Alternative Allocations: The growth and diversification of secondaries

In a traditional private equity fund, a pension plan, endowment, foundation or family office (a privately held company that handles investment and wealth management for a wealthy family) commits to invest capital over a period of time (seven-10 years). They are considered limited partners in the fund (LPs). When the fund manager, also known as the general partner (GP), finds an attractive investment, they call for capital from the LPs’ (capital calls) original commitment.  

The LPs understand that these are long-term investments, but sometimes they have liquidity needs, and they may seek a buyer for their ownership stake. These are referred to as secondaries transactions since the original owner seeks a secondary buyer.

As the data above illustrates, secondaries have traded at a discount to net asset value (NAV) since 2007, with more attractive pricing during periods of economic slowdowns. This is partially driven by the “denominator effect,” as public pension funds find themselves overallocated to alternative investments due to the decline in value of their public market positions. As institutional investors reduce or diversify their private equity, new investors have the ability to benefit through participating in secondaries and purchasing these positions at discounts.

According to PitchBook,¹ secondaries fundraising rose from US$20 billion in 2006, to US$100 billion in 2020. Up until 2022, most funds could exit their investments through acquisitions or initial public offerings (IPOs). This created a lot of cash flow and liquidity for LPs. In 2022, exits began to slow dramatically, and have essentially dried-up since the collapse of Silicon Valley Bank. LPs will likely need some liquidity in the coming years to meet capital calls and diversify their holdings.

Secondaries managers can diversify their holdings based on the stages, geography, industry and vintage of the primary funds available. By diversifying vintage years, the secondaries manager can attempt to mitigate the J-Curve effect, where capital is drawn down as opportunities are sourced and returns are typically negative. Secondaries managers with experience and capital to deploy may be able to take advantage of the current market and find many attractive opportunities in the coming years.

In today’s market environment, with exits slowing dramatically from peak levels, we anticipate that many institutions and family offices will seek liquidity in the near future. We believe this scenario provides a significant opportunity for secondaries managers to select highly prized assets from a diverse pool and negotiate favorable pricing.