Secondaries

From niche to normal: The global secondaries market commands attention

October 2, 2018

The once-niche area of secondaries is growing rapidly, outpacing the rest of the private equity industry. Developing since the 1980s, at its core the secondary market is where firms can buy pre-existing investor commitments—a simple premise, although more complex in practice.

Last year saw a record amount of capital going into secondary transactions, amounting to $52 billion, according to PE secondaries specialist Coller Capital. This is a far cry from the total of $16 billion just 10 years earlier, and 2018 is expected to continue this growing trend. And as deals get larger, so do the funds. Data from PitchBook shows that the median size of a secondary vehicle is estimated to be a huge $509.6 million this year, compared with $429.4 million in 2017.

Why such growth?

According to David Jolly (pictured), partner at Coller, time and acclimatisation appear to have helped the growth of secondaries; the uncertainty felt toward the market has dampened as secondaries have become normalised.

“If you go back to the 1990s, the PE secondary market was seen as a complex area—investors didn't know how to exit their illiquid fund holdings. Secondaries emerged as a way to provide liquidity, which is natural in any market, but it was nascent," Jolly said. "Now that part of the market is the vanilla part—where you're trading single fund positions.

"There are other asset classes where the type of analysis, skill set, risk is all quite comparable in terms of portfolios of illiquid interests, be that in credit products, real estate and so on. Those are creating some of the growth in the market."

Indeed, the prospect of liquidity is one of the main draws of this strategy, having risen to prominence particularly during the financial crisis when limited partners, such as insurance companies, were looking to free up capital as a way to meet their obligations. As necessity drew LPs to the market, many stayed and have grown comfortable with these types of transactions.

No longer limited

As the market matured and thus reassured LPs, other players began to take notice. This has led to the emergence of GP-led transactions, which are becoming increasingly prominent. Originally limited to the sale and purchase of limited partner interests in funds, the secondary market has opened to embrace private equity fund managers, as they take a more proactive role in offering liquidity options to their investors.

"Many LPs are repeat sellers and see it as a portfolio management tool; it has become a normal and accepted part of the market," Jolly said. "There's still more LP sales, and they can vary from an LP selling one fund position through to billion dollar-plus portfolios.

"Fund portfolios will continue to encompass a large part of the market, but we believe GP-led deals, currently standing at around 20% of annual transactions, will grow. We expect the secondary market to become a normal part of how GPs manage their portfolios and work with their investor base. This feeds into the growth of the secondary market."

One example of such a deal took place in April, when Coller backed a €2.5 billion restructuring of a Nordic Capital buyout fund. The deal saw Nordic transfer nine companies in its seventh fund to a continuation vehicle, during which the majority of the fund's original investors sold their stakes to Coller.

Come for the liquidity, stay for the returns

But things aren't that bad for investors anymore. Having recovered somewhat from the terrors of 2008, one could argue that the need for liquidity is not as prevalent—and yet the market grows larger. So why are investors staying?

"Secondary returns remain strong with less risk than other private equity strategies," Jolly explained. "LPs may aim to focus on good buyout funds delivering top-end returns, but selecting those is actually more difficult than it sounds, and as you build up a portfolio you can get average returns. Secondaries collectively over time have been able to grow well and maintain a really attractive risk/return profile."

Looking at the return rates of secondary funds compared with primary funds, the median IRR is far higher, standing at nearly 21.3% for the former and at 12.5% for the latter for funds with 2014 as their vintage year, according to PitchBook data. Fund-of-funds rates come in even lower, at 10.2%.

Global PE fund median IRR by vintage year


The higher returns of these funds are explained by the fact that secondary vehicles are not subject to the early effects of the J curve, a term usually used when discussing balances of trade when a country's currency devalues. Normally, private equity investments have negative returns and cashflows early on, as capital is deployed into companies before picking up as value is created.

Secondary transactions, on the other hand, mitigate this effect as investors acquire stakes in mature primary funds, with companies closer to exit. This not only delivers higher returns but also reduces risks.

The allure of bigger returns is naturally drawing investors to the space as more capital is pouring into secondary funds, which Jolly observes has brought up an unusual phenomenon for private equity. "One really interesting aspect of the market is that, although there is strong fundraising, because the market has grown quickly you don't have a significant overhang of secondary market capital beyond normal market volumes," he said. "When you look at the primary PE market, you've got four to five years' worth of dry powder when you compare it with annual transaction volume. In the secondary market, dry powder is only about 1.5x the annual transaction volume, which is a very healthy position."

Data from PitchBook shows that in 2017, there was nearly $94.3 billion of secondary capital overhang. Although this number increases year on year, it remains quite small compared with the $768.5 billion overhang for the global private equity industry.

The price is right

The lack of dry powder is not the only unusual aspect of the secondaries market. Despite its growing popularity, pricing in this space has remained relatively stable. Jolly explained: "Despite the bull-market conditions, we're not really seeing average pricing data going much beyond where it was in 2012/13. It hasn't reached pre-crisis levels.

"In terms of what's next for pricing, we can't predict the future, but if you look at general sentiment now, is there a little more caution in the market than two or three years ago? There are distractions from a political aspect, from a macroeconomic outlook, you've got very high valuations in public markets—you've got reasons why buyers may be saying, 'We like a portfolio; we're going to price it to win,' but there's still an element of caution which is not seeing a lot of stretch beyond the current pricing levels."

The maturity and stability of the secondary market is attracting more capital and resulting in larger deals, a trend which seems to show few signs of stopping. For those contemplating a move into secondaries, Jolly has one piece of advice.

"Secondary fund managers need to be quite generalist because we are looking to buy diverse portfolios," he said. "There are clearly sectors that when they crop up in a portfolio may make it more attractive. The same for a buyout fund but as a secondary player you can't just focus on a couple of sectors as you're seeking diversity. But it helps a portfolio to have some of these strong sectors in them."
 

For more private equity-related content, click here

Related content