Overview
- Secondaries refers to the buying and selling of existing stakes in private markets funds. These investments typically occur after the primary (original) investors (known as limited partners or LPs) have already committed capital to a private equity fund.
- Secondaries offer several advantages over primary investments: reduced J-curve impact (i.e. quicker distributions), shorter duration, lower blind pool risk (i.e. greater visibility of the assets), greater portfolio diversification, and potentially enhanced returns (via interests being acquired at a discount).
- The sellers in a secondaries transaction may be comfortable to sell their interests at a discount to manage liquidity, rebalance and adjust their portfolio exposure or exit investments early.
While this article primarily focuses on PE secondaries, the secondary market has expanded to encompass a wide array of asset classes, including real estate, infrastructure, and private credit. In this article we will dive into what secondaries are, what makes secondaries an attractive investment opportunity, the challenges associated with secondaries, explore the various strategies and types of secondary funds, and understand how they fit into a diversified investment portfolio.
What are Secondaries
Secondary funds purchase existing interests or assets from primary private equity fund investors. In these transactions, the original investor sells their stake in a fund’s existing portfolio, along with any uncalled capital commitments they are obligated to fulfil.
Secondary investments offer a distinct advantage for both sellers and buyers:
- Sellers gain liquidity, allowing them to exit positions early and reallocate capital to new opportunities. This will often occur during times of strong private equity performance when investors become overallocated to private equity and need to rebalance their portfolio to bring it back to their target asset allocations.
- Buyers on the other hand, acquire diversified portfolios of matured investments, enabling faster capital deployment and potentially purchasing stakes at a discount. This not only reduces the “J-curve effect” (early negative returns due to fees and delayed value creation, followed by gains as investments mature)[1] but also allows for quicker distributions, making secondaries an attractive option for investors seeking additional diversification and more immediate cash flows.
Why invest in Secondaries?
1. Attractive returns & lower risk profile: Secondaries typically have lower return volatility (largely due to the second feature noted below) and historically have performed well relative to primary funds.
2. Great diversification: An allocation to secondaries generally increases diversification across a relatively short time frame, as a single secondary fund can contain hundreds of underlying assets, rather than to 10-20 assets typically found in a single direct fund. In addition, secondary funds typically offer significant underlying diversification across vintage years, geographies, managers and sectors.
3. J-curve mitigation: Secondary funds mitigate the J-curve effect, as they acquire stakes later in the lifecycle when investments are more mature and therefore distributions typically occur quicker than a primary fund interest. This results in shorter J-curves and less capital at risk early on. Primary investors, in contrast, experience the full J-curve as it takes time for the GPs to execute their value creation plans whereas secondaries investors often miss the depths of the J-curve (refer to the illustration below).
4. Blind-pool risk reduction: “Blind Pool Risk” refers to the situation where LPs commit capital to a portfolio that may have very few assets (i.e. very little capital deployed), resulting in a “blind pool” of capital. However, with secondaries, particularly those acquired later in a fund’s lifecycle, investors have greater visibility of the portfolio companies. This offers the potential to analyse these companies and get better insights into their future value potential (note that the GP of a secondaries fund will get this visibility, but the LPs of the secondaries fund are unlikely to get the same visibility), thereby reducing the uncertainty typically associated with blind pool risk.
What Role do Secondaries Play in a Diversified Investment Portfolio?
Secondaries serve as a growth asset like listed shares and traditional private equity investments. The nature of secondaries (as explained in the why investors should consider investing in secondaries) lends itself to being a more liquid, less risky (i.e. more diversified, lower blind pool risk), but similar return generating (albeit with a more accelerated distribution pattern) to a primary private markets’ investment. Secondaries funds are also a great way of deploying capital to private markets relatively quickly. However, as investors will have less control over the exact exposures (which are determined by the GP of the secondaries fund) and there is an additional layer of fees, secondaries funds are unlikely to be a 100% replacement of a primary investment.
What are the Different Types of Strategies Available within Secondaries?
Investments into secondary funds can be categorised into LP-led secondaries and GP-led secondaries (you can think of the GP as the fund manager). The difference between these two types is who initiates the transaction and the objectives behind the transaction. These two types of secondaries have different risk and return profiles, and therefore can have different investment performance outcomes.
LP-led secondaries are the most common secondary investments and involve the transfer of the LP interests from one investor to another, freeing them from their long-term capital commitments to the private equity fund. LP-led secondaries are driven by limited partners seeking liquidity or to rebalance the asset allocation of their total portfolio. This type of transaction can often involve the transfer of interests in multiple private equity funds allowing the secondaries purchaser to diversify their portfolios across managers, sectors, strategies, geographies etc. Secondaries transaction often occur at a discount to net asset value (NAV) but on rare occasions can trade at a premium, particularly if the interest being transferred provides exposure to a highly sought after strategy/GP.
GP-led secondaries, on the other hand, are initiated by the GPs and are typically direct stakes in the portfolio companies of a fund rather than a stake in the fund itself. The reason a GP initiates secondary transaction is to manage or extend the life of their fund. GP-led secondaries often involve more complex restructurings or capital-raising efforts, and the purchaser is more likely to have the skills and experience akin to a GP given they are taking an interest in the portfolio companies directly.
In addition to LP and GP-led secondaries, secondary funds offer several other strategies, each with distinct characteristics and risk/return profiles:
- Asset classes: beyond private equity, secondary funds have expended into other asset classes like real estate, infrastructure and private credit.
- Geographic regions: some funds target specific regions or countries, while others have a global outlook.
- Industry sector: funds may specialise in healthcare, technology or even niche sectors like renewable energy while others may be sector agnostic, offering exposure across a wide range of industries.
- Vintages: some secondary funds focus on acquiring interests in older, more mature funds where assets are closer to realization, thereby offering the potential for quicker returns. Others may target newer vintages, seeking opportunities in funds that still have a long runway for growth. This approach allows investors to balance their portfolios according to their preferred risk tolerance and return timelines.
Navigating the Challenges of Secondary Fund Investments
While secondary funds offer significant advantages, they also come with a set of challenges. Apart from the risks inherent in primary private market investing, secondaries investing may introduce additional complexities:
- Fee structures: Investors in secondary funds are required to pay fees at both the primary fund level and the secondary fund level. These layered fees can potentially impact overall returns, making it essential for investors to carefully consider the fee structures and negotiate where possible. The additional fees make it critical to identify secondaries strategies that can source discounted primary funds with strong performance potential to overcome the additional fee burden. Note that historical data (refer to the first chart in this article) indicates that the median secondaries funds perform in line with primary funds albeit with a lower level of risk.
- Transparency and Information Access: Secondaries fund investors generally do not receive the same level of reporting and information-sharing from the primary fund GPs as the primary LPs. This may result in reduced visibility on underlying portfolio companies, valuations, fund performance and terms, making due diligence and accurate valuation of assets more challenging. Prospective secondary fund investors therefore need to be comfortable with the investment and due diligence processes of the GPs that will manage the secondaries fund being considered.
Conclusion
Secondary funds play a pivotal role in providing liquidity and facilitating capital reallocation. They offer strategic advantages such as potentially enhanced returns (via interests being acquired at a discount), access to mature assets, reduced J-curve impact, shorter duration, lower blind pool risk, greater portfolio diversification, and enhanced portfolio management capabilities (e.g. earlier distributions and options for liquidity). As such, we believe secondaries are integral to the construction of a robust private markets portfolio.
As the private markets continue to grow, we also believe that the secondaries market will become more important to create a more mature private markets industry by facilitating periodic liquidity for investors, making the private markets more accessible to a broader audience.
Footnotes
[1] For more information on the J-Curve effect, please refer to our webinar titled ‘Navigating the J-Curve in Private Equity,’ available on the Insights page of our investor portal: https://invest.reachalts.com.au/login
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