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.
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:
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.
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.
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:
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:
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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