Bigger isn’t always better

There’s a vacuum at the smaller end of the secondary market, argue Capital Dynamics’ Joseph Marks (pictured) and Sandro Galfetti.

Between 2010 and the start of this year, the secondary market has been home to record-breaking transaction volume. Yet despite such expansion and the market’s increasing sophistication, current transaction volume still only represents less than 5 percent of the US and European private equity supply (based on the aggregated NAVs plus unfunded commitments of all US and European buyout and venture capital funds from the vintage years 1999-2008, and factoring in a four-year lag effect). 

Joseph Marks

In the first half of 2013 however, secondary transaction volume was down approximately 50 percent year-over-year, primarily because of a drop-off in large/mega deals, according to Cogent Partners’ secondary pricing report published in July 2013. Nevertheless, deal activity in the small- and medium-sized end of the market is more resilient; thus we expect the secondary market to continue representing an important segment of private equity, and in particular, to continue expanding and creating value for investors – especially at the small and middle ends of the market.   

Today, there are 17 secondaries-focused funds with a fund size of $1 billion or more in the market, according to Private Equity International data. Large-scale fund sizes demand large-scale asset gathering, which consequently has created a vacuum for funds addressing the smaller end of the secondary market – the segment with the most prospective sellers. Due in part to its abundance of dealflow, the small end of the market is also one of the fastest-growing, expanding more rapidly than the overall secondary market. We estimate it currently accounts for $8-10 billion in annual transactions.

Size matters
Closely linked to size is the fact that the smaller end of the market usually exhibits more inefficiencies and information asymmetries than the larger end. Relevant intermediaries and Capital Dynamics estimate that today, approximately two-thirds of secondary transactions are intermediated; particularly large portfolio transactions (above $100 million) and those involving sellers with fiduciary duties to public shareholders or pension holders. Larger transactions are generally churned out of well-run processes and can be fiercely competitive, with sellers frequently securing prices above predicted fair value.

Smaller transactions are generally less intermediated, less competitive and often negotiated directly between the buyer and the seller – both of whom value confidentiality, quick execution and fair price. Generally, only a handful of global smaller secondary funds (i.e. with fund sizes below $500 million) participate in smaller brokered deals, meaning qualified buyers hold better odds of having their bids accepted. Another distinctive feature of the small end of the market, which often consists of individual LP stakes and small portfolios, is its “shadow market” status – a market open only to existing LPs.

Sandro Galfetti

During the last few years of expansion, the secondary market has split into a “flow-buying market” featuring large and intermediated portfolio transactions and a specialised “off-market” featuring smaller private equity stakes, specific strategies, deal types or geographies. Large flow-buying transactions are often bundled portfolios of mixed-quality assets that provide indexed exposure to secondaries. Multi-billion dollar secondary funds must bid on large flow deals to efficiently deploy capital during investment periods and maintain their investment pace. The competition to secure these deals often leads to unreasonably high pricing, benefiting only the sellers. This phenomenon is called the “winner’s curse” – a phenomenon detailed in a 1983 paper by Massachusetts Institute of Technology’s Max Bazerman and Paul Samuelson – because in common value auctions with incomplete information, the winner tends to overpay. Additionally, some larger secondary providers apply third-party leverage to their transactions (at the deal and/or fund level). Leverage may enhance returns – but it comes with higher commensurate risk and higher volatility.

The alternative to flow-buying is to tactically build a portfolio targeting the highest-quality funds and their managers, and finding relative value in the market through geography, strategy (buyout versus venture), vintage or other factors. Unlike their larger counterparts, smaller funds with commitment sizes below $500 million can be ultra-selective about the deals they choose since there are more positions for sale relative to their fund size. Furthermore, smaller, independent secondary providers normally do not use third-party leverage, as the leverage at the underlying company level is sufficient and will not expose investors to additional risk on the secondary fund level.

Other considerations
Some might say secondary investing is simply about acquiring LP assets at deep discounts. Discounts are relevant, but only one of the keys to a successful secondary transaction. Also necessary are:

  • Deep/long-standing knowledge of, and closeness to, the GP
  • Consistent ability of the GP to deliver top-quartile returns
  • Significant expected multiple uplift of the fund – substantiated by a thorough understanding of the exit expectations of the GP in relation to the underlying portfolio companies
  • Assets at an “inflection point”, when the fund is valued slightly below, at or slightly above cost

Quality-oriented secondary fund managers look for upside potential and near-term exits in the underlying portfolio companies, with realized performance increasing over time due to the high-quality nature of the manager and/or the portfolio.


The above commentary is based on a Capital Dynamics’ white paper published earlier this year. Click here to download the full paper. 

Joseph Marks is a managing director and head of Capital Dynamics’ secondaries team; Sandro Galfetti is a director on the secondaries team.