Investing in private markets funds has increased in popularity over the last few years as investors have searched for higher yields. According to Preqin, the size of the private markets assets under management has grown from approximately $1bn in 2000 to over $8 trillion in 2020. The bulk of this is represented by private equity funds which account for over $5 trillion of assets but other categories, such as Private Credit, have experienced dramatic growth as well. When they invest in private assets investors commit capital to a general partner (GP) for anywhere from 5 to 12 years. They expect an illiquidity premium in return for tying up their capital in this way.
Over the last few years, the growth of such inherently long duration private assets has fueled the growth of what is called the secondary market. This enables investors to sell a limited partner (LP) commitments in funds and thereby create liquidity for assets which otherwise would not offer any exit until the end of the fund’s life. Secondary transactions started in the late 90’s where transactions were characterised by limited liquidity and buyers. Transactions at that time were mainly done by distressed sellers and at significant discounts to fair value.
Since the Great Financial Crisis in 2008/9, secondary transactions have taken a definitive new turn and become more widely accepted. Today, these secondary markets have many dedicated buyers and almost any kind of fund interest can be sold. Evercore, in its most recent research, gauged the overall secondary market's size for 2020 to be around $60 billion, albeit a decreased number due to COVID, with approximately $110 billion of dry powder available at the end of 2020. With markets regaining their footing, many secondary market participants expect 2021 volume to exceed $100 billion.
But why do investors sell? With the evolution of the secondary market, the reasons to sell have drastically changed. Once used by distressed sellers, secondary transactions are now an accepted portfolio management tool used by CIOs to manage their portfolios. Rob Johnson at Dorchester Capital, a US based secondary fund running over $1bn of assets, highlights some of the reasons in his most recent market update. Any of organisational priorities, CIOs, board members, Investment Policy Statements, fundamental views on the markets, return expectations, regulations and GP & consultant relationships may change over time.
Consequently, portfolio holdings are re-evaluated, and investors increasingly use the secondary market in order to respond to those changes. Johnson also mentions that CIO tenures are relatively short compared to the life of a private asset fund, which can also lead to a portfolio reorganisation if sector or strategy preferences change, or managers fall out of favour.
Another reason to sell is simply the fact that institutional investors can end up with an excessive number of what are called tail-end funds. These are generally funds in their final years of life, near or beyond their 10-year anniversary mark. They tend to require the same amount of time to monitor and yet tend to deliver much lower rates of return because of their maturity, according to a research report published by Upwelling Capital Group. Although some investors continue to hold their partnership interests until the actual dissolution of the funds, it is increasingly common to sell tail-end funds in order to maximise returns. Upwelling Capital Group, in its research titled “Watch your tail end” argues that “in certain situations, an investor may be better off selling a tail-end fund at a discount of 35% or more when compared to holding the same fund and letting it “wind down” without a proactive rebalancing plan
Finally, many General Partners now use secondary transactions to raise finance, perhaps because they have a capital call elsewhere in the portfolio. In this case they do not sell their assets but raise finance or issue preferred equity at the fund level. It has the added advantage of alleviating any discussion around the potential discount.
Linchpin on a daily basis introduces prospective sellers or seekers of liquidity to secondary buyers in order to best position their portfolios for a secondary market process. If you are an investor and want to learn more about secondaries, do reach out to us.