Private Equity Secondaries: Benefits & Challenges

Private equity secondaries have become increasingly popular for allocators due to their various benefits, mainly their ability to provide liquidity. However, their illiquid nature also poses some challenges. 

What are Private Equity Secondaries? 

The private equity secondary market refers to the buying and selling limited partner interests and remaining commitments to private equity funds during a fund’s lifetime.  

To avoid confusion, when referring to both private equity secondaries and direct investments into private equity funds, these direct investments are often known as primary private equity. 

Types of Private Equity Secondaries 

There are two types of private equity secondary transactions: those led by a limited partner (LP) and those led by a general partner (GP). LP secondary transactions are the most common, and they occur when an existing LP sells its assets to a secondary buyer. The buyer, without prior investment in the fund, then replaces the LP with all their rights and obligations. 

In GP-led secondary transactions, the GP often forms a new continuation fund to acquire assets (single or multiple) from a predecessor fund. In essence, the GP is on both sides of the transaction. GP-led secondaries can offer attractive benefits in all market conditions because they allow the flexibility for GPs to hold their most promising assets longer and provide the possibility for added exit options. 

While most private equity secondary transactions were previously LP-led, recent years have seen a significant increase in GP-led transactions. The total value of these transactions hit $68bn in 2021, more than double the value in the previous year and more than half the total value of secondary fund transactions in 2021. 

Key Benefits of Private Equity Secondaries 

Secondaries have become a pivotal part of the broader private equity landscape because of their various benefits:  

• Secondary markets provide liquidity for existing investors. As mentioned above, this factor was the key driver in creating the original secondary opportunity and has, since then, continued to play a pivotal role in the growth of the asset. 

• Forced sellers create cheaper prices. The discount to NAV traditionally offered by secondaries is one of the largest appeals to new investors. 

• Secondaries give GPs an approved, accepted continuation vehicle. GP-led secondaries allow GPs to avoid selling down when they might not want to via an investment vehicle that LPs trust and that gives them ample opportunity to proceed as they wish. 

• Buyers already know what’s in the portfolio. Unlike the black box that often represents investing in private equity funds, with secondaries, buyers already know what the portfolio holds. They thus can conduct significantly more in-depth due diligence. 

• Secondaries have multiple layers of due diligence: Secondaries allow for more due diligence, and by nature, more due diligence is built into the process. A buyer of secondaries knows that the original PE firm conducted due diligence on the original investment, the initial LP conducted due diligence on the GP, and the secondaries manager conducted due diligence as well. 

• Diversification. Investors can access many underlying portfolio investments that a GP manages with keen knowledge and expertise. Diversification can reduce overall portfolio risk. 

• Faster returns (J-curve). Returns are faster due to a shortened J-curve, a trendline that depicts an initial loss followed immediately by a large gain. Buyers who invest in a PE secondary fund benefit from a reduced time until cash is returned to LPs. 

Challenges in Private Equity Secondaries  

There are potential drawbacks to PE secondaries, including: 

• Illiquidity. Although secondaries can help investors hurdle some of the liquidity issues their PE investments present, private equity is intrinsically illiquid compared to public assets. Once in, it can be difficult to exit the investment prior to the fund’s completion. 

• Complex valuation. In the secondary market, companies’ valuations can be challenging to determine, and the assets’ actual value may differ from the price paid. 

• Uneven cash flows. The secondary market’s cash flow profile depends on distributions, making it essential to choose experienced managers who have a keen eye on down-market protection and have a demonstrated record of getting through market cycles. 

Future Trends and Outlook for Private Equity Secondaries  

After a decade of strong volume growth, private equity investors now have access to a wide range of liquidity options and solutions covering all strategies (buyout, growth equity, venture capital, mezzanine, distressed, real estate, and increasingly infrastructure), investment types, fund maturities, and funding levels. In addition, there is a growing need for creative liquidity solutions outside the traditional routes. In tougher economic conditions, GPs also tend to hold assets longer, leading to fewer distributions for LPs in the near future and driving further interest in secondary transactions.  

In addition, with the widening of discounts, secondaries may be an opportunity for investors to make cheap additional investments in private equity. Therefore, competition in this market may increase as many investors are still looking to expand their private equity allocations. 

If you have additional questions about the potential of private equity secondaries, please use the form below to contact our team.