Private equity secondaries: How they work and what they can do
Secondaries can therefore have an excellent risk-adjusted return profile and defensive characteristics while offering attractive long-term returns. However, there are some specifics that need to be considered in order to take full advantage of this asset class.
Mechanics and functioning of secondaries
Private equity funds are generally organised as limited partnerships into which investors - also known as limited partners or LPs - contribute funds as part of a capital raising process. The collected capital commitments are managed by a general partner (GP) who is responsible for the funds. 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) in which the investments are terminated. Private equity funds are designed to have no redemption or liquidity mechanisms for investors. Therefore, if an LP needs or wants to exit a fund early, there is no other option than to sell it on the secondary market.
Over the past two decades, a robust and active secondary market has developed that allows investors to sell their positions in private equity funds. A transaction in this "off-market" secondary market involves the transfer of a limited partner's interest from the selling limited partner (seller) to the new owner (buyer), who assumes all of the seller's rights and obligations, including any outstanding obligations to the funds sold. As a rule, this transfer process requires the consent of the general partner of the respective fund.
Valuation and settlement
The pricing of secondaries is based on valuations, usually published by the private equity fund's management company, and is expressed as a percentage of the reported net asset value (NAV).
Typically, the 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 prior to the closing date) between the buyer and the seller. All cash flows after the closing date are considered 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 valuation changes in the interim period usually benefit - or harm - the buyer and do not affect the final payment.
Quantitative data
The results of various analyses indicate that secondaries - especially secondary funds - have attractive return characteristics that make them a valuable complementary strategy for investments in primary funds: A historically higher average internal rate of return (IRR), lower volatility, a lower number of secondary funds that have lost capital, faster cashback and lower dispersion of returns underscore that secondary portfolios have historically offered attractive returns with significantly lower downside risk for investors.
Outlook
After a decade of strong volume growth, private equity investors now 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 types, fund maturities and funding levels. In addition, there is a growing need for creative liquidity solutions outside the traditional routes. This means that more GPs will need to consider a secondary sale to another sponsor or to a strategic buyer rather than an IPO. In the tougher economic conditions, GPs also tend to hold assets longer, which could lead to fewer distributions for LPs in the near future. In addition, with the widening of discounts, secondaries may be an opportunity for investors to make cheap additional investments in private equity. Therefore, competition in this market may increase as there are still many investors looking to expand their private equity allocations.
Conclusion
Secondaries are an extremely attractive asset class, both from a risk/reward perspective and on an absolute return basis. However, it is important to understand what secondaries are, how they work and what is required to be successful with secondaries investments. In addition, it is crucial that tailor-made structures, individual and specific needs and lean configurations are taken into account for such complex investments.
VP Fund Solutions is a strong partner with the necessary know-how and individual advice based on many years of expertise in order to be optimally positioned for the opportunities offered by secondaries.
