The duration of a typical private equity (PE) fund is between 10 and 12 years. It can be seen as an investment period, generally, the first five years, and afterwards, a harvesting period. During the harvesting period, investors can exit. By nature, PE fund investors do not enjoy liquidity mechanisms. If an investor or limited partner needs to exit a fund prematurely, selling via the secondary market is the only option. The pricing, a percentage of the reported NAV (Net Asset Value), in the secondary market is based on quarterly valuations reported by the PE funds. It will be an over-the-counter transaction that transfers all rights and obligations of the new buyer.
PE investors can find huge liquidity options at different maturities and funding levels in the present investing world owing to strong volume growth in the PE secondary market. It reached an all-time high of $88 billion in 2019, rising from $37 billion three years prior. Analysts anticipate growth of $250 billion in the next 5 years.
Factors impacting growth
- Active portfolio management: Sophisticated investors in the secondary market have coincided with a desire to participate actively in managing their investment portfolios. For example, an investor can shift its investment focus to strategy, geography, or the industry sector. Sellers in the secondary market often look to dispose of certain existing fund interests to rebalance their overall exposure.
- Gains and premiums over NAV: High performing funds are often priced at premiums over the NAV of the remaining assets. The ability to provide significant returns while achieving liquidity entices more investors to dispose of their investments before the end of the fund term.
- Regulatory regimes: New rules, like Basel III2 and Solvency II3 for insurance groups and banks, have driven significant selling in the secondary market in the last few years. More market participants may be affected by similar impacts of future regulations.
- Exposure to highly-coveted assets with enhanced visibility: The secondary market provides an opportunity to access preferred sponsors as well as obtain exposure to highly-coveted assets. Sponsors may look for capital from outside the fund to incentivize its value-building activities. These are general partner-led restructurings where a new fund of third-party investors capitalizes on remaining assets. It provides more time to maximize the asset value. These transactions with a high-quality sponsor may enable a secondary investor to leverage the general partner’s knowledge.
- Access to specific funds or preferred sponsors: In the secondary market, a buyer can access previously unavailable funds. It may be a missed opportunity during fundraising or a restriction from fund managers to access their funds in the primary fundraising process.
- Strong returns and lower risk: Acquiring an established fund often carries less risk than a new fund. When investors commit to a PE fund in the primary market, they believe that the sponsor can identify strong performing investments. On the other hand, an investor acquiring an interest in the same PE fund in the secondary market can diligence the fund’s existing portfolio. Therefore the secondary market can evaluate the fund’s potential returns better.
- Faster deployment of capital: By acquiring an interest in the secondary market, an investor can have a PE portfolio faster compared to primary commitments.
- Diversification: With exposure to secondaries, an existing PE portfolio widens diversification across sectors, geographies, strategies and managers. The risk of losing capital can be attributed to greater diversification and the acquisition of assets at a discounted NAV. secondary fund of funds typically acquire interests in primary funds for a diversified portfolio. With each acquisition, they are being exposed to many holdings. The resulting secondary portfolio provides the investors’ exposure more efficiently.
- Lower volatility of quarterly returns: Considering global secondary fund returns and primary PE funds, returns from secondary funds are less volatile.
Thus, the main advantage of a secondary fund purchase over a primary fund investment is that investors deal with funds in secondaries that have already deployed significant capital. It enables the investor to analyze the actually purchased assets instead of making a blind commitment to the fund manager at the beginning of the fund and looking for good investments. A secondary transaction has a lot more information to make your investment decisions.