A secondary fund is an investment vehicle specialising in the acquisition of holdings in existing private equity funds or in portfolios of unlisted assets. These transactions allow investors to sell their shares before the end of the fund's term, thus offering liquidity, while new investors gain access to more mature assets with better visibility on performance. Discover with Private Corner, a digital native management company, the benefits of investing in secondary private equity funds.
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The origin of the strategy
Secondary funds were created primarily in response to the growing need for liquidity and flexibility in the private equity sector, which is characterised by long-term capital commitments. Originally, they were presented as a solution for investors wishing to disengage from their positions in private equity funds before the end of the planned holding period, often set at a decade or more. This need was particularly apparent in contexts where investors sought either to readjust their investment portfolio for strategic reasons or to liquidate assets for cash flow needs.
The development of these funds was particularly marked in the 1990s, a period during which the private equity market began to mature and diversify. According to Preqin data, this period saw a significant increase in the number of private equity funds, as well as in the variety of investment strategies on offer. This phenomenon led to a more complex and interconnected ecosystem, thus increasing the need for mechanisms enabling more dynamic and flexible management of capital commitments.
The creation and growth of secondary funds has also been influenced by changes in financial regulations and a better understanding of the specific characteristics of private markets. Investors, faced with increasingly strict rules on risk management and liquidity, have found in secondary investments an effective way to manage their exposure to illiquid assets while respecting regulatory frameworks.
The denominator effect
The denominator effect occurs when the value of investments in shares and other liquid assets decreases rapidly during a period of economic crisis or market downturn, while the value of illiquid investments, such as those in private equity, remains apparently stable due to their periodic valuation. This situation leads to institutional investors' portfolios appearing unbalanced, with an unusually high proportion of illiquid assets compared to liquid assets, thus exceeding target strategic allocations.
In this context, secondary private equity funds offer a valuable solution by enabling institutional investors, such as pension funds and foundations, to quickly readjust their exposure to private assets without having to wait for the usual ten-year or longer maturities of private equity funds. Originally designed to provide liquidity in a market where it is traditionally limited, secondary funds gained popularity in the 1990s, when the private equity market matured and the number of investment funds and the diversity of strategies increased.
The ability of these funds to mitigate the denominator effect was therefore a key driver of their development. By offering an early exit route for investors seeking to realign their asset allocations according to changes in market value, these funds have enabled more responsive and strategic portfolio management. This function has become particularly valuable during periods of market volatility, where rapid portfolio adjustment can play a crucial role in preserving capital and complying with investment policies.
A rapidly developing asset class
Secondary private equity funds allow for increased flexibility and strategic asset management.
For investors:
Liquidity: the growth of secondary funds is mainly linked to the changing needs of investors seeking more flexible liquidity options and adjusted investment horizons.
For management companies (General Partners or GPs):
For GPs, the secondary market provides a means of extending their holdings in choice assets with a long track record of value creation and growth potential. Moving high-quality portfolio companies into continuation vehicles has become an alternative exit route to a sale process or an IPO. These secondary expansion vehicles allow managers to continue to increase returns on their flagship assets while potentially offering liquidity to investors who want it.
In the case of management companies covering all unlisted assets (platforms), secondary fund managers work with primary fund managers to continue to create value and improve the performance of the underlying assets, which can benefit all investors involved.
All-terrain assets?
Economic cycles such as the dot-com crisis, the global financial crisis and the pandemic have catalysed interest in secondary private equity funds, which offer opportunities to buy discounted assets and the prospect of attractive returns during the economic recovery.
These funds have the ability to thrive in a variety of economic environments. In periods of growth, they can benefit from the increase in the valuation of underlying assets. In periods of slowdown, they can find opportunities to buy at attractive prices. Thus, rather than simply revealing crises, secondary funds offer solutions to navigate and capitalise on market volatility.
secondary private equity investment in a crisis
The secondary market benefits from consistent performance throughout the cycles
The secondary private equity market has outperformed after periods of economic uncertainty and volatility.
A strategy tailored to an intermediary asset management clientele
Secondary private equity funds are traditionally more suited to institutional investors due to their complexity, minimum investment size and long-term investment horizon.
However, some private equity platforms have made these institutional funds accessible, convinced of the particular interest of these funds for wealth management clients.
Secondary private equity is an extremely diversified ‘core portfolio’ strategy that is particularly suitable for investors who benefit from a very balanced risk/return ratio.
A variety of strategies
To fully understand secondary funds and before discussing the types of funds, it is first necessary to discuss the types of transactions.
There are two main types of transactions in the world of secondary funds:
LP-Led transactions: the repurchase of an investor's positions in a private equity fund or portfolio of funds. LP-leds enable the active management of an investment portfolio and the reallocation of portfolio capital.
‘GP-Led’ transactions: transactions generally initiated by a manager (GP) that can take several forms, often involving the purchase of existing investments that will be transferred to a new vehicle. For example, GPs use secondary funds to optimise the management of the holding period of assets, meet the liquidity needs of investors, and adjust investment strategies in response to market changes. Continuation funds, which are an illustration of this, make it possible to retain high-quality assets beyond traditional holding cycles in order to maximise their growth potential.
To go further: continuation funds
A continuation fund is a specific type of secondary private equity fund that allows private equity fund managers to extend the life of certain assets beyond the initial period planned by the primary fund.
A continuation fund is created to transfer assets from a primary private equity fund to a new investment vehicle, thus enabling managers to continue to manage these assets beyond the initial lifespan of the primary fund. The main objective is to maximise the value of the assets by giving them more time to develop and reach their full potential.
How it works
Identification of assets: GPs identify assets in their portfolio that still have significant growth potential but have not reached full maturity within the primary fund.
Creation of the continuation fund: a new fund, the continuation fund, is created to accommodate these assets. This fund can be structured as a secondary fund, allowing existing investors to sell their stakes in the transferred assets.
Asset transfer: the selected assets are transferred from the primary fund to the continuation fund. This transfer may involve an independent valuation of the assets to determine their market value.
Ongoing management: the managers of the primary fund continue to manage the assets transferred to the continuation fund. This allows them to benefit from their expertise and in-depth knowledge of the assets.
New investors: the continuation fund can attract new investors who wish to benefit from the growth potential of the transferred assets. These investors may include secondary private equity funds, institutional investors or individual investors.
Why such funds?
Maximisation of value: by extending the management period of the assets, GPs can maximise their value by giving them more time to develop and reach their full potential.
Flexibility for investors: existing investors have the option of selling their holdings in the transferred assets, thus offering increased liquidity and flexibility to rebalance their portfolios.
Management continuity: managers can continue to manage assets with which they are familiar, which can improve performance and value creation.
Attraction of new capital: the continuation fund can attract new investors, providing additional capital to finance the growth and strategic initiatives of the transferred assets.
Practical case
Suppose a primary private equity fund is nearing the end of its 10-year lifespan, but still holds several companies that have not reached their full potential. The fund managers can create a continuation fund to transfer these companies. Existing investors can choose to sell their holdings in these companies to the continuation fund, while new investors can enter to benefit from the remaining growth potential. The managers continue to manage these companies as part of the continuation fund, giving them more time to develop and maximise their value.
In short, a continuation fund offers a flexible solution for extending the management of private equity assets beyond the initial lifespan of the primary fund. This maximises the value of the assets, offers increased liquidity to existing investors and attracts new capital to finance growth.
These vehicles are particularly useful in times of uncertainty in listed markets, when exit options such as IPOs may be less attractive.
What are the return objectives of a secondary fund?
A BlackRock report indicates that secondary funds have posted a median internal rate of return (IRR) of 15.9%, compared to a median IRR of 13.2% for primary funds for the fund vintages analysed from 2002 to 2021. This superior performance is attributed to the increased diversification and reduced risk associated with the initial portfolio construction, which are characteristics of secondary private equity funds.
In terms of market growth, secondary market transaction volumes have expanded significantly, reaching annual transaction volumes of over $100 billion, reflecting the increased maturity and broader acceptance of this investment strategy.
! objectives of secondary private equity
What are the advantages? What are the disadvantages?
advantages are as follows:
- High diversification (geographical, sectoral, vintages, managers, etc.): private investors, accompanied by their advisor, are exposed to a wide range of underlying companies (1500 to 3000 companies via the fund we offer, for example) and managers through several entry points over time.
Assets acquired with an average maturity of 3 to 6 years: there is a lever for value creation combined with attractive price levels, in some cases with a discount.
Velocity of capital thanks to exposure to mature assets: potential for rapid distribution and consequently a faster return on investment.
A competitive value preservation business model (management fees & carried interest competitive with primary private equity).
A maximum net cash exit lower than in primary private equity, historically around 60-70%.
A J-curve mitigated by the discount levels at entry.
Recycling of distributions, allowing 100% of the funds to be invested while reducing investor commitment.
In addition, the secondary market has matured considerably:
Growth in size, stimulated by the increase in primary fund raising.
Natural turnover rate of around 1.5% to 2.0%.
Better selectivity and quality of portfolios traded on the secondary market.
Source: Partners Group.
The secondary market could thus exceed $1 trillion in transaction volume by 2030, making it one of the fastest growing private markets.
The disadvantages
Secondary funds are private equity funds. The main associated risks are therefore the risk of total loss of the capital invested and the liquidity risk.
Risk of overpaying for assets if the discount is not sufficient or if the underlying assets do not perform as expected.
Dependence on the expertise and access to inside information of the managers to correctly assess the quality and potential of the underlying assets.
Complexity of the structure and transactions, which can make it difficult for less experienced investors to accurately value the assets.
These points highlight the importance of the choice of the selected team and its ability to deliver performance over several vintages. To do this, it is necessary to refer to a digital private equity platform with a robust management team selection process.
