Solving the Illiquidity Challenge: The Role of Secondary Markets

The illiquidity of private markets reflects the nature of the assets involved. Private equity, venture capital, real estate, and other alternative assets typically entail long-term direct commitments by so-called limited partners (LPs) who entrust a general partner (GP) with the day-to-day management of the investments. Unlike public markets, where stocks and bonds are traded easily on short notice, private market investments often have a value creation plan (e.g., growing revenues, market share, acquisitions, etc.) and an exit strategy (through an IPO, acquisition by an industry player) that may tie up capital for years, if not decades, until the strategy is executed, hindering the ability to sell or rebalance the portfolio when needed.

Direct private market investments are the “primary markets.”  Secondary markets involve players who see value in buying or selling existing private market investments, thereby offering a liquidity solution to investors. Such players may be led by GPs or LPs alike.

GP-led transactions may involve fund sponsors who sell one or more assets from a fund they already manage to a new fund. These “continuation vehicles” are managed by the same sponsor and generally capitalized by one or more secondary buyers.[i] These transactions may be driven by the need for liquidity, portfolio optimization, or fund restructuring. Investors have the opportunity to exit their investments, allowing new investors to enter the fund. Continuation vehicles are just one common example of GP-led secondary deals.

Despite the economic uncertainties, the GP-led secondary market remained robust in 2022, representing around 42% of secondaries volume in the first half of the year, amounting to an estimated US$24 billion.

Unlike a sale to another private equity sponsor, GP-led secondaries allow the same sponsors to continue their investment strategy without having to renegotiate the existing leverage on investments or disrupt portfolio-company management teams. LPs have the option to either cash out or roll into the new continuation vehicle to maintain their exposure to the investments, often at more LP-favourable economics”.

When IPOs are at relatively weaker levels and mergers and acquisition activity slows significantly, GP-led secondaries allow sponsors to provide proceeds to existing investors at favourable pricing.

LP-led transactions are one-off transactions typically initiated by LPs seeking to sell their interests in private funds to a buyer who assumes their rights and obligations in the existing fund. These transactions may involve the sale of individual LP stakes or entire portfolios in multiple funds. Buyers in LP-led secondary transactions may include other LPs, secondary funds, or institutional investors.

When deciding between a GP-led or LP-led secondary, investors consider many factors, including diversification, return expectations, and immediate liquidity needs.

Figure 1: The growth of the secondaries market

^{Source: Pitchbook}

The benefits of secondary transactions

GP-led and LP-led transactions provide liquidity to the market. Investors can exit illiquid private market investments, providing liquidity when needed for other opportunities or obligations. Secondary transactions also provide a relatively transparent pricing mechanism for private assets, helping investors understand the true market value of their holdings. They also allow investors to diversify their portfolios by acquiring stakes in a wide range of private assets without the long-term commitment associated with primary investments. Investors can reduce concentration by selling underperforming assets and reallocating capital to more promising opportunities.

The advantages for buyers include a shorter holding period, which is reflected in the price: the shorter the holding period, the more expensive it will be.

Secondaries also mitigate “blind pool risk.” LPs in primary funds commit capital to a portfolio that is yet to be constructed, with unknown risks. Investors in secondaries, by contrast, can analyse the performance and associated risks of a fund more clearly.

Secondaries may offer other advantages to buyers.

Lower fees. Secondary funds typically charge lower fees than “primary” funds because the GP role is closer to that of a portfolio manager, rather than adding value to the individual underlying companies.

Early liquidity. A secondary fund invests in funds of various vintages, which balances commitments against distributions. Early liquidity means a far shallower J-Curve.

In conclusion, secondary markets in the private equity and alternative asset space usher a new era of liquidity and flexibility. These markets allow investors to navigate the traditionally illiquid terrain of private markets more easily. As these markets continue to evolve, their transformative potential in addressing the illiquidity challenge makes them an integral part of modern investment strategies.

Key takeaways

The secondaries market has grown rapidly since the global financial crisis, bringing much-needed liquidity and flexibility to private markets.

Other advantages of secondaries to investors include diversification, cost reduction and risk mitigation.

The secondaries market offers opportunities for investors to achieve their financial objectives while reshaping the landscape of private investments.

[i] Preqin