Understanding the Secondaries Market

Welcome to Commonfund Institute Online, dedicated to the advancement of investment knowledge and the promotion of best practices in financial management. Hello, my name is Lawrence Shoykhet, and I'm a senior associate on the secondaries team at CF Private Equity. Today, we're going to explore the rapidly evolving world of secondaries. Within the secondary market, there are two core transaction types which drive a majority of annual volumes. There's LP secondary transactions and GP led secondary transactions. On the LP side, this is typically either the purchase and sale of a single interest or a portfolio of interests in private capital funds. On the GP led side, a majority of these transactions are either a single asset continuation vehicle or a multi asset continuation vehicle. Throughout this presentation, we'll dive deeper into the structure and statistics for both type of transactions. So what is an LP secondary? An LP secondary investment is typically the purchase of an existing private capital commitment or commitments in the instance of a portfolio sale from another limited partner or LP. These sales occur at some point after the initial close of the fund interest being sold and at some point during the fund life. Breaking this down further, as you can see on the screen, there are generally three main parties involved in a transaction. On the right side of the chart, you have the seller or limited partner who is often an institutional investor or a high net worth individual. This group is seeking liquidity for one or several of their limited partnership interests in different private capital funds. On the left side of the chart, you have the secondary buyer. The secondary buyer provides this desired liquidity to the seller or LP in exchange for their limited partnership interest in the private capital fund. As you can see here, in between the two parties, you have a purchase price coming from the buyer to the limited partner or the seller, and in exchange, you have a transfer of this limited partnership interest. The buyer often sets the price, and while it's situationally dependent on multiple factors, this liquidity is often provided at a discount to the net asset value or NAV of the seller's interest. Thus, secondary buyers often have an attractive investment opportunity to purchase quality private equity assets at a discount to their fair value. Additionally, given this often discount, the secondary buyer sees an immediate uplift in the holding of their investment upon the completion of the transfer. And now to the transfer. At the bottom of the screen, you see the general partner or private equity manager. The general partner is the party responsible for managing the private capital fund that the seller is looking to get liquidity for and that the buyer is acquiring. The GP must approve any transfer between the two parties mentioned above. One more comment on LP secondary transactions. These transactions can range in size, being from as small as, call it fifty thousand dollars for a single LP interest, all the way up to over five billion plus for a large diversified portfolio. Now that we've discussed some of the general mechanics of LP secondary transactions, we can dive deeper into the growth of this segment of the market that it's experienced over the last twenty years. As you can see, LP secondaries continue to exhibit strong growth year over year, and they remain the core segment of the overall market. In fact, this past year, according to a Jefferies report, LP secondaries represented fifty four percent of the overall market, and they accounted for eighty seven billion dollars of transaction volume in twenty twenty four. A staggering fact is that this eighty seven billion dollars would represent the sixth largest overall year on record for the entire secondary market, which just goes to show how important LP transactions are to the whole secondary market. The main takeaway from this slide is that LP secondaries are extremely resilient. And as you can see, that we've more than bounced back triple from the trough in twenty twenty, where we saw twenty five billion dollars to today, where we have eighty seven billion dollars of LP transaction volume, and the market is poised to continue to grow and be a key source of liquidity for the LP community. So now switching gears to GP leds. GP led secondaries are the complement to the LP led segment of the market. A GP led secondary transaction typically involves the creation of a new vehicle known as a continuation vehicle to acquire either a single asset or a group of assets from an existing fund managed by a general partner or GP. This continuation vehicle, and in turn, the underlying assets that are being transferred to it, are overseen and managed by the same GP. And this new continuation vehicle is largely funded by secondary investors who are seeking to gain exposure to these assets. The exposure of these assets is being sold by existing LPs in the original fund, and these investors are often offered the opportunity to either sell their stake or hold onto it, retaining their exposure to these assets by transferring it into the newly created continuation vehicle. As shown on the screen here, there's several moving parts in its GP led continuation vehicle transaction, which we'll go through now. On the left side of the screen, you have the original fund, which holds one asset in the case of a GP led single asset continuation vehicle transaction, or multiple assets in the case of a multi asset continuation vehicle transaction. This original fund transfers these assets that it's selling to a newly created continuation vehicle, as seen on the right side of the screen, in exchange for an agreed upon purchase price. The original fund, as I touched upon, is made up of LPs, some of whom will sell their stake as part of this continuation vehicle process, which are denoted as selling LPs, and they'll be receiving the sales proceeds. On the other side, you have rolling LPs, which are the LPs from the original fund that are seeking to hold onto their exposure and retain this exposure by rolling it into the continuation vehicle. On top of them, you have the secondary buyer who are investing new capital in order to acquire a stake in the continuation vehicle, and the majority of the capital requirement needed to fund this transaction is going to come from these secondary buyers. One thing to note is that these transactions often have both lead and syndicate secondary buyers. The lead buyers are responsible for underwriting the assets and typically setting the price at which the new continuation vehicle is acquiring the assets or pool of assets from the original fund. Lastly, at the bottom of the diagram here, you have the private equity manager or general partner who manages both the original private capital fund that's selling the interest, as well as this newly formed continuation vehicle. The GP is responsible for initiating these transactions with the motivation being to reset investor time horizons and effectively get a second bite of the apple. One more point to note is that in recent times, the GP led market has served as an alternative exit path for financial sponsors to generate liquidity when the regular way M and A and IPO route isn't actionable. Looking at some of the statistics of the GP led secondary market. This is a newer phenomenon within the broader secondary space and has only started to see real widespread adoption over the last five years. As you can see in the chart up top, twenty twenty one marked a huge jump in GP led market volume as we saw the market grow from thirty five billion in volume in the year prior to sixty eight billion. And since then, the market has been a consistent mainstay as part of the broader secondary space. Within the GP led market, the continuation vehicle transactions that we just spoke about are the dominant drivers of volume across GP leds. These type of transactions accounted for nearly eighty percent of total GP led volume, with roughly fifty percent coming from single asset continuation vehicles and approximately thirty percent coming from multi asset continuation vehicles, as you can see in the charts here. Moving to the next slide, liquidity to an illiquid asset class. We've talked about the main two types of transactions within the secondary market. So let's dive into some of the key trends which are driving more investors and asset managers to embrace secondaries. As it relates to LP secondaries, there are several themes that are underpinning the growth of this segment of the market. The first is the need for active portfolio management, which is made possible through proactive sales on the secondary market. So limited partners understand that secondaries give them the flexibility to manage their portfolios, whether it's by reducing their allocation to a strategy to fix their allocation percentages, cutting off a non core relationship, or for noneconomic reasons. Secondaries are a very helpful tool to manage your portfolio. Second is investors' need for cash. This is especially important in today's market environment as the quiet M and A and IPO markets have resulted in a slower pace of distributions coming back to limited partners. And in turn, it's taking longer for investors to see the cash flowing back into their portfolio. And thus, there's a great need for cash in investors' portfolios. The last point we'll touch on as it relates to LB secondary transactions is the vast supply of tail end funds that are entering the market. So a tail end fund is a fund that is ten or more years old, and the vast supply of these funds in the market today is a symptom of both a weaker exit environment, which is preventing GPs from fully winding down older vintages, and the aforementioned proactive portfolio management that's being taken on by investors. On the GP led side, one of the key themes is the idea of crown jewel assets. And this refers to the topic that we just discussed around continuation vehicles. GPs are seeking to hold on to their best assets, And rather than sell them to a competing financial sponsor or strategic buyer after they've generated a strong return on the asset in their original fund, instead, they're now opting to go to the secondary market to continue to hold this asset or assets via a single or multi asset continuation vehicle so they can continue to execute on a value creation plan. The attractiveness is that in these instances, the GP has already owned the asset for a number of years, so they're very familiar with all the nuances and measures necessary for creating additional value within a portfolio company, and they're able to sustain the growth within the company on a go forward basis. The attractiveness here is that the GP knows the company better than anyone else and is well positioned to continue to execute and generate a strong new return for secondary buyers and all investors within this continuation vehicle. Moving to some headlines we're seeing in the secondary market. It's clear that secondaries, it's a very exciting time to be investing in secondaries. And this is being validated by the media, as we can see from some of these recent headlines. Looking at a couple, private market secondary deals hit record levels in twenty twenty four from The Wall Street Journal. A majority of GPs plan to use the secondaries market over the coming two year period from secondaries investor. And from The Financial Times, private equity is more stuck than ever, and secondaries will benefit. These headlines hit on many of the themes that we just talked about, whether it's crown jewel assets, active portfolio management, or the need for cash from investors. All these themes are driving people to the market and are positioning the secondaries market for continued growth. Since we've discussed the structure of LP transactions and how this segment is racing to record highs in terms of volume, now let's dig a little deeper into who's driving these sales. According to Jefferies report, the key sellers driving the market in terms of volume, which is shown in the chart on the left, are pension and sovereign wealth funds, who account for over fifty percent of LP secondary volume sales in twenty twenty four. They're followed by fund to funds, which are at nearly twenty percent of all LP secondary volume. And then financial institutions round out the top three. And together, these three groups represent over eighty percent of the total LP volume that we saw in twenty twenty four. Looking at the market in terms of transaction count, which is the chart on the right, paints a fairly similar picture. Pension and sovereign wealth funds dominate the market and represent over thirty five percent of all LP secondary transactions. They're followed by fund to funds, which represent twenty three percent of LP secondary transactions. And again, financial institutions representing eleven percent help round out the top three at over seventy percent of all LP secondary sales. Now that we've talked about who the key groups selling into the market are, we can better understand the reasons driving their decisions to sell. Sellers often have economic and non economic reasons for selling their stakes onto the secondary market. Currently, the four main reasons why groups are selling into the market are, first, to wind down older vehicles, which represents thirty percent of sales. And this reinforces the idea that we talked about, how there's a vast supply of tail end funds on the market that need to be wound down and are creating attractive buying opportunities for secondary groups. Second, representing twenty nine percent of reasons why sellers are going into the secondary market, is portfolio rebalancing or over allocation to private equity. Portfolio rebalancing is an important aspect of portfolio management, and at a time currently when groups may be over allocated to private equity by virtue of the volatile public markets and the denominator effect, they're turning to the secondary market to manage this over allocation. Third is a general push to generate liquidity, which represents twenty seven percent of sellers going to the market. As we've talked about, investors have a need for cash, especially in the current market environment. And if they're not seeing this come through organically, they're forcing the issue themselves to drive cash back to their portfolios. And lastly, representing fourteen percent of reasons why people are coming to market to sell is to reduce exposure to non core managers. This is an example of a non economic reason why sellers are coming to the market. So why invest in secondaries? We've discussed what a secondary is, who's selling into the market, and why they're selling. Now let's focus on the appeal of investing in secondaries. So secondaries has many benefits, some of which include offering the potential to reduce the J curve and enhance returns. Let's dig into this some more. With a secondary transaction, you're buying in at a point in time, typically in year five or six, as shown in the chart on the left here, when drawdowns are starting to slow down and instead you're starting to see distributions and cash inflows. If we look at it here in year five or six, which represents when a typical secondary investor will buy in, the light blue bars representing the drawdowns or the capital calls are starting to decrease. And instead, we're starting to see an increase in distribution activity or cash coming back to the portfolio. And if you look at the shape of this orange line, which represents the cumulative cash flow, a secondary buyer typically buys in at year five or six at the bottom of the J, thus effectively reducing the J curve, and enters at a point when positive cash flow starts to ramp up. Secondaries also reduce blind pool risks as you're buying into a fund after a majority of the money is already in the ground. Looking at the chart on the left again, most of the assets were bought in years one through four. And now that a lot of the capital is deployed, when a secondary investor buys in, they have good insight into the assets already in the portfolio, as opposed to a primary investor who's committing capital in year zero, year one, and is then waiting to see as the private equity firm or GP deploys this capital. Additionally, secondaries provide vintage year diversification and balance the timing of distributions. Secondaries allow you to purchase vintage years that are potentially missing within a private capital program so you can balance the expected timing of cash inflows and outflows across the different funds in your portfolio. More on diversification, secondaries allow you to get exposure to different alternative asset classes, whether it be private equity or venture, and allow you to shape up the mix of your portfolio if you're missing certain elements within your private capital program. And lastly, secondaries shorten the time it takes to reach allocation targets as it speeds up the pace at which you could deploy capital into private equity versus if you're just relying on your primary commitments to be slowly invested over a five or six year span. Looking at the chart on the right here, we can see that with a primary only acceleration program, you are deploying capital and it'll take you close to seven or eight years before you reach your twenty five percent allocation target. On the contrary, if you have both a secondary and a primary program, this pace of deployment is accelerated, and instead, you reach the same point around year six, close to two years before. Moving to the next slide, the private equity universe. This chart maps out the private equity universe and shows how the portfolio and maturity of companies changes with time. When a company is just a concept, it's generally considered a startup and is raising venture capital, and would be in the bottom left corner of this chart. As the company starts to mature and move to a point of positive cash flow, moving up the y axis towards maturity, it becomes more of an emerging growth company that's better suited for investment by private equity. Under private equity ownership, the company continues to grow and reaches a point where the natural sale or exit path for the company is an IPO, at which point it crosses over from private equity into the public markets. And that point is represented here where the dark blue line becomes a light blue line. As it relates to secondaries, all different asset classes trade within the market, and whether it's early stage venture, later stage growth, or just mature regular way buyout. So we've talked about the record year that the secondaries market experienced in twenty twenty four, but it's still extremely important to contextualize just how small the market is compared to the broader private equity and private capital markets. So the broader private capital market is over twelve trillion dollars And of this twelve trillion, five trillion is represented by the private equity market. To put this into perspective, with the one hundred and sixty two billion of volume that we saw in the secondaries market in twenty twenty four, this is less than two percent of the total private capital market that's trading on the secondary market on any given year. To me, this highlights just how much white space and room for growth there is and how underpenetrated the market is. It also underscores that the secondary market is still very much under resourced and undercapitalized, as we'll discuss later on. Moving to the next slide on secondary volumes, like I just touched about, this shows a combination of the previous charts that we've looked at, which split the growth of the secondary market into its LP and GP segments. The main takeaway from this chart is that the secondaries market continues to grow. And over the last ten years from twenty fourteen to twenty twenty four, has been growing at a fourteen percent CAGR and is well positioned to continue this trajectory over the next decade. As I mentioned, the secondary market is under resourced and undercapitalized. In twenty twenty four, the capital overhang multiple, which is the ratio of dedicated available secondary capital to the secondary volume in the last twelve months, was one point eight times. What does this mean? This would suggest that the entire pool of dedicated secondary capital could be invested in less than two years. Additionally, when we look at the overhang multiple in twenty twenty three and compare it to twenty twenty four, we see that it dropped from two point three times to one point eight times. But what's the significance of this? This implies that the pace at which the market is growing in terms of volume and deal making is outpacing the growth of the fundraising market. And secondary groups aren't able to keep up and raise enough capital for how much volume and supply and demand there is in the secondaries market. Looking at secondaries performance versus other private classes tells a very attractive story. And it's clear to see why this segment has been such an attractive source of investor capital. Ninety percent of secondary funds with vintages ranging from two thousand to twenty nineteen have not lost investor capital. Additionally, secondaries has had the highest median net IRR across private equity, venture capital, real estate, and natural resources, according to a Bain private equity report. Secondaries offer investors a very attractive risk return profile relative to other alternative asset classes, and they're gaining significant interest from the broader investment community. Turning to pricing. Selling on the secondary market often means taking a discount to the net asset value or NAV. The level of discount depends on the age of the underlying assets, as we'll dig into further in a few slides. Deal flow within secondaries is robust and buyers are constantly looking at multiple transactions at the same time. They're also seeking out opportunities where they can acquire interest at attractive pricing. So how do buyers determine the right price to pay? One way is by conducting a bottoms up analysis and underwriting the individual assets within a fund. So what does this mean? Buyers take into account historical growth profiles. They take into account the leverage on these assets, the sectors that these companies operate in, the holding valuations and how they compare to that of comparable companies and comparable precedent transactions that have occurred in those segments in the industry, the end markets the companies serve, etcetera. Secondary buyers then take all of these metrics and factors into account and forecast an ultimate exit value for the underlying assets. From that, what you're effectively doing is projecting the future cash flows for these assets individually, and then you aggregate this up all the way up to the fund level. Buyers then underwrite to a specific return profile for the investment. And based on this target return and the forecasted expected cash flows that they've deducted based on their analysis of these underlying companies, they can then derive a price to pay for a specific LP interest in order to achieve their target return. As I mentioned a couple times, secondary deal flow is robust, so it's crucial to stay disciplined and selective as a buyer. From twenty ten to twenty twenty, there's been over ten trillion dollars of capital raised. And as such, there will be a continued source of secondary supply as LPs in these different vintages elect to seek proactive liquidity through active portfolio management. In terms of what the supply looks like, it's spread across traditional LP positions, private bank feeder funds, secondary directs, tail end wind downs, fund to fund positions, and GP led opportunities. Given the vast amount of opportunities currently in the market, it's extremely important to stay opportunistic and flexible to make sure that you're seeking out the best opportunities across different sub strategies within the secondary market. And now looking at some average secondary market buyout pricing by the age of fund and talking about a theme that I mentioned earlier with price being dependent largely on the age of the positions you're buying. If we look at pricing for buyout funds, there's a clear picture here being painted. As buyout funds get older and are older vintages, the pricing for them on the secondary market tends to decrease. Looking at newer funds that are zero to three years old, we can see that they fetch a price of near par. As you get to funds that are four to six years old, we slowly come to see pricing come down from ninety nine percent of NAV to ninety six percent. The real decline starts to occur once funds cross that ten plus year barrier and are then considered tail end funds, as at that point, you see pricing drops into the 70s at seventy nine percent of NAV. And for funds that are thirteen plus years old and really tail ends, pricing drops even further to seventy percent of NAV. The reason for this is that it's much less likely for there to be significant upside remaining in funds that are this old. In conclusion, today we talked about the secondary market, talking about LP transactions, GP led transactions, why sellers sell into the market, who's selling, and the great growth the secondary market has ahead. Thank you very much.