April 24, 2024

It’s Just the Beginning for Surging Secondary PE Sales

Used as an escape hatch when private equity is in the doldrums, this venue has become established enough to keep going in better days, strategists say.

Reported by Larry Light

When financial times are challenging for private equity and liquidity is sparse, secondary sales have a ready fan base of PE fund investors seeking to cash out early. These investors need their money now, and secondaries give them a convenient exit.

This past couple of years have been tough for PE, and secondaries are flourishing as a result.

Mergers and acquisitions and initial public offerings—the usual avenues for PE funds to sell assets and pay investors with the proceeds—are at a low ebb lately. The PE funds typically have a five- to seven-year life. Their investors, who are limited partners, often must wait until the fund termination date to get all their money back and the profits distributed to them.

Secondary market volumes increased 5% in 2023, compared to the year before, a report from investment firm William Blair stated. What’s more, last year secondary volume more than doubled to $130 billion versus 2020.

Volumes have fluctuated in the past in accord with M&A and IPO fortunes. “You see more interest in secondaries when liquidity” is hard to come by, says Andrew Krei, co-CIO of Crescent Grove Advisors and Barrett Upton Capital Partners, private markets-oriented investment managers, including secondaries.

No wonder secondaries are especially in vogue lately. The New York State Teachers’ Retirement System was one of many to sell out of PE positions thanks to secondaries. Last year, the plan confirmed, it sold 34 private equity holdings, and published reports put the aggregate value at $3.5 billion.

In fact, secondaries are so well-liked that many expect them to continue at a high level even when a profusion of IPO and M&A exits re-appear. Reason: Investors have a taste for secondaries now, and more and more see the sales as a tool to manage money, rather than merely to serve as just an escape hatch.

“Secondaries will have a bigger role going forward,” says Mark Steed, CIO of the Arizona Public Safety Personnel Retirement System, which has 23% of its $19.5 billion in PE. He has sold PE stakes via secondaries and also has invested in funds specializing in secondary deals. “The stigma is gone” of turning to secondaries, he adds.

“Optimism about secondaries” means they will keep on growing, regardless of the liquidity climate, says Jerald Khoo, senior vice-president at Aon M&A and Transaction Solutions, which advises investors on secondary funds.

Indeed, top-flight investment firms are sponsoring funds that focus on buying secondary positions, such as Blackstone, Apollo Global Management, France’s Ardian, HarbourVest Partners, Neuberger Berman and Hamilton Lane. These buyers of PE stakes have prospered, according to a report from private market investment firm Hamilton Lane, terming them “opportunities that generate superior returns.”

Private Equity Profusion

PE has been a very popular asset class, especially among institutional investors, figuring it is a good long-term investment. Public pension programs in North America allocated 11% of their assets to PE in 2023, up from 8% three years before, per data provider Preqin.

Despite the liquidity drawback, the PE sector’s superior performance over time has spurred its allure, investment firm Neuberger Berman found. Over five years ending in mid-2023, PE funds returned 16.7% annually, compared with 8.6% for equities as measured by the MSCI World Index; over 20 years, PE outshined the index 14.2% to 8.7%. With this in mind, the California Public Employees’ Retirement System in March approved a plan to boost its PE allocation to 17% from 13%. CalPERS said PE was its top performing asset class over the past 20 years.

Over the last two years, however, things came undone for the PE sector. “We’ve had a nice party for the past 12 or 13 years, and now the bills are coming due,” says John Ivanac, senior vice president, alternative investments, at investment firm Franklin Templeton. PE investors “lack the exits,” he laments.

In 2021, PE deals peaked at a record 40,000 deals globally, valued at just over $6 trillion, per a Bain & Co. study. In March 2022, the Federal Reserve began hiking interest rates. That was bad news for private equity, which depends on borrowed money.

M&A shrunk markedly from there, with dollar amounts and deal count almost halved since 2021, Bain found. The IPO dive was even steeper: Dollar volume and deals dropped more than 90%, Renaissance Capital stats showed. In the U.S. at least, and likely worldwide, PE activity did not improve in this year’s first quarter, FactSet reported, although some on Wall Street say there are signs that private equity will rebound this year.

Secondaries Rise

Cashing out early has a downside for investors. Secondaries often are sold at discounts, and these have been lowered in recent times as the ability of PE funds to exit their investments has eroded. In 2021, the average discount was 79% of net asset value, and by 2023, that had shrunk to 68%, according to Franklin Templeton.

Secondaries, which have been around since the 1980s, really began to expand as the result of the 2008-09 global financial crisis, when the long-touted illiquidity premium became a problem for investors that could not pull cash out of PE, hedge, venture and other funds.

Limited partners may need the cash they can raise in the secondary market to meet their liabilities or to rebalance their asset allocations as the financial ground shifts, and thus accept the discount. Either LPs sell their stakes in a PE fund to another investor, or the GP rolls the fund’s assets (after some have been sold) into a new vehicle, called a continuation fund, and gives LPs the option to sell their stakes and leave, or to invest in the new fund.

Other reasons to unload a PE position: A PE fund has a change of leadership. Or LPs find a better investment and want to switch. Or these investors want to leave when things are good, not waiting for a fund’s maturity date. “They trade out of something strong,” says Christopher Zook, founder, chair, and CIO of CAZ Investments, which buys PE stakes. “They bought at $1, it’s $2 now, and they sell at $1.60.”

Investors who buy into continuation funds at their outset, as opposed to LPs moving over from previous PE funds, enjoy the edge of getting into a pool of discounted assets, the value of which should spring back toward NAV if all goes well. In addition, continuation funds have the virtue of investors knowing ahead of time what is in them—with a nascent PE fund, the positions obviously have yet to be chosen.

For new investors not rolling over from an old fund, another advantage of continuation funds is that they “mitigate the J-curve effect,” according to a report on secondaries by J.P. Morgan Asset Management. The J-curve is the cash flow pattern of a PE investment: Investors in the early stages face capital calls and fees, and only later do they reap the rewards. Continuation vehicles allow the new investors to skip a lot of the starting costs and get distributions relatively sooner. They also allow GPs a way to keep receiving fees.

In 2024, there is ample funding among secondary buyers, like his own firm, Zook notes. “The industry has a lot of” capital to deploy buying secondaries, he observes. Even though the current environment has propelled secondary activity, freaked-out sellers are not abundant. “There’s a lot less panic than in 2009,” he says. “People had to sell [their stakes] then.”

To JPM, the future is bright for secondaries overall, now that they have established themselves as a growing financial force in bad times and, if predictions prove true, good. As the firm’s report declared, “the secondary market has evolved from an outlet for distressed LPs to a widely utilized portfolio management tool. LPs will continue to use secondaries as a way to rebalance their portfolios, further supporting transaction volume.”