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Historical secondaries market growth has largely been driven by LPs’ increased use of the secondaries market to quickly and efficiently reposition their portfolios in line with shifting strategic priorities. There are five major catalysts for much of the secondaries market volume growth and supply composition.
- Non-core GP relationships. Early LP portfolio construction strategies were centred on diversifying commitments across a broad spectrum of various managers and strategies. Following the 2007 financial crisis, LPs began to shift toward a more focused portfolio composition with a targeted set of core managers. Given this shift, many LPs are reducing the number of managers they will support going forward by 50 percent or more. The LPs leading this trend have used secondaries sales to accelerate the shift to fewer core managers. A strategic shift of this magnitude would take decades to implement through natural fund liquidations, but by using the secondaries market LPs have been able to materially change the composition of their portfolios via a deliberate strategy to sell interests in non-core manager relationships at attractive pricing.
- Sub-portfolio allocations. Another common trend among LPs has been the use of the secondaries market to reposition sub-portfolio allocations. The specific sub-portfolio allocation shifts have varied based on the specific LP, but a common trend among mid- sized LPs has been to re-allocate from large/mega-buyout funds to middle-market buyout funds, and select large LPs have shifted allocations from fund investments to a sizable allocation to direct and co-investments.
- Tail-end sales. Early investors in private funds were motivated to utilise the secondaries market due to the prevalence of tail-end fund interests, which are a distraction and administrative burden for many LPs. The scale of legacy tail-end portfolios has grown alongside the prevalence of lengthening fund lives. LPs use the secondaries market to sell tail-end portions of their portfolios in order to redeploy capital with core managers and to relieve the outsized administrative burden created by these interests. Greenhill Cogent estimates that nearly 20 percent of 2015 secondaries market volume was tail-end transactions.
- Economic arbitrage. A growing sentiment among LPs is that current fair value marks used by GPs incorporate near-peak cyclical valuation multiples and additional future upside may be limited. As such, LPs are finding opportunities to reduce exposure to funds where secondaries offers imply more bullish expectations and LPs are redeploying the sale proceeds into areas where they see more favourable conditions.
- Regulation. Volcker, Basel III and other similar regulations have been meaningful drivers of secondaries market volume over the last three years, but as the final implementation deadlines near, most of the large sales have already been completed. The handful of remaining transactions that are necessary for regulatory compliance are expected to be moderate in size and are likely to have a diminishing impact on secondaries market volume growth.
Buyside demand drivers
Strong returns from secondaries transactions in the early 2000s fuelled LP interest in funds raised by managers with secondaries expertise and, consequentially, drove the initial growth in dedicated secondaries dry powder. As dry powder and buyside competition increased, discounts narrowed and the market applicability expanded to a broader set of institutional investors. As the market has continued to develop, three primary factors have driven increased buyside demand for secondaries.
- Excess LP liquidity. During the last six years (2010 to 2016), private portfolios have produced record levels of distributions, creating a need for LPs to redeploy capital in an expedited manner. Dedicated secondaries funds have been a beneficiary of this cash-rich environment as average secondaries investment pacing is relatively quick and secondaries buyers are typically purchasing seasoned assets with a shorter duration compared to primary commitments.
- Leverage availability. The readily available and inexpensive sources of third-party leverage provide an added dynamic impacting buyside demand. Financial institutions and specialty finance companies are actively providing leverage to secondaries buyers through fund-level credit facilities and deal-level financing (with private portfolios as collateral). This financing is provided at attractive terms and has allowed secondaries buyers to offer competitive prices to potential sellers while delivering adequate returns to their investors.
- New participants. In contrast to the secondaries market, which has eclipsed volume and pricing records, LPs have noted difficulty in identifying compelling opportunities to invest primary capital at sufficient scale. Due to the challenges with investing larger primary commitments with fewer core manager relationships, traditional LPs have allocated internal resources to evaluate expanded relationships with dedicated secondaries buyers as well as to pursue secondaries transactions directly. Select large LPs have emerged as formidable competitors to dedicated secondaries buyers while others have chosen to partner with existing buyers. Greenhill Cogent estimates that the entrance of large traditional LPs as direct buyers has added approximately $7 billion to annual secondaries dry power availability.
In aggregate, these dynamics have driven current dry powder to record levels. Greenhill Cogent estimates that there is approximately $95 billion of near-term capital available to purchase secondaries, nearly 2.5x recent annual secondary volume. While expected secondaries returns have moderated from the early years of the secondaries market, the broader investment environment is such that there is expected to be ample buyside dry powder targeting secondaries for the foreseeable future.