With the FTSE 100 up less than 1% last year and the S&P 500 down 18%, according to data from MarketWatch, one constraint facing private equity investors, also known as limited partners (LP), is the so-called denominator effect, triggered by the decline in public asset valuations.
Because their holdings of private assets exceeded the allocations allowed under their mandates, some LPs have been forced to reduce their investments in private fund managers, or free up cash through secondary sales of their fund stakes.
After a record year for secondary transactions in 2021 ($130bn), the market recorded $105bn of volume in 2022, up from $25bn in 2012, according to Coller Capital.
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The secondary market allows LPs to make an early exit, liquidate assets or rebalance their portfolios, while offering incoming investors a place to buy assets years into their performance cycle, usually at a discount.
During a presentation at Investment Week's Alternatives Summit, Brendan McCurdy, co-head of the financial adviser solutions team at private markets firm Ares Management, said current dynamics make the secondaries market an attractive way to access private equity.
Given the supply in private asset secondary markets is currently high, prices are lower than they have been for several years as sellers accept the discounts imposed on them by buyers. According to McCurdy, the average discount at present is around 15-20%.
The secondaries fund appeal
The investment term of traditional private equity funds can be upwards of seven to ten years, divided into three stages: the fundraising period, the investment period and the harvest period, which is when most investments are realised and cash is returned to investors, if successful.
In funds dedicated to secondaries, the managers, known as general partners (GP), invest in stakes in funds from year four and beyond, explained Wilfred Small, senior managing director at private markets firm Ardian.
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According to Small, investing later in the life cycle of the fund rather than at inception provides greater visibility of its underlying portfolio companies, rather than allocating into a blind pool of assets.
"We think that the net asset value that you are buying is a better reflection of the true value of the fund, as the better performing assets are marked up and the less performing assets are marked down," he said.
"Some of the typical risks associated with operational execution in private equity are largely de-risked by this stage in the life of the fund. Your cash at risk is commensurately lower than when you are buying a traditional direct strategy."
In secondaries funds, portfolio companies tend to be in the value creation phase, or sometimes even the distribution phase of their life, which means the average holding time of the fund's underlying assets will typically be shorter, McCurdy said.
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According to Small, investors in the private wealth channel that may be new to the private equity space may utilise secondaries as an attractive way to build out their private equity programmes.
"[Investors] are getting immediate diversification as it relates to fund relationships, geography, sector, company size. We see the benefits of that in terms of ramping up a private equity portfolio," he said.
Why do investors sell?
During the Global Financial Crisis, banks selling out of private equity created a secondary market driven by distressed or regulation-driven sellers. According to Small, this period catalysed proof of concept of secondary liquidity and private equity on a large scale.
More than a decade on, however, today's sellers are not limited to financial institutions, but also "usual private markets allocators", such as pension funds, insurers and sovereign wealth funds.
"These are not distressed groups by any means, even in today's dislocation. They are not necessarily liquidity driven sellers but much more opportunistic sellers as a way to achieve a proactive portfolio management objective," Small added.
The private market's dependency on the public markets
This could include crystallising returns on unrealised funds to deliver a return but not necessarily to pay back cash, instead reallocating capital or prioritising certain GP relationships.
"A really opportunistic base of sellers is driving sustainable, long term deal flow in secondaries. We see a clear path to market for secondaries of an excess of $300bn by 2030," he said.
"In terms of absolute dollars [the market] is becoming more and more meaningful, and far from a cottage or niche part of the industry, but really a fully functioning and healthy part of a historically illiquid asset class, embraced by LPs and GPs alike."