Private equity secondaries refer to the buying and selling of pre-existing investments in private equity funds. This secondary market enables investors to divest their positions before the fund’s lifespan concludes, typically to achieve liquidity, manage risk or adjust their investment strategy. Such transactions occur in various contexts, including shifts in market conditions or fund performance, or where there are changes in the seller’s investment horizons.
Participants in the secondary market may include institutional investors, funds-of-funds and specialised secondary market firms. Transactions can involve entire funds or specific interests within a fund, allowing sellers to recoup some of their invested capital while offering buyers opportunities to acquire assets at potentially discounted prices.
Why do investors sell their interest via a secondary investment?
Limited Partners (LPs) may decide to sell their positions for various reasons, including:
Liquidity: A crucial factor for any investor is liquidity – the ability to buy or sell interest in a fund without significantly affecting its valuation – and LPs are no exception. An LP may choose to sell their interest in a fund simply because they need cash and prefer not to remain invested for the fund’s full lifecycle.
Risk management: Unexpected overcommitments or changes in market valuations may require an LP to alter their investment strategy and/or rebalance allocations.
Portfolio management: An LP might wish to reduce their unfunded commitment balance or sell their interest in older funds to decrease the number of General Partner (GP) relationships.
Why do investors buy secondary investments?
LPs may decide to buy secondary investments for various reasons, including:
Diversification: Investments in newly established Secondary Funds, (“Secondary Funds”) enable buyers to access a diversified portfolio across various strategies, sectors, vintage years, geographies, and GPs, which can help reduce risk. Buyers can also leverage secondaries to strategically manage their portfolios, aligning their private equity exposure with their existing investments, and targeting specific themes or risk profiles.
Liquidity: Secondary Funds offer access to a comparatively more liquid market for private equity investments. Buyers can sell their interests in the secondary market to achieve liquidity and manage their portfolios more effectively.
Reduced uncertainty: Secondary Funds provide buyers with transparency into the underlying fund assets. Buyers can assess historical financials, track records, and valuations of the portfolio companies, enabling more informed decision-making compared to investing in “blind pool” primary funds.
Pricing efficiency: Secondary buyers typically acquire private equity investments at a discount to their net asset value compared to primary market counterparts. Secondary market pricing inefficiencies can present attractive investment opportunities and potentially enhance overall risk-adjusted returns, including the possibility of downside protection.
Importance of independent governance in private equity secondaries
Independent governance plays a critical role in the private equity secondary market for several reasons:
Enhances transparency: Good governance practices ensure that transactions are conducted transparently. Investors can make well-informed decisions when they have access to detailed information about the underlying portfolio.
Mitigates risks and conflicts of interest: The secondary market can be complex, with various risk factors such as liquidity risks and valuation uncertainties. Strong, independent governance frameworks help in establishing clear guidelines and mitigating operational risks and conflicts of interest.
Protects investor interests: Effective governance mechanisms, free from undue influence, protect the interests of both sellers and buyers. They ensure that transactions are fair and equitable, helping to maintain trust in the market.
Facilitates compliance: Regulatory compliance is vital in private equity transactions. Robust, independent governance structures help ensure adherence to legal and regulatory standards, reducing the risk of potential penalties and legal issues.
Improves portfolio management: Governance shapes how private equity firms manage their portfolios, directing the focus toward value creation. Independent governance can assist with transparent investment decisions, exits, and the overall performance of secondary market transactions.
Conclusion
Private equity secondaries present unique opportunities and challenges in investment. Understanding these can be complex; however, the importance of governance cannot be overlooked. Ensuring robust governance not only aids in enhancing transparency and protecting investor interests but also promotes a healthier market ecosystem.
By prioritising governance, entities involved in private equity secondaries can foster more resilient investment frameworks, ensuring long-term value for all stakeholders involved.
