Spotlight on secondary private markets

Please note: This article is intended for readers with a solid understanding of investments. Private markets are often complex, illiquid and bring higher idiosyncratic risks than public markets, and so are typically only suitable for sophisticated investors. This communication is also general in nature and provided for information/educational purposes only. It does not take into account any specific investment objectives, the financial situation or particular needs of any particular person. 

Investors are increasingly turning to private markets for diversification and returns in the uncertain macroeconomic environment. The secondary private market is evolving and growing rapidly, but is less widely understood compared to its primary counterpart. Here we offer an overview of current secondary market trends, and factors worthy of potential investors’ attention. 

Evolution of the secondaries market  

Once a relatively niche segment characterised by distressed sellers and limited buyers, the secondaries market is now an established market with a growing and diverse range of participants, strategies and buyer/seller motivations. 

Secondary deal volume grew from $26 billion in 2013, to a record $134 billion in 2021, which equates to a compound rate of 23% per year¹. Volumes in 2022 remained high at $108 billion, the second biggest year on record, but slowed during the second half amid public market volatility and lower market pricing². Nonetheless, the upward trend is expected to continue in 2023 and beyond, as the market continues to develop³. Some estimates project deal volume to double over the next five years⁴. 

Growth in secondary market opportunities has been fuelled in part by strong demand in the primary private markets, which have raised $3.2 trillion of capital over the past five years⁵. 

There’s also been a shift in perception around the role of secondaries. Whereas trading in the secondary market was traditionally seen as a potential sign of financial troubles, it’s now broadly accepted as an essential component of private markets – and a valuable source of liquidity for wide-ranging needs.  

Understanding changing market dynamics

In brief, secondary market funds, or secondaries, buy an existing interest or asset from primary fund investors, known as limited partners (LPs). General partners (GPs) who manage private markets funds, may also initiate deals in order to transfer one or more assets from one vehicle to another. These transactions vary in structure and complexity, and cover a range of strategies, including private equity, debt, real estate and infrastructure.

LP-led activity: active management and the ‘denominator effect’ 

Traditionally, secondary market transactions were initiated by LPs looking to sell their commitments in a private markets fund ahead of maturity – and they remain core to the market today. However, LPs are increasingly using secondaries more strategically, to actively manage their portfolios and meet a wider range of needs – including rebalancing, portfolio repositioning, reducing non-core managers or strategies, as well as generating liquidity.  

Current public market volatility is also driving LP-led activity. Some LPs are looking to de-risk, while others are suffering from what’s known as the ‘denominator effect’. This occurs when disproportionately weaker performance from an LP’s listed market investments causes their private markets allocation to increase as a percentage of their total portfolio. Where these allocations breach investment policy or regulatory limits, LPs are turning to the secondary market to reduce their exposure. Pension funds and insurance companies are among those affected, with the former representing 65% of secondary sellers in H1 2022⁶. For buyers, this may present opportunities to acquire high-quality assets at an attractive discount. 

GP-led transactions: extracting value for longer  

In recent years, there’s been a clear increase in GP-led deals, which accounted for more than 50% of all secondary deal flow in 2020 and 2021 (as shown in the chart above)⁷ – although this dipped to 48% in 2022⁸. Often more complex in nature, these transactions include creating continuation funds, which allow GPs to hold onto strong-performing assets for longer, while returning capital to their original investors as required – a topic we touched on in our previous article Trends in private markets.  

GPs are also using secondaries as an alternative to traditional exit routes, as macroeconomic uncertainty has seen exit activity slow and the IPO market grind to a halt. In this environment, secondaries can offer GPs both liquidity and flexibility around when to sell. For buyers, they can be an opportunity to access seasoned assets with a proven track record, where the GP sees potential to extract even more value.  

What’s the appeal for investors?  

The secondary market offers some potential benefits (and risks) for investors that differentiate it from the primary market. 

Accelerated returns  

In a typical primary private equity fund, it can take five years or more to deploy capital raised, and several years before investors receive any distributions. Investor returns can therefore be negative during the initial years, as they commit capital and pay manager fees/costs – known as the J-curve effect. Secondary funds typically acquire stakes at a later stage in the process (around years 5-7) when assets are often already entering the distribution phase, meaning investors could receive pay-outs from the outset. 

More visibility 

Primary fund investors commit capital without knowing exactly where the manager will invest, and so take on some degree of ‘blind pool’ risk. Whereas secondary fund investors know which assets they’re investing in from the outset, and can assess the manager’s track record to date – which can be especially valuable in very challenging markets as we saw last year. For continuation funds, which are typically created after a primary fund has reached maturity, the track record is even longer.  

Diversification 

Secondary investments are subject to different dynamics than primary market, and so can provide diversification within a broader allocation to private assets. Many secondary funds will invest in a range of managers and portfolio companies, across different vintage years, regions and sectors, allowing investors to build a diversified exposure.  

Why consider secondaries in the current environment? 

Supply-demand dynamics in the secondary market are currently skewed in favour of buyers. While there has been an increase in buyers looking for secondary opportunities, the market remains under-resourced and under-capitalised, with supply considerably outpacing demand. 

Secondary ‘dry power’ (i.e. capital already raised) would run out within less than a year if current volumes are maintained (compared to almost three years for the buyout market), as shown in the chart below. Dry powder is also relatively concentrated across a small number of buyers – some estimates suggest around half of secondary dry power has come from just four buyers⁹.

In a market where more sellers are competing to secure funding, buyers are increasingly able to be selective on which assets they buy, as well as negotiate attractive discounts. For example, discounts in the LP portfolio market are at their highest level since at least 2016¹⁰. Secondary investors can benefit immediately from these discounts, as well as any longer-term value creation. 

What about potential risks?

Secondary market transactions can be complex, particularly in GP-led deals involving fund restructuring, and so require careful, extended due diligence – especially where conflicts of interest between GP and LP could arise. Meanwhile, negotiating discounts with LP sellers, especially in challenging markets, can take time and skill. Investing with an experienced manager with the relevant expertise and market access can reduce this risk. 

Private market investments are by nature less liquid than public markets, including secondaries, and there is no guarantee of returns. Diversifying across managers, vintages and strategies can help spread risk and build a more resilient portfolio exposure.

Please note: Past performance and simulated past performance are not reliable indicators of future results The value of investments can fall as well as rise and you may get back less than you invested. 

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