The private equity market is constantly evolving. The desire for liquidity has seen innovation in deal structures and investment fund strategies with a range of alternative types of investment growing increasingly popular.
In this article, we’ll focus on private equity secondaries, which are transactions in which an investor buys an asset later in its investment cycle. We’ll explain what secondaries are, highlight how the market is growing and run through some of the many benefits they can provide that make them so attractive to investors.
What Are Private Equity Secondaries?
A private equity secondary is a trade in which an investor purchases an asset from another investor.
Private equity primary investments are transactions made by investors (either directly or via a fund) where a stake in a private company is acquired. This may be as part of a management buy-out transaction or a growth capital funding round.
On the secondary market, by contrast, investors trade assets with other investors.
|Primary investment||Secondary investment|
|Purchased from a company's ownership||Purchased from an initial investor|
|Purchased at initial sale||Purchased at a later date|
What is a secondary investment fund?
As the name suggests, a secondary investment fund is a private equity fund that focuses on secondary investment. Investors tend to have specific expertise in the secondaries market and will often be better equipped to handle the complexities of secondary transactions, as well as to manage more mature investments over a shorter timescale.
Growth of the market
It’s worth noting the sheer value of trades in the secondary market. In 2021, the total volume of secondary deals bounced back from a COVID-impacted 2020 to hit a record high of $132bn — far surpassing the previous record of $88bn, set in 2019 (source: PitchBook).
This is part of a broader trend that has seen private markets swell. “By most measures”, according to The Economist, the sector “is three times larger than a decade ago”. Increasingly in the United States “secondary buy-outs can exceed the volume of initial public offerings”. This is a major sign of the growth of the market, and one that would have been hard to predict in the 1990s, when the first secondaries funds were formed with “tens of millions of dollars of committed capital”.
What is a GP-led secondary?
There are two types of private equity secondary transactions: those led by an LP, or limited partner, and those led by a GP, or general partner.
An LP is a limited partner in a fund. Effectively, this is an individual or institutional investor who makes their investment by buying into part of a larger fund. In an LP-led transaction, an LP sells their stake in a fund, including their entire portfolio of assets and attendant liabilities, to a secondary buyer. The overall structure of the fund and the assets remains the same, and the secondary buyer simply steps into the shoes of the selling LP.
In a GP-led transaction, by contrast, a general partner, or a fund manager, will sell part or the whole of its fund to a secondary investor. The existing LPs in the fund will generally have the option to roll their assets over to the new vehicle or cash out.
These GP-led transactions often take the form of a continuation vehicle. In a continuation vehicle, which can also be known as a continuation fund, a GP is able to hold onto their portfolio of assets, while some LPs retain their investment and others exit.
GP-led secondaries may also be single-asset transactions — an increasingly popular model that allows GPs to focus on their preferred individual assets while divesting themselves of those they no longer want to hold.
While most private equity secondary transactions were previously LP-led, recent years have seen a significant increase in GP-led transactions, with the total value of these transactions hitting $68bn in 2021 (source: Lionpoint). This is more than double the value in the previous year, and more than half the total value of secondary fund transactions in 2021.
Why Consider Private Equity Secondaries?
Now we’ve explained what private equity secondaries are, we can turn to the question of why investors can be so keen to snap them up and that the secondary market has grown as much as it has.
Why should aspiring and actual private equity investors consider investing in secondaries?
Discount access to private equity funds
The first reason we’ll list here is also perhaps the simplest: the price. Secondary investment can offer access to assets, whether whole portfolios or individual companies, at a significant discount.
The value of an investment company is referred to as its net asset value, or NAV.
This is calculated according to a simple formula: the total value of a company’s assets, minus its liabilities.
The per-share value is then calculated by dividing the net value by the number of shares.
- If a company has £100m in assets and £10m in liabilities, its NAV will be £90m
- If the same company has a total of one million shares, the value of each share will be £90
Note: NAV fluctuates with the value of a company and the cost of its liabilities. So, as with many investment classes, the value of private equity assets can vary significantly from one day to the next.
When sellers exit private equity funds early, they have historically had to offer their assets at a discount, below their NAV.
The upshot of this for secondary investors is that they can acquire assets for less than they are notionally worth. This, in turn, means that the investor may be able to turn a higher profit when they eventually exit.
However, as you’d expect, this does not always hold true, and in times of particularly high secondary market activity, secondary buyers may expect to pay a premium for their acquisition.
Limited blind pool risk
Investors in primary funds take on blind pool risk. This means they don’t know the eventual contents of their investment when they invest — they are blind to what will be in their pool of investments.
In secondary investment, by contrast, this blind pool risk is limited, as secondary investors buy pre-existing assets and portfolios. Knowing what they’re getting increases their opportunities to engage in due diligence and, therefore, their ability to make more accurate predictions about the future performance of their investment.
The value of private equity investments are usually subject to a J-curve. This means that investors often see negative returns in the early stages of their investment as capital is provided to fund acquisitions/growth and in the case of funds, set up costs and fees are absorbed. Later, as investments are realised and distributions are provided to the investors, the value rises.
As an example, a private equity fund cycle of 10 years will tend to break down as follows:
- First five years: acquiring assets and financing transactions
- Second five years: exiting positions and turning profit
In secondary investment, however, investors can pick up an asset further along the J-curve. This means that, in theory, they have less time to wait before the returns on their investment tick up into profit.
In this way, secondary investors can benefit from the work already done by primary investors, potentially taking on less risk as investee companies are further along their growth journey and closer to exit.
Investing in private equity secondaries can potentially provide significant benefits to investors, from discounts in asset price to a shorter time to wait for investments to secure a return.
Coupled with LPs increasing needs for liquidity, this has helped generate a flurry of activity in the secondaries market. If you’d be interested in investing in this market, why not contact us, and learn how Connection Capital can help you access the high potential returns private equity secondaries can provide?
Investments in private equity secondaries are high risk and speculative which means there is no guarantee of returns and investors should not invest unless they are prepared to lose all of their money. Past performance is not a reliable indicator of future performance. This type of investment is illiquid so can’t be easily accessed until the exit point. The investor is unlikely to be protected if something goes wrong.