund, or the fund's general partner (GP) in a GP-led deal.
• Intermediaries: Specialized secondary advisory firms often serve as intermediaries responsible for sourcing secondary deal opportunities and facilitating negotiations between buyers and sellers. They help provide liquidity in the secondary market.

The mechanics of secondary transactions:

• The seller conducts a competitive bid process and invites secondary buyers to submit bids. An intermediary usually handles this.
• Buyers perform due diligence on the assets and submit indicative bids. The buyer with the highest bid secures the opportunity to purchase the secondary stake.
• Both parties (buyer and seller) sign a binding purchase and sale agreement to formalize the transfer of limited partnership interest.
• The general partner consents to transfer LP interests as per the fund agreement. This is required for the secondary transaction to be completed.
• Once the transaction closes, the buyer assumes the economic rights and obligations attached to the acquired fund stake. This exposes them to the remaining value creation in the fund's portfolio.

Secondaries transactions require extensive due diligence by buyers seeking to appropriately value the fund assets acquired from sellers. The deal terms are negotiated comprehensively between both parties.

Drivers of Secondaries Activity

The secondary market is driven by various factors influencing the decision-making behind deals and transactions. Some of the key drivers include:

Portfolio Rebalancing

• General partners may look to sell stakes in funds or portfolio companies to rebalance their portfolio exposure and risk. This allows them to crystallize returns, pursue new investment strategies, or manage liquidity.

Liquidity Needs

• Limited partners like pensions, endowments, and family offices may seek liquidity earlier than the typical private equity fund lifecycle. Secondaries provide an avenue to liquidate their interests.

Changing Investment Strategies

• Institutional investors periodically review their portfolios of different asset classes. A change in investment approach can lead limited partners to divest through the secondary market.

Regulatory Changes

• Evolving regulations like Solvency II in Europe have increased insurers' capital requirements, driving the need for liquidity through secondary transactions.

Performance Issues

• Investors might opt to sell their share in an underperforming fund on the secondary market instead of retaining it further.

Investment Periods

• As funds enter their later stage beyond the investment period, secondary transactions pick up as portfolios mature.

The interplay between these diverse factors drives secondary flow and opportunities for specialized secondary buyers.

Continuation Vehicles: Enabling Extended Holds

Continuation vehicles are an important tool secondary investors and sponsors use to enable extended holds of portfolio assets. These vehicles allow general partners and limited partners to roll over their existing stakes into a new fund rather than exit during a regular liquidity window. 

For sponsors, continuation vehicles allow them to retain control over key assets while providing liquidity to existing investors. The sponsor can raise additional capital through the continuation fund to support add-on acquisitions or growth investments in the rolled-over assets.

Overall, continuation vehicles increase flexibility for secondary investors and portfolio companies alike. Their creative use of fund life extension helps unlock greater value and enables secondary investors to maximize the return potential from high-quality assets. The secondary market is expected to continue leveraging continuation vehicles as a strategic tool for portfolio management.

Current Secondaries Market

The secondary market has experienced growth and activity over the decade. Recent estimates suggest that the global secondary market surpassed $100 billion in transaction value in 2021, doubling from $40 billion in 2015. Several key trends and factors fuel this exponential growth:

Increasing LP interest in secondaries:

Limited partners (LPs) have allocated more capital to secondary funds and transactions. Secondaries provide LPs access to attractive alternative asset classes with the potential for higher returns than traditional private equity. LPs also utilize secondary funds for portfolio balancing and liquidity needs.

Rise of GP-led deals:

General partner (GP) led secondary deals have become increasingly popular, making up over 50% of secondary transaction volume. In GP-led deals, GPs facilitate secondary sales of assets to generate liquidity without disrupting their existing funds.

Expansion across geographies:

Secondaries deal activity is rising across emerging markets in Asia and Latin America, broadening from traditional hotspots like North America and Europe. This presents new secondary deal opportunities for global investors looking to diversify their portfolios.

Increasing dry powder:

Specialized secondary funds amassed unprecedented unallocated funds, exceeding $230 billion in 2019. This position positions secondary investors to pursue larger and more complex transactions.

Consolidation:

As the secondary market matures, consolidation is rising, with larger specialized secondary firms gaining market dominance through acquisitions and successful fundraising efforts.

The secondary market is currently at a turning point with growth opportunities. With expanding options and reserves, secondary investors are well-positioned to capitalize on this high-growth private equity market segment.

Conclusion

Over the decade, the secondary market has grown, becoming an appealing sector in private equity and alternative investments. Secondary investors provide liquidity, facilitate portfolio restructuring, and enhance the efficiency of the private equity ecosystem.

With over $1 trillion in committed capital, they have evolved into a robust asset class. There is anticipated investor demand due to expectations of investment durations, unique return profiles, and access to a wider range of assets through secondary transactions. LPs are increasingly turning to secondaries to manage their equity portfolios actively.

Meanwhile, GPs have been embraced as a strategic tool, utilizing secondary spinouts and GP-led deals to optimize portfolio composition. As consolidation between GPs and the specialization of secondary firms continues, the market is likely to gain further sophistication and scale.

While pricing and asset dilution risks remain, the secondary market appears well-positioned for the future. With their specialized expertise and access, secondary investors can capitalize on market dislocations and unlock value through active management. For LPs across the institutional landscape, secondaries are becoming an integral component of portfolio strategy rather than an opportunistic sideline.