Private Equity Secondaries: Functionality and Opportunities

Background

Investors are confronted with a historically difficult macro environment, with significant headwinds in various asset classes, which in turn has a significant impact on return targets. The price losses in the first half of the year for both equities and bonds have weighed on investor sentiment. On the US stock market, the first six months were the weakest half-year since the 1970s. High inflation rates, non-functioning supply chains, the war in Ukraine and now an impending gas crisis are weighing on consumers and entrepreneurs alike. The service sector is currently still benefiting from catch-up effects. In the fall, consumers in all sectors are likely to tighten their belts. These facts do not bode well  for private consumption. While a recession is already expected in Europe in the current second half of 2022, the USA could stay afloat a little longer. However, by 2023, the economy on the other side of the Atlantic is also likely to be in reverse gear.

Mechanics and functioning of secondaries

Private equity funds are usually organised as limited partnerships, into which investors - also commonly referred to as limited partners or LPs - contribute funds as part of a capital raising process. The aggregated capital commitments are managed by a general partner (GP) who is responsible for managing all aspects of the fund. A typical private equity fund has an initial term of 7-10 years, which can be divided into an investment period (usually the first five years) and a harvest period (after five years) during which the investments are terminated. By design, private equity funds do not provide redemption or liquidity mechanisms for investors. Therefore, if an LP has to or wants to leave a fund early, there is no other option than to sell it on the secondary market.

Over the last two decades, a robust and active secondary market has developed, allowing investors to sell their private equity fund positions. A transaction in this "over-the-counter" secondary market involves the transfer of a limited partner's interest from the selling limited partner (seller) to the new owner (buyer), who takes over all rights and obligations of the seller, including all outstanding obligations to the funds being sold. Typically, this transfer process requires the approval of the general partner of the respective fund.

Valuation and settlement

The pricing of secondaries is based on valuations generally published by the management company of the private equity fund and is expressed as a percentage of the reported net asset value (NAV).

Generally, buyer and seller agree on a valuation date (sometimes referred to as the "reference date") at the beginning of a transaction. The valuation date is a NAV Valuation Date and is used to determine the settlement of cash flows (capital calls and distributions before the closing date) between the buyer and the seller. All cash flows after the reference date will be taken into account in determining the final purchase price payment at closing. The seller is normally compensated for capital calls, while distributions are retained by the seller and reduce the purchase price payable. Any changes in valuation in the interim period are usually to the benefit - or disadvantage - of the buyer and do not affect the final payment.

Quantitative data

The results of various analyses indicate that secondaries - especially secondary funds - offer attractive return characteristics that make them a valuable complementary strategy for investing in primary funds: A historically higher average net internal rate of return (IRR), lower volatility, a lower number of secondary funds that have lost capital, accelerated cash-back and a lower spread of returns underline that secondary portfolios have historically provided attractive returns with a greatly reduced risk of loss for investors.

The Secondaries Market in 2022

According to the 1H 2022 Global Secondary Market Review issued by Jeffries' Private Capital Advisory, the global secondary volume amounted to USD 57 billion. This constitutes another record volume, as the prior 1H record of USD 48 billion in 2021 was surpassed. The market can be split into LP-led transactions and GP-led transactions.

For the LP-led transactions the major reason to exit via secondaries deals is that their PE allocations are increasingly overweighted given the disruptions in public markets. Therefore, they need to rebalance their asset allocations through the secondary market. According to Jeffries' the volume of the LP-led transactions amounted to USD 33 billion respectively 58% of the market volume. Furthermore, according to a report published by Setter Capital, pension funds are expected to become largest sellers on private equity secondary market in H2 2022. The rise of pension funds among the largest sellers came as the California Public Employee’ Retirement System (CalPERS) recently divested stakes close to $6bn in private equity funds. On the buyers' side, secondary funds were again the most active buyers in H1 2022, accounting for 84.2% or $48.68bn of total purchases, while funds of funds accounted for 12.9% or $7.48bn, according to the report issued by Setter Capital.

For the GP-led market, according to Jeffries', there was a lot of activity given. However, according to Bain Capital, after a record-setting 2021 for PE-backed exits, 2022 has seen a major slowdown in both numbers and values of transactions. The window for IPOs, which were a massive driver of exit values, shut down almost completely. Therefore, the overall transaction volume amounted to USD 24 billion, which mainly concentrated in high-quality, buyout focused single-asset transactions, as, as mentioned before, traditional M&A exits and distributions have slowed down.

Across all strategies, the average discount for LP transactions amounted to 14% of NAV. This means, that compared to the previous years, the discount has risen in parallel to the declining market prices and the increasing volatility.

In parallel, the capital overhang multiple (capital raised by private equity funds, but as yet uninvested) has decreased from 1.8x to 1.6x at the end of 2021. This move was mainly driven by a strong capital deployment.

Outlook

Today, after a decade of strong volume growth, private equity investors have access to a wide range of liquidity options and solutions covering all strategies (buyout, growth equity, venture capital, mezzanine, distressed, real estate and increasingly infrastructure), investment vehicles, fund maturities and funding levels. In addition, the need for creative liquidity solutions apart from the traditional ways are increasingly in need. The market for IPOs is not expected to pick up substantially in the second half of the year 2022, which means that more GPs will instead be eyeing a secondary sale to another sponsor or to a strategic buyer. Under the more challenging economic circumstances, GPs also tend to hold assets longer which could result in fewer distributions for LPs in the near future.

Furthermore, given the widening of the discounts, secondaries can be an opportunity to make cheap additional investments in private equity for investors. Therefore, the competition in this market may rise, as there are still many investors looking to expand their private equity allocations.

Conclusion

Secondaries are an extremely attractive asset class from a risk/return perspective and on an absolute return basis. Nevertheless, it is important to understand what secondaries are, how they work and what is required to be successful with investments in secondaries. In addition, it is essential that such complex investments take into account tailor-made structures, individual and specific needs and lean configurations. In order to be optimally positioned for the opportunities offered by secondaries, VP Fund Solutions is a strong partner with the necessary know-how and individual advice based on many years of expertise.