Private Equity Secondary Investments: What You Need To Know

Secondary private equity investments, or secondaries, refer to the buying and selling of commitments to private equity funds during a fund's lifetime. They are a means for private equity asset owners to generate liquidity in place of traditional exits. In other words, secondary investments are transactions in which an investor purchases an asset from another investor later in its investment cycle. The secondary market has steadily grown since the turn of the century, with its benefits becoming increasingly difficult to ignore.

Secondary market transactions

The private equity secondary market refers to the buying and selling of commitments to private equity funds during their lifetime. This market has grown steadily since the turn of the century, with benefits such as access to liquidity, faster returns, and the ability to mitigate blind pool risk. The total secondaries market volume grew to a record $134 billion in 2021.

There are two main types of secondary transactions: LP-led and GP-led. LP-led transactions are the most common, where a Limited Partner sells its assets to a secondary buyer, who then replaces the LP with all their rights and obligations. In GP-led transactions, a General Partner extends the investment period of a fund that has reached the end of its life, and existing LPs can choose to 'roll over' or cash out to a secondary buyer.

Secondary transactions can also be categorised as direct secondary transactions, which involve the trade of directly-held ownership interest in a company from Limited Partners to an existing investor. This provides an opportunity to sell stock before the entire portfolio of companies has been sold.

For sellers, secondaries offer a mechanism to better manage illiquid private equity portfolios, creating a stream of cash that can be deployed into new investment priorities or to satisfy an urgent need for capital. Buyers benefit from shorter durations and faster returns on capital, potentially at a discounted price, with enhanced transparency into the underlying portfolio or assets.

The private equity secondary market provides several unique benefits for investors, particularly those seeking to gain private equity exposure but concerned about the duration and significant gap between commitment and distributions. It is important to select experienced managers who are focused on downside protection and have a proven track record of navigating market cycles.

LP-led secondaries

In an LP-led secondary transaction, an existing LP sells its assets to a secondary buyer, who then replaces the LP and assumes all their rights and obligations. This allows LPs to cash out of a fund before the technical end of its life, providing them with a valuable mechanism to manage otherwise illiquid private equity portfolios.

In summary, LP-led secondaries provide a robust and flexible mechanism for LPs to manage their private equity portfolios and generate liquidity, while also offering buyers attractive benefits such as diversification and faster returns.

GP-led secondaries

The most popular type of GP-led transaction is the 'continuation vehicle transaction', which takes place when a GP needs to extend the investment period of a fund that has reached the end of its life. Portfolio companies are moved to a new fund vehicle, enabling additional follow-on capacity and extended hold periods. Existing LPs have the option to either 'roll over' or cash out their interest to a secondary buyer. This type of transaction is also known as "fund recapitalisation".

Continuation vehicles

A Continuation Vehicle (CV) is a secondaries structure that allows general partners (GPs) to transfer assets from a fund that has reached the end of its term into a new fund. This enables GPs to retain and reinvest in quality assets with growth potential, while providing limited partners (LPs) with liquidity options: they can choose to cash out, take an equivalent ownership interest in the new fund, or do a combination of both.

CVs have become a significant component of the private equity secondary market, with billions in transaction volume annually. They are often used as an alternative to selling an asset to an outside buyer, allowing GPs to continue managing high-performing assets in a format that offers a larger fee base and a resetting of the deal carry pool.

CVs can be structured in different ways, including single-asset continuation funds and multi-asset continuation funds. Single-asset deals comprised 52% of all continuation vehicles in 2021, and they are generally easier to price and structure due to the focus on a single asset. On the other hand, multi-asset continuation funds offer diversification benefits for incoming investors, smoothing returns.

To ensure strong alignment of interests between GPs and LPs, it is important to analyse the CV's terms with a focus on the GP's reinvestment and carried interest structure. Ideally, the GP should roll 100% of their investment from the prior fund into the continuation vehicle, and their investment should comprise 10% or more of the total capital.

While CVs involve risks, such as potential conflicts of interest and GP alignment, they also offer potential benefits. They provide GPs with the ability to continue managing high-performing assets and offer LPs an attractive opportunity to maintain exposure to a successful company at a lower fee/carry basis.

The use of CVs has grown significantly over the past decade, driven by factors such as the need for flexible liquidity solutions, the ability to inject capital into known and high-quality assets, and the opportunity for new LPs to gain immediate and concentrated exposure to assets with a shorter duration and tapered J-curve.

Discounted access to private equity funds

Private equity secondary markets refer to the buying and selling of commitments to private equity funds during their lifetime. This market has grown steadily since the turn of the century, reaching a record volume of $134 billion in 2021.

Secondary funds, also known as secondaries or continuation transactions, purchase existing interests or assets from primary private equity fund investors. For example, a primary private equity fund may purchase a stake in a private company and then sell that interest to a secondary buyer.

One of the benefits of investing in private equity secondaries is the potential for discounted access. Buyers of secondaries may benefit from purchasing assets at a discount to their reported value. This is because sellers are often seeking to generate liquidity, which can create opportunities for buyers to acquire assets at a lower price.

In addition to potential discounts, buyers of private equity secondaries may also benefit from shorter investment durations and faster returns of capital. The ability to analyse the performance of more mature companies and calculate their future value potential can also help to mitigate risk.

It is important to note that private equity investments, including secondaries, are considered high-risk. They often require significant capital and are typically only accessible to institutional investors or high-net-worth individuals.

Frequently asked questions