In recent years, the private equity (“PE”) landscape has witnessed a notable surge in the secondary market, driven by demand for flexibility, liquidity, and innovative solutions to investors’ evolving needs. Originally seen as a niche segment, secondary transactions are now recognized as essential components of portfolio management, providing both liquidity options and strategic advantages to limited partners (“LPs”) and general partners (“GPs”). This article explores the drivers of growth in the private equity secondary market, the innovations shaping this sector, and its future outlook.
Some Trends That Will Likely Shape The Future Include:
Rising Innovation in Deal Structures: As secondary deals become more sophisticated, expect innovative transaction structures to arise, tailored to meet specific investor needs and market conditions.
Expansion into New Asset Classes: The secondary market is expanding beyond traditional buyout funds into areas like private credit, venture capital, and real estate, providing even more flexibility for investors.
Continued Technological Transformation: Technology will play a crucial role in increasing transparency, streamlining processes, and reducing costs, further enhancing the efficiency and appeal of the secondary market.
The secondary market in private equity is no longer a peripheral component but rather a core element of the industry. It offers investors the opportunity to optimize portfolios, manage liquidity, and navigate market uncertainty more effectively. As this market continues to grow and innovate, it will likely reshape the landscape of private equity investing, attracting a broader range of participants and fueling the expansion of the entire asset class.
Second Place is Not (Necessarily) First Place Loser
The secondary market in private equity involves the buying and selling of pre-existing investor commitments in private equity funds. This differs from the primary PE market, where funds are raised directly from investors by PE firms. In the secondary market, LPs looking to exit early can transfer their fund stakes to other investors. This exchange offers LPs liquidity, while enabling buyers to access mature assets with shorter holding periods and potentially lower risk profiles.
Secondaries also include GP-led transactions, where fund managers create liquidity for their LPs by selling assets into a new vehicle managed by the GP. LPs can elect to take liquidity with the sale or roll their interests into the new vehicle. The new vehicle is generally infused with some new capital to allow for growth investment into the underlying assets. This structure allows GPs to keep high performing assets and maximize returns with some extra capital to continue to grow the company for a few more years.
And as our client and dear friend Paul Cohn of Tail End Partners[1] stated, “Independent Sponsors are also participating in the secondary market by executing equity recapitalizations. Similar to the GP-led structure above, the independent sponsor uses the recap to provide liquidity to its investors and there is also dry powder infused into the company for future growth.”[2]
The growth of the secondary market in the independent sponsor space is further vindication that the space has grown and become even more efficient.
A Brief History of Secondaries
As sweeping regulatory changes occurred in both private (Taft Hartley—think private unions) and public unions (think municipalities and state pension plans) in the late 1970s permitting pension funds to invest in private equity, assets under management in the organized private equity market increased dramatically, from under $5 billion to over $175 billion between 1980 and 1995.
By the 1990s, private equity had become a core holding for most institutional investors, with average portfolio allocations ranging from 5% for public pension plans to nearly 15% for endowments and foundations. The secondary market began to emerge some 50 years ago but really became a well-known asset class by mid-to-late 1990s which coincided with the geometric growth of PE. In fact, the latter half of the 1990s saw the first secondary fund (say that thrice).
No Distressed Assets Just Distressed Owners
Like so many things that rise from the ashes, the secondary space really saw supply growth, as a result of the Savings and Loan Crisis in the late 80s and 90s and the subsequent regulator reaction, which resulted in an adjustment in the capital-to-risk-weighted-asset ratios and capital requirements covering of-balance-sheet activities which forced many institutions to rebalance their private asset portfolios. The foregoing resulted in an oversupply of LP interest in the market (and who doesn’t love a bargain).
Moreover, after the dot-com blowup in 2000s, more distressed sellers entered into the market resulting in more supply coming onto the market. Hence, you had sellers searching for a bid which resulted in a buyer’s market. And while downward pressure on pricing doesn’t make for a healthy market, it does attract value buyers and after buyers recognized the value of secondary purchases and excess capacity eroded, the market began to stabilize around 2006.
Normalization of Bid/Ask Spread
As a result of market normalization, LPs viewed the secondary sales opportunity more favorably. The removal of the stigma of not being a distressed seller allowed LPs to both use Secondaries as a means to get liquid and rebalance portfolios. In fact, starting in the mid to late 2000s secondary total deal flow began to increase from approximately $20 billion in 2008 to more than $100 billion in 2021 and 2022. Furthermore, GP-led Secondaries also took off and become a huge part of the Secondaries space as it allowed GPs to continue to grow top platform companies and LPs were interested (and that interest grows today in single platform funds and/or independent sponsors) in single platform deals.
More data on the growth of the secondaries market is the total volume in the deal market. Hamilton Lane provides great data on this in a report published in 2023:
“2012 secondary market volume was $25 billion compared to $463 billion of the overall market equal to 5% the size. By 2022, secondary market volume rose to 10% of the overall size of the PE market.”[3]
Moreover, as of July 2024, secondary transactional value (total value) in both GP led and LP led volume equaled $137 billion which exceeds the record total deal volume for all of 2021.[4] The foregoing is a testament to the growth of the secondaries market, which was a direct result of LPs frustration at the lack of liquidity in the PE market combined with GPs looking for an opportunity to stick with their best investments to optimize their economic potential (also known as carried interest)> The GP-led market provided a tool for GPs to hold on to their best assets while also giving LPs much in demand liquidity. A perennial PE problem has been the GPs desire to compound returns by holding onto good assets battling against the LP need for liquidity and ten year lives of most funds. This duration mismatch has plagued the alternatives space for as long as I can remember (be it evergreen credit funds of the late aughts or venture funds of the early aughts). This dichotomy of push/pull between investors and GPs has further fueled the growth in the secondaries space.
Secondaries continue to grow and for many investors, either in an individual investment or pooled platform, secondaries, as an investment, provide a better MOIC score.[5]
Below find some reasons why we think secondaries as an investment class will continue to grow.
Why Are Secondaries Growing?
Secondaries are growing rapidly for a number of reasons:
For one thing, it’s healthy and desirable for a mature asset class to offer investors a liquidity outlet.
It helps with rebalancing of portfolios.
It lessens the blow to investors who are sensitive to elongated hold periods (the average life of a fund is now 15 years).[6]
In the shorter term, cyclical factors such as the denominator effect and slowed distributions in an uncertain environment provide even more tailwinds.
Supply notably outstrips demand in today’s secondary market, where prices are coming down and where the dynamic for buyers is likely to continue improving as more supply hits the market. This is also the area of the market where the most innovation and creativity are occurring around exits and liquidity options, according to the report.
From 2018-2022, eight secondary funds raised enough capital to be classified as “Mega” if they had been buyout funds. That figure was zero just one decade earlier (2008-2012). And now the largest secondary fund ($22 billion+) is nearly the same size as the largest buyout fund ($25 billion).[7]
Key Drivers Behind the Growth of Secondaries.
Historically, PE investments were highly illiquid, requiring investors to lock up capital for a decade or longer. However, investors today seek greater flexibility, especially during economic uncertainties. The secondary market enables LPs to sell their fund commitments, which increases overall market liquidity and attracts more institutional investors.
Increased Complexity and Innovation in GP-Led Deals.
GP-led secondaries have grown in prominence, representing nearly half of all secondary transactions in recent years. These deals, often involving single-asset continuation funds or sales of specific fund assets, give GPs the ability to extend their hold on prized assets while offering existing LPs an exit option. This dynamic allows GPs to capitalize on assets that still have room to grow, while giving new investors a targeted entry point.
Market Volatility and Portfolio Rebalancing
The secondary market has grown in tandem with heightened market volatility, which has encouraged investors to rebalance portfolios and manage exposure to specific sectors or geographies. The ability to exit or acquire positions in PE funds helps investors maintain optimal portfolio allocations amid changing market conditions.
A Growing Base of Specialized Buyers
The influx of specialized secondary funds and dedicated buyers is a testament to the attractiveness of this segment. Firms like Blackstone, Ardian, and Lexington Partners have dedicated secondary funds, which have raised billions of dollars, underscoring their commitment to secondary transactions. This institutional interest has provided sellers with more options, thus further driving the market.
Technological Innovations and Efficiency Gains
The expansion of digital platforms and data analytics has helped to streamline the secondary market, making it easier for LPs and GPs to connect with potential buyers. Specialized digital platforms now allow for faster pricing and more transparent deal processes, which improves efficiency and reduces transaction costs.
Moreover, advancements in due diligence technology have simplified the complex analysis required in secondary deals. Enhanced data access and analytics allow buyers to assess potential investments more thoroughly, helping them make more informed decisions.
Risks and Challenges
While secondary transactions provide much-needed liquidity, they carry unique risks. Accurate pricing is critical, as assets traded in the secondary market may be subject to economic shifts that impact valuation. Furthermore, GP-led transactions may face regulatory scrutiny, as they can create conflicts of interest when GPs have the incentive to maximize the price of assets being rolled into continuation funds.
The market's growth has also led to increased competition, driving up asset prices and potentially eroding some of the risk-adjusted returns for buyers. Navigating these challenges requires due diligence and careful asset valuation by both buyers and sellers.
Future Outlook for the Secondary Market
The private equity secondary market is projected to continue growing, with industry reports estimating its potential to reach $500 billion in transaction volume over the next few years. (Pitchbook estimates the market will reach $800 billion by 2028). As private equity matures, secondaries will remain essential in meeting the liquidity needs of LPs and providing flexibility for GPs.
Simplicity and Clarity: MOIC is a straightforward metric that provides a clear picture of an investment’s profitability. It is easy to calculate and understand, making it accessible for investors to quickly gauge the success of their investments.
End-of-Lifecycle Assessment: MOIC is particularly useful at the end of an investment’s lifecycle, as it focuses on realized returns. It provides a definitive measure of the total value generated by the investment, which is crucial for assessing the overall success of the investment strategy.
By using MOIC, investors can gain a clear and concise understanding of their investment’s performance, allowing for better-informed decisions and more effective investment strategies.
[6] The long-term trend has been that GPs are holding assets longer – whether in existing fund structures, through continuation funds, or by raising long-dated vehicles. The median hold period for exited private equity investments has risen from 2.9 years in 2002 to 5.6 in 2022. There can be benefits to compounding returns over longer periods under consistent GP ownership, and private markets have been recognizing that. In such a world, it’s only fair for LPs to have more options and influence in generating liquidity when needed (https://www.hamiltonlane.com/en-us/insight/secondary-market-growth) (visited, 12/12/2024)
