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.

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.

Advantages and Disadvantages

As with most anything, there are benefits and drawbacks to secondaries:

Benefits:

• They provide liquidity.
• They allow investors to check the pricing and interest rates of financial instruments such as stocks and bonds.
• They help determine the price of securities during a transaction.
• They help mobilize and channel investors’ savings.
• They provide security, as capital markets regulate companies listed.

Risks:

• Volatility. Secondary market prices are established by market conditions and shareholder decisions, which are inherently unpredictable.
• OTC trading risks. There are risks that come with trading over the counter. They can include lower transparency, because such markets sometimes do not require companies to give to the public the same information. Also, there is more volatility linked to newer so-called penny stocks.

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.