The rise of direct secondaries

A generational boom in fund liquidations could prompt an explosion in direct secondaries activity.

When direct secondaries firm Cipio Partners announced it had made its 19th exit from its latest fund this week, an executive from the firm told Secondaries Investor that it will be back in market with a successor fund – possibly this year – due to positive market sentiment.

That positivity comes from a steady increase in activity across the market. Deal volume for direct secondaries – purchases of stakes in usually privately-held companies from historical shareholders – rose by 21 percent to around $5.5 billion in the first half of 2015, compared with a year earlier, according to Toronto-based Setter Capital. Some market participants expect 2016 will be an even stronger year for activity in direct secondaries investing. Here’s why.

A generation of pre-crisis private equity and venture capital funds, those raised in the exuberant 2005-7 years, are reaching the end of their lives; their managers are accordingly looking to liquidate the vehicles and dispose of investments in underlying portfolio companies. This is creating a huge cyclical opportunity for direct secondaries investors, say market sources, as GPs are increasingly turning to direct secondaries players to sweep up tail-end assets in older funds.

“Direct secondaries are growing significantly,” says a partner at a European fund of funds. “Many funds that historically were doing almost exclusively LP stakes are going to be doing a lot more direct secondaries, and some of these through fund liquidations.”

With roughly $43 billion in dry powder to deploy in private equity in the first half of 2015, according to Evercore (the figure doesn’t include capital being raised or leverage), and with increasing competition for LP stakes, secondaries firms are being forced to find other ways to put their money to work.

The universe of pickings for direct secondaries players is huge. In venture capital secondaries alone there may be over $500 billion of direct investments in companies that will need a third avenue for liquidity outside IPOs and trade sales in the coming years, the chief executive of a US-based VC secondaries tells Secondaries Investor. VC funding rocketed by 62 percent to over $47 billion in 2014, and industry participants believe this rise in primary financing of tech start-ups will flow into the secondaries market. Around half of this capital is direct investment by mutual funds, hedge funds, corporations and family offices, and many of these investors are expected to become sellers in a down market, says the same executive.

Exchange operator Nasdaq clearly sees potential for growth in the direct secondaries market; last October the company acquired SecondMarket, an online platform that facilitates the trading of stakes in private companies.

One region in which direct secondaries may certainly play a bigger role is Asia, according to participants on the ground. Recent stock market volatility could well stifle exit opportunities through the public markets, and secondary buyouts, widely accepted as a valid exit route in Europe and the US, are still viewed with suspicion. Buyers keen to pick up minority stakes in companies are, therefore, becoming increasingly sought after, a partner at a Hong Kong direct secondaries firm tells Secondaries Investor.

However, there is one unhealthy market dynamic that may well stymie the possible direct secondaries explosion, particularly in the VC secondaries market. “For very old funds,” says one market participant, “the motivation for the manager is to keep getting extensions, hoping that those companies eventually get sold successfully.”

Unless LPs start refusing to give fund extensions, assets in older funds will remain under the management of GPs who continue to hold out hope for an exit through a trade sale or IPO. The key to unlocking the potential in the direct secondaries market, therefore, may well lie in the hands of the LPs.

What do you think? Tell me at