The Rise of Private Equity Secondaries
The Rise of Private Equity Secondaries
The private equity (PE) industry continues to experience impressive growth as investors embrace the potential diversification benefits of private investment strategies. According to a March 2023 McKinsey study, total private markets assets under management reached $11.7 trillion as of June 30, 2022 and have grown at an annual rate of 20% since 2017.
Many investors are familiar with private equity. But a narrow segment of the private equity industry—private equity secondaries—is gaining traction among investors who are eligible to pursue this asset class.1 The PE secondaries market presents interesting opportunities today due to a confluence of factors, including a growing need for institutional investors to rebalance their portfolios after private equity strategies outperformed public equities and bonds in recent years.
In this article, BDO Wealth Advisors’ investment committee provides an introduction to the PE secondaries market and discusses potential risks to keep in mind.
What are PE secondaries?
The term private equity secondaries refers to the buying and selling of existing private equity stakes from one investor to another. By design, private equity fund investments are intended to be held over the long term—private equity funds typically have a life of about seven years. Because private equity funds (“general partners” in private equity parlance) typically don’t offer investors a redemption mechanism prior to the fund’s maturity, the secondary market is often the only option for PE fund investors (“limited partners”) to gain liquidity prior to the end of the fund’s life.
Sellers in the secondary market are typically institutional investors—such as hospitals, public pension plans, foundations, or endowments. The secondaries market has evolved over time and now features sophisticated specialist managers dedicated solely to investing in diversified portfolios of secondaries. This market is vibrant today, and a confluence of factors are expected to push record levels of deal flow into the PE secondary market in 2023.2
What’s fueling the growth of secondaries?
Several factors are fueling interest in the PE secondaries market. Recent declines in public equity and bond prices mean that many institutional investors’ portfolios may be overweight exposure to private equity, where value has remained relatively stable. This means that many institutional investors could be required to trim their private equity exposure to rebalance their portfolios to the target ranges specified by their investment policy statements. To do so, many will likely tap the secondaries market.
Another factor driving institutional investors’ need to trim PE exposure is the recent compression in the private-equity fundraising cycle, which has accelerated from a four-year to a two-year cycle. Due to this faster fundraising environment, many limited partners have over-committed to new private funds and therefore may need to generate liquidity from existing investments to honor their new commitments. This again is expected to lead to a greater supply of secondary investment opportunities.
What is potentially appealing about secondaries?
Various features of secondaries make them potentially attractive from an investment perspective.
Potential for discounted access: Buyers can often acquire secondaries at a discount to net asset value (NAV)—or even the intrinsic value of the underlying assets. This is because the market for private assets is inherently illiquid. Under current market conditions at the time of writing (late March 2023), secondary transactions have been trading at significant discounts to NAV due to sellers’ need for liquidity and rebalancing. In other words, the market features “forced sellers,” which may allow sophisticated investors to buy secondaries at attractive values.
Transparency: Secondaries tend to offer greater transparency than traditional private equity investments. PE secondaries investors don’t buy into a “blind pool,” where a fund raises capital and then seeks investment opportunities, which is often the case with private equity fund investing. Instead, buyers know what is in the portfolio and can conduct due diligence on the underlying investments, understand their performance to date, and assess prospects for success.
Diversification: Accessing the PE secondary market through a secondaries manager offers greater diversification relative to committing to a private equity fund. Secondaries funds typically provide broad diversification to different industries, sectors, investment years (often called vintages), and risk factors compared to investing in a single PE fund or deal.
Multiple layers of due diligence: When investing in secondaries through a dedicated secondaries fund, the underlying investments and their management teams have generally been vetted through multiple rounds of due diligence from sophisticated investors. The multiple levels of due diligence involved include the private equity firms that originated the initial investments, the institutional investors that sold their interests on the secondary market, and the secondaries manager that acquired them.
What risks should investors be aware of in secondaries?
Like all asset classes, the PE secondary market carries its own unique risks. First, as is the case with any investment in the private markets, secondaries are illiquid relative to public equities and bonds, so investors must be prepared to part with the required capital for several years.
The PE secondaries market is highly complex and requires extensive research and due diligence expertise. To value the assets and negotiate effectively, investors must be able to analyze financial statements, assess managers and management teams, and understand the underlying industries and end markets involved in each opportunity. Relative to the public equity market—which often features broad analyst coverage of investment opportunities and detailed research reports—buyers must evaluate specific assets using their own expertise and resources. For these reasons, many investors opt to access secondaries opportunities through a dedicated secondaries manager.
Are secondaries right for you?
If you are a qualified purchaser with a sizable, diversified portfolio, exposure to PE secondaries may be worth exploring. To learn more, please reach out to your BDO Wealth advisor.
1 Because private investments are illiquid and lack the level of disclosure associated with registered public securities, the U.S. Securities and Exchange Commission (SEC) sets requirements regarding what types of investors are allowed to take on the risk of private investments. Private equity secondaries generally are limited to qualified purchasers, which generally refers to investors with at least $5 million in investments.
2 PitchBook, “PE secondaries market set to boom in 2023,” December 7, 2022.