What are Private Equity Secondaries?

Key Takeaways

• The secondary market is a way for private equity (PE) investors, also called limited partners (LPs), to get out early, reshape their portfolios, or liquidate assets.

• The secondary marketplace now offers a host of strategies, including real estate, private credit, natural resources funds, infrastructure.

• Secondary markets also offer incoming investors opportunities to buy private equity assets – typically at a discount that are well into their performance cycle.

Rather than awaiting the end of a fund’s life to cash out their assets, investors can use the liquidity presented by the growing secondary market. They can also use the markets to rebalance their portfolio. What are private equity secondaries? That is covered below, in addition to why they exist, and how retail investors can get involved.

What are Private Equity Secondaries?

Essentially, the secondary market is a way for private equity (PE) investors, also called limited partners (LPs), to get out of funds early, reshape their portfolios, or liquidate assets.

These markets also offer incoming investors opportunities to buy private equity assets – typically at a discount — that are well into their performance cycle.

In the first phase of a PE fund’s lifecycle, which usually lasts between 10-12 years, fund managers (general partners) will seek deals and procure stakes, financed in part by PE investors’ paid-in capital.

Following an investment period of three to six years is the phase in which the general partner begins selling stakes and making profit distributions to investors.

Limited partners who wish to leave their position before the fund’s lifecycle ends might be able to do just that through a secondary transaction.

What is the History of these Secondaries?

In the financial services space, selling secondary-market investment stakes is not new. For example, the New York Stock Exchange has operated since the late 18^th century as a secondary market for PE. Still, in private equity, investors have historically been hesitant to sell out of their positions too early. 

And despite explosive growth in the last 20+ years, secondaries began in the current iteration in the 1990s as more of a cottage industry, with just tens of millions of dollars of capital committed. 

Why Does This Market Exist?

Secondaries have experienced great market growth in the last few years. Consider what occurred following the effect of the pandemic on markets in the first half of 2020, for example: transaction volumes not only rebounded — but set records.

In addition to benefits to investors, growth drivers likely include the market’s swift diversification. Once dominated by buyouts, the marketplace now offers a host of strategies, including real estate, private credit, natural resources funds, infrastructure, and more. This allows for a broader range of market participants.

Who Can Invest in Secondaries?

Secondary funds buy from primary private equity fund investors existing assets or interests. For instance, a primary private equity fund might buy a stake in a private company, then sell it to a secondary buyer. On the other end, sellers end up gaining liquidity.

Secondaries Payouts

It was between 2004 and 2007 that the secondary market began surging. Assets for the first time traded at or above estimated fair values and liquidity rose significantly. In 2014, small and medium buyers made their mark on the market. Large buyers comprised 59.8% of the market’s overall volume, while small buyers represented about 5.3%, and midsize buyers, some 34.9%.

Then in 2021, deal volume in the general partner-led secondary market hit $68 billion globally. That figure comprised about half the overall secondaries market and was nearly a 100% hike over the year before.

Most recently, research indicated that, compared to other market segments, single-asset secondaries have the best prospects, in terms of rewards. Some 62% of secondary investors are looking at net internal rates of return of at least 20% in that segment.

How Can You Invest in Secondaries?

There are various ways retail investors can tap into the secondaries market, including through registered offerings such as:

• Interval funds. While they do not trade on an exchange, these funds offer investors the opportunity to redeem shares of disparate asset classes at intervals – quarterly or annually, for example. Individual investors, in exchange for such illiquidity, have access to strategies that can provide a return edge and even more diversification. They also benefit from lower investment minimums, more regulatory oversight, and less-complicated tax reporting.
• Registered funds of funds. These multi-manager investment vehicles invest in holdings that comprise other funds. Such funds usually have lower minimum investment amounts and income requirements than private funds of funds.
• Business development companies (BDCs). These continuously offered or perpetual BDCs offer direct loans to middle-market enterprises and seek to produce high current income through coupons, origination fees, and other sources. They offer a premium to offset their reduced liquidity, relative to fixed-income investments.
• Non Traded real estate investment trusts (REITs). With these, investors gain access to a portfolio containing commercial real estate. This approach seeks to offer an income stream that’s not directly tied to stocks and bonds, while potentially protecting against inflation. In recent years, the REIT industry has improved liquidity, more-transparent pricing, and better oversight.

What are the Advantages of Secondaries?

There are distinct benefits to secondaries, including:

• Liquidity access. Selling stakes produces a stream of capital that can be used for new investments or for some obligation that requires capital. This is valuable since PE portfolios can be otherwise illiquid.
• Faster returns (J-curve). Returns are faster due to a shortened J-curve, a trendline that depicts an initial loss followed immediately by a large gain. Buyers who invest in a PE secondary fund benefit from a reduced time until cash is returned to LPs.
• Mitigates blind pool risk. For investors in primary funds, there is a blind pool risk. This means they are “blind” to the contents of the pool of their investments. But in a secondary, that risk is mitigated since investors purchase pre-existing portfolios and assets. This knowledge permits due diligence and, thus, can lead to more accurate predictions about their investment’s future performance. 
• Diversification. Investors can access many underling portfolio investments that are managed by a GP with keen knowledge and expertise in a field. Diversification can reduce overall portfolio risk. 

What are the Challenges of Private Equity Secondaries?

There are potential drawbacks to PE secondaries, including:

• Illiquidity. Although secondaries can help investors hurdle some of the liquidity issues presented by their PE investments, private equity is intrinsically illiquid, compared to public assets. Once in, it can be difficult to exit the investment prior to the fund’s completion.
• Complex valuation. In the secondary market, companies’ valuations can be challenging to determine, and the assets’ actual value may be different from the price paid.
• Uneven cash flows. The secondary market’s cash flow profile is dependent upon distributions, rendering it essential to choose experienced managers who will have a keen eye on down-market protection and have a demonstrated record of getting through market cycles.  

What are the Different Types of Secondaries?

There are a couple of types of PE secondaries: one is led by a limited partner (LP), and the other type is led by a general partner (GP).

• LP-led. The most common secondary type, an individual or institutional investor here buys into a larger fund, becoming a limited partner. When an LP leads a transaction, the partner sells their entire stake in the fund to a secondary buyer. Note that, even with the transaction, the fund’s overall structure and assets remain unchanged.

• GP-led. Transactions here, which are on the rise, involve the general partner selling part or the entire fund to a secondary investor. Generally, the fund’s LPs can either cash out or rollover their assets to the new vehicle – often a continuation fund, in which a general partner may keep their assets as some LPs maintain their investment and others bail. Another popular GP-led secondary model – single-asset transactions – permit GPs to pay close attention to their preferred individual assets while dropping others.    

What is the Denominator Effect?

This happens when the fund’s value decreases, causing the portion of the fund’s assets that are invested in a certain asset class to seem bigger than it is. In other words, what is commonly known as TDE is caused by public market values dropping more quickly than private-market assets. This most often impacts investors who have mature private-market holdings.

How Do Secondaries Differ from Primaries?

The two differ in that PE primary investments are transactions involving the acquisition of a stake in a private company, either directly or through a fund. The transaction may be part of a growth capital funding round or a management buyout.

On the secondary market, meanwhile, assets are traded with other investors. 

What Role Do Secondaries Play in Private Markets?

Investors can use PE secondaries as an accessible way to enter private markets. According to investor insights, the secondaries market is currently primed for PE investors who need to deploy capital but, due to sustained volatility, cannot do so in larger markets.

The market also may be particularly suitable for those who wish to gain PE exposure but are worried about the duration or large gap between committing and getting distributions. 

Private equity is an alternative investment, and as such, Yieldstreet, the leading alternative investment platform, has dropped the industry minimum required to access this space, permitting investors to build modernized portfolios with asset classes that have low correlation to constantly fluctuating public markets. Yieldstreet’s PE offerings also include early liquidity options.

Remember, an important benefit to the secondaries market is diversification, as secondary funds can purchase stakes in different PE funds by controlling the stakes of limited partnerships in various funds. In fact, diversification is essential to long-term investment success. Holdings comprised of varying asset types can reduce overall investment portfolio volatility, protect against inflation, and even improve returns. 

How Yieldstreet Can Help

There are many ways to take advantage of the private market, including through alternative investments – basically any asset other than stocks, bonds, and cash. While no investment is risk free, alternatives including art, real estate, private equity, and secondary venture capital are increasingly popular as ways to avoid public market volatility.

As cited by the alternative investment platform Yieldstreet, which offers the above opportunities and more, private markets have historically outperformed stocks during every economic downturn of the past 15 years. To date, more than $3.2 billion has been invested with Yieldstreet, which offers highly vetted, consistent secondary income opportunities with low minimums.

Taking positions in alternatives also diversifies one’s investment portfolio. Such diversification helps protect against market risks, in that if some investments are underperforming, others have an opportunity to perform. It’s one important reason why participation in private equity secondaries is increasing.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Risks notwithstanding, investors have opportunities to reduce volatility during depressed markets by taking positions in secondaries, which also have greater liquidity. The platform Yieldstreet can help investors gain access to private markets, which in addition to providing secondary income, diversifies investor holdings.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information. Diversification does not ensure a profit or protect against a loss in a declining market.