A once stigmatized outlet for LPs to raise cash by selling a fund or portfolio of funds before full maturation, the secondary market has become an increasingly significant cornerstone of private equity since the Global Financial Crisis. While secondaries transaction volume dipped in 2022 following the heights of 2021, last year’s activity rebounded to the second highest on record and has highlighted secondaries’ crucial role in providing liquidity to the industry. Moreover, secondaries have maintained resilience amid a challenging fundraising landscape for most private capital asset classes. In 2023, fundraising for secondary funds exceeded figures from both 2022 and 2021, showcasing their appeal in an otherwise muted climate. Here, we explore the burgeoning secondaries market and factors contributing to its continued growth.
A sustained gridlock in traditional exit routes has left LPs in a prolonged period of negative cash flows. Heightened volatility, rising interest rates, increased regulatory scrutiny, and sustained pricing disconnects collectively led to substantial declines in global M&A activity throughout 2022 and early 2023. Global IPO markets continue to languish, showing no signs of bouncing back from their historic peaks in 2021. Moreover, lackluster post-IPO performance has compounded investor reluctance to face public markets, prompting many to explore alternative avenues for generating liquidity.
Amid these dynamics, the secondary market has emerged as a vital tool for investors grappling with urgent liquidity requirements, offering a more favorable environment than traditional exit routes for both LPs and GPs to attain liquidity, evidenced by significant growth in both LP and GP-led markets.
Initially, LP-led deals involved distressed situations and were executed at substantial discounts to net asset value (NAV) in a non-economic manner. Over the past decade, these transactions have taken place in more favorable market conditions, leading to the maturity of their use cases and reputation. As more and more LPs have adopted these transactions as a liquidity tool, pricing has generally become more stable at narrower discounts to NAV. Today, LPs sell their portfolios for various reasons, including adjusting exposures, releasing capital from aging commitments that have mostly realized their value, or reallocating capital to strengthen key relationships.
The ability to actively oversee portfolios in an inherently illiquid asset class has proven remarkably potent in the current landscape, particularly for those facing cash shortages and overexposure to private equity. According to Lazard’s Secondary Survey, in 2023, 83% of sellers pursued a secondary market transaction for liquidity or portfolio management purposes, while 63% indicated a need to fund an excess of capital calls in their existing portfolios.
While LP-led deals comprise the majority of secondary market share, the rapid growth in the market can largely be attributed to the substantial rise in GP-led transactions, consuming 44% of transaction volume in 2023. GPs have flocked in droves with prized assets to the secondary market over the past year. Continuation funds have provided buyout shops with a much-needed opportunity to return cash to investors, enabling them to sustain fundraising momentum without divesting prized assets in a challenging M&A and IPO climate.
Rolling over assets into continuation vehicles allows firms to obtain cash to infuse into companies with promising growth trajectories, wait for a better exit environment, or secure an extended runway to fully execute the value creation plan, all while affording LPs flexibility to maintain or exit their exposure – and most LPs are taking the cash. Just 10% of LPs are electing to reinvest their capital into continuation vehicles, marking a significant decline from previous years.
Importantly, as GPs inundate the secondaries market, a notable supply-demand imbalance has emerged, creating a landscape where only the most compelling opportunities are closing. It’s a buyer’s market, with secondaries investors being highly selective in the deals they pursue. Realistic valuations, limited cyclical exposure, top-tier assets and managers, strong alignment, and sound transaction rationale are just a few attributes that characterize deals crossing the finish line.
This dynamic has created a high degree of nuance on both sides of the deal. Buyers need an attractive valuation, a solid underlying asset(s) with strong fundamentals, and a clear path to future growth and upside to ensure strong demand for an attractive exit down the line. At the same time, these transactions need to price well and provide a favorable return for LPs exiting the fund. Consequently, GP-led deals often encounter significant friction.
Another catalyst for the secondaries market is the increasing participation of institutional investors attracted by more appealing entry points compared to traditional funds, reflected in record fundraising figures for 2023. Secondaries funds closed $117.9 billion, more than doubling YoY. Attracted to J-curve mitigation, appealing return profiles, and diversification, LPs continue to pour capital into secondaries funds, with the asset class emerging as a bright spot in a broadly chilled fundraising climate.
Investors in secondaries funds have the chance to invest in funds that have already concluded their investment period, bypassing the initial years of negative returns typical in traditional funds and enjoying shorter holding periods with quicker distributions. PitchBook data reveals that secondaries funds generally achieve net positive cash flows by year four, a year earlier than private equity funds. Additionally, the proportion of distributions relative to fund size is higher in secondaries funds, surpassing that of private equity funds until the fifth year. Moreover, entering during the investment period enables LPs to mitigate blind pool risk by often accessing companies with established business models, proven track records of performance, and clear paths to future growth.
Diversification has been another draw to secondaries. Historically, most secondaries funds were primarily composed of LP portfolios, which inherently offer a highly diversified underlying base of portfolio companies. Today, secondaries investors often give their LPs the option to choose between a diversified LP portfolio strategy or a more concentrated exposure via investing in continuation funds — or a mix of both. However, this evolution of investment products has surfaced several considerations from a diversification perspective.
While single-asset continuation funds have been and continue to be a popular structure, secondary investors’ portfolio concentration limits and fund construction considerations come into play. For example, the concentration of continuation vehicles can quickly result in meaningful ownership of an underlying asset. LPs with ownership limitations or secondary investors bound by concentration limits in their LPAs may find it challenging to monitor these ownership concerns if pursuing a solely focused GP-led strategy.
As a result, the enthusiasm for single-asset deals, which surged in the aftermath of COVID-19, has somewhat waned as secondaries buyers prioritize diversification and lean towards multi-asset deals. This said, a growing preference for multi-asset continuation funds does surface some tension against broader secondary dynamics. Given the strong demand for quality assets, GPs must exercise utmost selectivity when choosing assets for continuation funds to finalize deals. In some instances, pursuing single-asset transactions may be preferable unless they can put forward multiple assets of adequate quality for a rollover.
Secondaries post strong returns relative to other private asset classes, which has also attracted LPs to the asset class. However, given the difference between LP-led and GP-led transactions, the portfolio construction of secondaries funds plays a significant role in their return profiles. Continuation vehicles provide meaningful exposure to quality assets at a greater concentration and are typically priced higher than their LP counterparts. While GP-led pricing took a dip in 2023, 70% of transactions were still priced at or above 90%, with 54% of single-asset vehicles priced at par or premium. However, despite a higher entry point, continuation funds appear to perform better than diversified direct portfolios, reflecting the quality of assets GPs are placing into these vehicles. This said, the concentrated nature of these funds can result in a greater dispersion of returns. Conversely, LP portfolio stakes, made up of a highly diversified base of underlying assets, provide a more predictable return profile but tend to target lower return multiples.
While experiencing a notable uptick in capital inflows, the secondary market still remains under-capitalized relative to other private capital asset classes. Yet, the versatility of these transactions suggests they will remain an all-weather solution for private market investors well beyond the current liquidity crunch. Moreover, GPs’ increasing focus on attracting the wealth channel seeking higher returns than public markets will likely fuel further growth in the space in the coming years. Lastly, as these factors continue to contribute to heightened fundraising activity in the secondary market, enhanced dry powder in the system will likely increase pressure to deploy, infusing more competition in the market that could narrow bid-ask prices.
Chronograph for Limited Partners helps LPs gain a complete view of private capital performance and exposure across their portfolios. Request a demo to learn how Chronograph can help unlock the strategic value of your investment data to accelerate and enhance your evaluation of secondaries opportunities.
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