The Private Equity Secondary Market – Has COVID-19 Created a New Buying Opportunity?Anchin AlertDecember 10, 2020
The typical way to invest in private equity is by investing when a fund initially raises capital. However, it is also possible to invest by taking over the position of an existing investor by purchasing the position on a secondary market. Under the right conditions, there can be significant advantages to investing through the secondary market - and the COVID-19 crisis may have created such an opportunity.
The Secondaries Market
The private equity secondary market (“secondaries”) involves the buying and selling of pre-existing investments in private funds. Sales are often driven by limited partners seeking to exit primary private equity funds before they are fully liquidated.
Secondaries are composed of existing assets, which means the underlying fund may have already deployed the majority or all of its capital to portfolio companies. Accordingly, secondary private equity investments are viewed as more mature investments than primaries, and typically have shorter investment periods and accelerated returns on invested capital.
Purchasing a stake in an investment fund that is closer to the end of its investment cycle and further along the J curve gives an investor a chance to attain a higher internal rate of return (IRR) than someone who bought in during the primary funding. It may take a primary private equity fund five to six years to fully deploy the capital, which delays when investors receive distributions and means they may initially have a negative return.
Since a secondary investor is buying later in the cycle, the timeline for when they see a potentially positive return on their investment shortens. Occasionally, a new secondary investor is able to start receiving distributions from the fund right away.
Another advantage is that a secondary investor can see what the private equity fund has invested in, whereas primary investors often go in blind when they contribute capital because the fund manager hasn’t made any commitments yet.
The History of Secondaries
The financial crisis of 2008 created a period of extreme stress in global financial markets and banking systems. Consequently, a niche secondary private equity platform emerged that was characterized by a limited pool of buyers, motivated sellers and steep, discounted prices.
However, as the market has matured over the last decade, it has seen an increase in the sophistication level and diversification of its participants, including large pension and sovereign wealth funds, family offices, and foundations. The market’s intermediary channel has also expanded significantly – secondary advisory firms are now available to identify buyers and sellers, structure transactions, negotiate trade offers and help price portfolios, among many other services aimed at helping to facilitate these secondary deals.
Increased competition due to new participants and the scarcity of better deals has led to high valuations and smaller discounts in recent years. In fact, some buyers were even willing to pay a premium above the net asset value (NAV) of some funds for the advantage of seeing what commitments the fund had made. As a result, secondary investors had reduced opportunities for large, immediate positive returns.
The uncertainty caused by the current COVID-19 pandemic in the United States and around the world has resulted in substantial volatility in the financial markets. This volatility has also led to the expectation that pricing levels in the secondary market will adjust downward, creating a more attractive buying opportunity for secondary fund managers and enabling them to purchase positions at greater discounts.
Liquidity-strapped sellers, such as institutional investors, secondary funds and financial organizations may be looking to exit positions at a discount on the secondary market, like they did after the 2008 financial crisis. In addition, banks that took over overly-leveraged positions as well as restructuring funds may also be willing to sell at a discount.
The current crisis may likely trigger unique secondary opportunities, enabling fund managers who have success in identifying these assets to greatly diversify their portfolio.