On ‘main street’ there is a boom in the second-hand market. Driven partly by the squeeze in disposal incomes (from inflation, from muted pay growth) but on more structural basis by sustainability considerations. Why sent to land fill when someone else can make use of it. Indeed the growth of online markets is making second hand a first choice for some.
There is also a ‘second-hand’ market in private equity/venture capital. This note seeks to provide some background to the Secondaries market. The note is based on information from a variety of sources and provides references for those who wish to explore this further.
Q: What is it?
In public equity markets the exchange (eg NYSE) provides a ready mechanism to sell the ownership in an equity. In private markets (including VC) there is no ‘exchange’, the mechanism to transfer rights is via the Secondaries market. The Secondaries market is the mechanism through which an LP can transfer its interest in a GP to another investor. Unlike an exchange this transfer takes place via a negotiation of the price between the two parties.
There are essentially two types of sellers. LPs and GPs.
LPs may be selling for a variety of reasons. Portfolio rebalancing, a change in strategy, ‘tidying up’, tactical (a belief that the NAV may decline) or simply a need for liquidity. This transfer of interest provides an alternative source of liquidity to the LP.
The GP opportunity in secondaries results from the tension of providing liquidity to the end investors, having to realize an asset as the fund approaches the end of its life and a view that selling this asset at this point does not maximise its value. . Holding on to the asset whilst providing liquidity to the current LPs is effected by setting up a Continuation Vehicle and transferring the asset to this vehicle. In effect the sale of the asset is carried out by transferring it to the continuation vehicle. The Continuation Vehicle will have new investors (the Secondaries funds) and some of the previous LPs may also continue their investment but now via the continuation vehicle. The exit via Continuation Vehicle provides a a fourth option to GPs to exit portfolio companies. The first three being, IPO, trade sale and sale to another GP. In the current market environment, it may be the only reliable exit route but is only achievable for top quality portfolio companies.
Q: What are the LPs selling?
In a disposal via the secondary market, the LP is transferring the existing investment in the GP as well as the future commitments to that GP. The contractual commitment for future capital and receipt of future distributions will pass onto the new investor.
Q: Does a GP have to approve the transfer of rights?
GPs are typically required to approve the new investor (the Secondary fund) into their fund and some GPs still use this right to restrict access into their funds only to existing investors, although the very large majority of GPs now take a constructive approach to consent, so as to avoid limiting the options of their investors.
Q: How big is the market?
In the early 2000s the secondary market was smaller than $5b[1]. Now the market is about $100b, some suggest it could be about $200b in a few years’ time. This is small compared to the primary market but substantial nonetheless. The growth is partly due the growth in private markets investing and the more varied type of investors in the asset class over this period but also due to the increased sophistication of the secondary market that is now providing more options to investors in the asset class. More recently the growth has been driven by the stress in public markets, the drying up of IPO activity and the very limited number of GPs making new investments (thereby providing an exit to other GPs).
Q: What are the main differences between primary and secondary investing?
One: investing period
In Primary investing the investor endures a 2 to 3 year period of negative returns as the manager takes time to identify and carry out due diligence of potential investments. The fund will be experiencing fees and costs during this period. There may be a further period of capital investment in the portfolio companies. All this results in the J-Curve effect with profits and value being realized a few years later.
For Secondary investing, there is still a waiting period as the fund decides which of the secondary opportunities to invest in, but this is likely to be shorter. Also when the investment decisions are made the investments are in existing assets and many of these may be mature (especially in the GP -led secondary market).
Overall this results in Secondary investments having a shorter ‘waiting time’ and shorter duration.
Two: access to financial information
Secondary funds are purchasing assets already managed by GPs. This means that there is greater level of transparency and availability of financial information on the assets on offer. All other things equal this means that it makes it easier to decide on what good value looks like. This will also reduce the idiosyncratic risk.
Three: pricing
Secondary pricing tends to be at a discount to the net asset values of the assets. When the market is buoyant the discounts will be small, eg in 2017 the discounts were 1% to 2%. Towards the tail end of 2022 and in the first half of this year the discounts have increased to about 15% to 20%. Discounts vary depending on the sector (Real estate, credit, equity, VC).
A higher discount does not mean that it’s a bargain. It could be that the NAV is overstated. Expert analysis is needed to understand and arrive at ‘fair value’; this is especially so when uncertainty is elevated.
Q: But don’t I end up paying an additional layer of fees?
A Secondaries fund investor that has bought out the interest of LPs in a primary fund will end up incurring two sets of fees. The fees of the Secondaries fund plus the fees of the primary fund. To allow for this the modelling carried out by the Secondaries fund (including the scenario testing) to arrive at the price paid for this transfer of interest allows for the fees that paid to the primary fund. So the price of the transaction is net of the primary fund fees to ensure that the return requirement of the Secondaries Fund is not compromised.
Q: Are current market conditions favourable?
The private markets sector is experiencing a dis-location. The primary driver for this being regime change in the rates environment (from low to zero to higher or ‘normal’). The usual routes to exit are more challenging, this has resulted in an inversion of the cash-flow dynamics for private markets investors: the cash-flow positive dynamics (whereby distributions outpaced the capital calls of most mature private equity programmes) that prevailed until 2021to a cash-flow negative dynamics. . Investments in secondaries post the 1999/2000 ‘dot com’ burst and 2008 financial crisis delivered favourable returns. But these are but two data points so we have to be cautious to over- extrapolate. On a forward looking basis the appeal of secondaries is:
Exits in the public markets are not as attractive. This is slowing the normal maturation process of prior funds. For LPs this can create a liquidity issue, for GPs this can delay capital raising and origination for their new funds. Transacting in the Secondaries market can release some of these pressures.
Some investors may be ‘forced’ sellers in this environment. The motivation could be a need for liquidity, a change in strategy or a need to balance the portfolio to an inadvertent over -allocation. The reasons for selling may be non-economic and therefore less price sensitive.
Buyers have pricing power. Sensible modelling with scenario testing can put a sensible floor on the NAV in what is otherwise an elevated environment of uncertainty. A good Secondaries manager should be able to identify and invest in a good portfolio of Secondary opportunities.
There is a natural discount to the NAV for providing the (forced) liquidity to the seller. This is a nice pick up over the usual premia for investing in this sector.
Advantages:
| Buyer | Seller |
| Reduces the period of illiquidity | Generates liquidity outside of the normal maturing process |
| The asset may be available at a discount | Reduces or eliminates future capital calls. |
| Reduces ‘blind pool’ risk as there is visibility on the existing assets in the GP | Reorientate the investment strategy |
| Reduces period ‘waiting’ and thereby reduces operational complexity | Redirect capital to more favoured opportunities |
Second hand has negative connotations; something that is past its best. In private markets this is may not be case, in private markets it could be that the best is yet to come.
This content is for information purposes only. Treble Peak does not provide investment or tax advice, and information on this website should not be construed as such. Potential investors should seek specialist independent tax and financial advice before investing in any alternative investment. Past performance is not a reliable guide to future returns. Your capital is at risk.
Further reading
https://www.caisgroup.com/articles/an-introduction-to-private-equity-secondaries
[1] Source: Coller Capital
