For a long time, the private equity secondary market lived on the fringes of the alternative capital world. It was considered a grey market, a sleepy backwater populated by quirky iconoclasts, fund allocators, and wayward direct investors unable to make a go of it in the mainstream private equity market.
The secondaries market was a place where limited partners went to get liquidity for old partnership interests. Often volume spiked during financial crises when financial institutions were dumping their commitments and reacting to regulatory pressure. Transactions routinely took place at deeply discounted levels.
The only involvement of general partners was to approve transactions, which they did reluctantly, concerned that the departure of an LP could taint their franchise. This was a small, uninspiring transactional business that had all the deal-making excitement of signing tax returns in a small accounting firm’s office. The secondary market was a labouring Cinderella cleaning her stepmother’s stylish, private-equity-bankrolled apartment.
Today, the private equity secondaries market is one of the most vibrant segments of the global financial markets with a vast ecosystem of participants seeking a variety of transactional objectives. In 2018, transaction volume crossed the $70 billion threshold, increasing five times over the past decade. This market today is expansive, innovative, global, and powered by trends decades in the making. Five of the top 25 private equity funds raised or in the market over the last 18 months are secondaries funds.
However, the market is not oversupplied with capital; on the contrary, most knowledgeable parties agree that the market has roughly two years of dry powder, a distinct contrast to the mainstream private equity market which is said to be fuelled with six years of capital commitments. In short, the private equity secondary market is currently in a virtuous circle of growth with expanding transaction opportunities being met with robust fundraising and increasing availability of low-cost leverage. It would seem that today’s secondaries market is Cinderella dancing with the Prince (private equity) and positively glowing at the centre of the ball.
How did this transformation occur? Was it a wave of the Fairy Godmother’s wand? Or the payoff to years of scrubbing floors?
The answer is both. The vibrant market is the result of decades of increasingly sophisticated information management, ever-expanding proprietary dealflow and rapidly growing barriers to entry. The vast majority of dedicated secondaries investors worked hard to establish a firm foundation for investment success and future growth. They established valuable information archives across GPs, funds, and underlying investments; they refined investment protocols, decision-making, and risk management; they internalised risk-return tradeoffs acceptable to LPs and expanded investor support globally; and they methodically innovated across the investment landscape.
This last element – innovation – has proved the key to the market’s success, its Fairy Godmother. With the overall private equity sector maturing, all sorts of new liquidity needs have emerged – not only for LPs, but also for GPs, portfolio company management teams and other stakeholders. The market has gone from being a plain, simple transactional market to a solution-driven market where liquidity is designed, arranged and negotiated. Flexibility and alignment have become the catchwords for the moment in a way that no other secondaries market can replicate. A “total solution” has always been the mantra of the secondaries market, but it has become the market’s practical reality more than ever before. This has fundamentally altered the market and has placed it on the threshold of having a $100 billion annual volume.
Secondaries capital is flowing into a variety of uses and structures that would have been alien to the market 10 years ago. This flowering of innovation is evidenced by the dramatic growth in GP-led transactions such as fund recapitalisations, strip sales, single-asset fund recaps and stapled deals that have taken the market by storm. In addition, new investment strategies pursuing specific risk-return trade-offs have further expanded the pool of available liquidity solutions – examples include inexpensive asset-backed senior financing, issuer-friendly preferred equity securities, and a wide variety of contractual waterfalls and joint ventures between owners of private equity exposure and counterparties.
This is all a logical progression of a multidecade trend; however, no one outside the secondaries market community saw this coming and many still do not recognise what has actually occurred. However, word is increasingly getting out—the secondaries market has gone mainstream and is a potent part of the capital markets presenting new options for the thousands of GPs and LPs who participate in the near $6 trillion private capital partnership world. It is the focus on solutions that has brought this market to new heights and will likely assure its future for years to come. The glass slipper has found its home in the Cinderella story of the private equity secondary market.
Jeff Hammer and Paul Sanabria are managing directors and co-heads of the illiquid financial assets practice at Houlihan Lokey.