In the current private equity (PE) world with low liquidity, investors may cash out their assets in secondary fund of funds. Since an investor need not wait until a fund’s life ends, both sellers and buyers can exploit a plethora of benefits. In a nutshell, the secondary market enables PE investors to liquidate assets, rebalance portfolios or make an early exit. Besides, new investors may buy PE assets much before the performance cycle, often at discounted rates.
Let us examine how private equity secondaries are the case for disciplined investing and why they have spurred higher demand.
Overview of secondaries
Secondary investment refers to the purchase of 3-7 year old funds with an underlying portfolio company. Investors’ need to liquidate or actively manage their PE portfolio drives sales in this market. Since secondaries do not have an established market, they typically trade in privately negotiated transactions.
Investors’ strategies and situations change with time, generating the need to liquidate early. Mortgages, commercial loans and insurances are a few segments with actively developed secondary markets. Since PE is an asset class with low liquidity, investors must commit their capital for 10 years. Therefore, advancement in the secondary market is inevitable and necessary.
The secondary fund of funds consists of existing assets and underlying funds that have already deployed capital in the portfolio companies. This is the reason investors consider secondaries to be more established than primaries. The invested capital generates accelerated returns, due to shorter investment periods and the absence of J-curve characteristics.
Benefits of secondaries to sellers
Investors believe secondaries are better managed than primaries. Apart from asset benefits, sellers reduce outstanding capital calls. So their capital remains free for alternative investments and strategies. Also, many investors find secondaries an excellent conduit to rebalance the portfolio and prematurely lock gains from PE investments.
Benefits of secondaries to buyers
Secondaries are mature PE assets that benefit buyers by mitigating the effects of the J-curve. Usually, the capital invested shows negative performance initially and creates value at a later stage. However, since secondary investors enter the game at a later stage, they avoid the initial dips and receive higher returns.
In addition, secondaries reduce blind pool risks since investors invest in known companies. Secondary buyers can better analyse an asset’s performance and calculate its potential value.
Easy access to private market: Secondary fund of funds offers an attractive entry point to investors compared to primary PE funds, thanks to their unique return features. They are more diversified, due to their pre-existing commitments to multiple funds. They offer significant diversity across geographies, industries and strategies. Therefore, they have lower risk compared to primaries.
Faster returns: Primary PE funds take 5-10 years to deploy capital, and investors may receive returns after several years. On the other hand, secondaries deploy capital faster, and returns start trickling in much quicker, sometimes right after inception, mitigating the effect of the J-curve, which brings negative returns in initial years.
Discounted PE access: Secondary fund investors buy pre-existing funds at a reduced rate. As the secondary market has grown exponentially over the last few years, investors may immediately benefit from discounted rates, translating into value creation immediately after an investment.
Minimal blind pool risk: Primary fund investors find it challenging to predict investments made by fund managers, known as blind pool risk. However, secondaries mitigate this risk, allowing investments in existing commitments. They are already aware of the assets to be invested in, providing visibility and enhancing potential with clarity of future performance.
Opportunities in secondaries market
The recent market volatility has lowered secondary market pricing, creating more attractive purchasing opportunities for secondary fund of funds. Currently, the secondary market is trading at an all-time high, with substantial buyout funds and heightened pricing. Since secondary funds primarily rely on distributions, it is critical to select a disciplined manager with a focus on protection and proven record in market cycle navigation.
The secondary PE market offers lucrative portfolio benefits. Investors seeking to gain exposure to the PE market and faster returns will find secondaries attractive. Selecting the right manager is key to realising the expected benefits with a PE investment. Secondary investors, institutional investors, alternative asset managers and other PE professionals must hire PE secondary fund support for deal pricing, portfolio monitoring and other services required to optimise returns.
