Evercore: The evolution of the secondaries market

Once regarded as a ‘cottage industry’, secondaries has transformed into an intrinsic part of private markets, write Evercore’s Nigel Dawn, Dale Addeo and Chase Johnson.

This article is sponsored by Evercore.

Nigel Dawn

Since the advent of private equity, limited partners have faced a dichotomy: investments in illiquid securities can create outsized return opportunities, though that same illiquidity can make it difficult to actively manage investment portfolios. Over nearly any return horizon over the past 20 years, private equity has consistently outperformed public equity, making it an attractive segment to allocate capital for institutional investors.

To access these returns, investors agree to commit capital into blind pools without redemption options for the entire fund’s life. Closed-end private equity funds typically have a fund term of 10 years, though in practice are extended until all investments are liquidated, which can stretch a fund’s life to 12 years or more.

Given investors’ desire to actively manage their portfolios, a secondary market developed for investors to sell fund interests prior to fund liquidation. The secondaries market, as it is now known, has grown from a relatively niche area within private markets to a dynamic tool for LPs and GPs to manage their portfolios.

Phase one: Pre-GFC… a niche industry

The secondaries market began humbly enough. Entrepreneurial investment firms saw the opportunity to acquire stakes in private equity funds from capital-constrained LPs, and began raising their own dedicated funds to capitalise acquisitions.

Dale Addeo

Many of the secondaries investors that are now stalwarts of the industry, including Coller Capital, HarbourVest Partners, Landmark Partners, Lexington Partners and Pomona Capital, raised their first secondaries funds in the 1990s. The earliest funds only had tens of millions of dollars of committed capital – a far cry from the multibillion-dollar funds raised in recent years.

These upstart firms predominantly acquired portfolios of LP interests in private equity funds – often non-intermediated at significant discounts to net asset value – and built diversified exposure to private equity with a shorter time horizon, given acquired funds were often already deployed. Returns for early secondaries funds could exceed 20 percent net IRRs, leading to greater investor interest in the nascent but growing asset class.

Still, supply was relatively limited and was usually driven by large portfolio sales from financial institutions. The early 2000s saw the completion of multiple billion-dollar transactions, including RBS’s sale of the NatWest portfolio, UBS’s sale to a joint venture with HarbourVest and the spin-out of DB Capital Partners to create MidOcean Partners. As transactions became larger, investors sought out advisers to run marketing processes to maximise value, and investment banks set up specialised secondaries advisory teams to originate and structure transactions. By 2008, secondaries transaction volume had increased to $20 billion.

Phase two: GFC to 2014… recession creates opportunity

The impact of the global financial crisis reverberated throughout financial markets, and the secondaries market was not immune, with transaction volume halving to $10 billion in 2009. With uncertainty around asset prices, investors were sceptical about selling private equity funds while the world seemingly crumbled around them. As global economies began to rebound, governments instituted new regulation to provide additional safeguards around financial markets. Coupled with constrained balance sheets post-GFC, this regulation forced many financial institutions to exit their private equity exposure, both direct and indirect, in transactions welcomed by secondaries investors.

Chase Johnson

Financial institutions were not the only private equity investors impacted by the GFC. The denominator effect, where the value of an investor’s broader portfolio decreases more than its private exposure, put pressure on other institutional investors to right-size their portfolios. Some LPs were no longer able to meet their unfunded capital commitments, given distress in other parts of their portfolios. In both situations, secondaries investors served as willing buyers of private equity exposure from LPs in the wake of the GFC.

While initially developed to provide solutions to LPs, the secondaries market also became a tool for private equity sponsors themselves. The first test case was to unlock value held in ‘zombie funds’ – funds that were in extension and managed by sponsors not able to raise successor funds. In this first wave of ‘fund restructurings’, secondaries investors capitalised a new special purpose vehicle, managed by the ‘zombie’ sponsor or a new sponsor, to acquire the remaining companies left in the fund. These could then be managed under extended duration, with refreshed alignment and access to follow-on capital.

These transactions, and the returns they generated, set the stage for the modern continuation fund movement as secondaries investors gained comfort in taking more concentrated exposure.

Phase three: 2015 to 2019… growing acceptance

For all the opportunity created by the secondaries market in the years following the GFC, secondaries remained a four-letter word for many GPs and LPs. However, that perception began to change as more investors reaped the benefits of the secondaries market.

For LPs, that meant being able to take a more active role in managing their private exposure. No longer just for forced sellers, the secondaries market was usable for LPs to focus their portfolios on core managers, strategies and vintages. In as little as a few months, LPs could generate as much liquidity as desired to redeploy into their highest conviction investment themes. These LP-led transactions continued to serve as the bread and butter of the secondaries market, always representing at least two-thirds of transaction volume.

Similarly, GPs found new ways to manage their portfolios through the secondaries market. While it had been previously reserved primarily for zombie funds or bank spinouts, a going concern sponsor could use the market to provide optional liquidity to their own LPs. ‘GP-led’ transactions took a variety of forms, including tender offerings, single- and multi-asset continuation funds and strip sales. Several well known sponsors completed GP-led transactions, helping to remove the stigma associated with the market.

Another theme during this period was the expansion of adjacent private markets strategies. While buyout private equity comprised the majority of secondaries transaction volume, deals were completed across growth equity, venture capital, private credit, private real estate and private infrastructure. Given the different return profiles of the underlying asset bases, dedicated pools of capital were raised by secondaries investors to target these opportunity sets. Preferred equity also became a tool for both LPs and GPs to accomplish their objectives, even if there was a significant bid-ask spread in a traditional sale.

Maybe more than most, the secondaries market was a beneficiary of stable global markets following the GFC, notching up a record year at the time in 2019, with $80 billion of transaction volume. Many questioned how the industry would hold up in another crisis.

Phase four: 2020 and beyond… no longer the ‘cottage industry’

While 2020 started off looking like another record year for the secondaries market, the covid-19 pandemic brought deal activity to a grinding halt as investors grappled with how the effects of the pandemic would impact their portfolios. Given the sharp decline in the public markets, many market participants predicted that a rush of LPs would be forced to sell due to the denominator effect, similarly to after the GFC.

While a few LPs did sell in distressed situations, this expected wave of LP sales did not occur for two reasons. First, LPs were more flexible with their allocation targets, particularly given the quick rebound in the public markets. Second, LPs simply did not know how the pandemic impacted the value of their portfolios. Given the limited interest from LPs in pursuing full sales, preferred equity solutions came to the fore to help LPs meet their capital needs without taking a discount.

“The secondaries market is resilient and sees the most innovation in challenging times”

As the global economy shut down, GPs were forced to pause exit processes and push out exit timing until financial performance normalised. Continuation funds were an ideal alternative that could allow a sponsor to provide optional liquidity to LPs while extending duration and accessing follow-on capital.

While it was difficult to ascertain the fair value of an LP portfolio with hundreds of underlying companies, secondaries investors felt comfortable transacting on more concentrated exposure where they could thoroughly diligence the underlying assets.

Software and healthcare were viewed as the most covid-resilient sectors and received the majority of interest from secondaries investors. GP-led transactions helped buoy the secondaries market in 2020, growing more than 20 percent year-on-year and surpassing LP-led transaction volume for the first time ever.

2021 was a strong rebound year for the secondaries market. Following strong success in 2020, GP-led transactions entered the mainstream as high-quality sponsors completed transactions focused on the top assets in the private markets. Single-asset continuation funds in particular surged in popularity as GPs sought to retain exposure to their ‘crown jewel’ companies.

No longer stigmatised for GPs, continuation funds became ‘the fourth exit option’, particularly for sponsors’ best performing companies, meaning they could hold on to their winners while generating strong returns for LPs. LPs themselves initiated a record number of portfolio sales, driving total secondaries transaction volume to $134 billion in 2021.

Even though secondaries firms have raised record amounts of capital, the largest constraint on the growth of the secondaries market has been the amount of buyside capital available, particularly for GP-led transactions. With single-asset transactions of more than $1 billion becoming more prevalent, secondaries advisers have been forced to syndicate transactions beyond traditional secondaries buyers, stretching out processes by months.

Sponsors have seen the opportunity to apply their direct expertise to the secondaries market and a number have either bought or built their own secondaries businesses, and are raising capital to deploy into the space. Several secondaries firms are in the process of raising dedicated GP-led pockets of capital, and LPs that previously eschewed continuation funds are dedicating pools of capital for concentrated transactions. With several fund closes expected from secondaries firms over the next six months, the capital shortfall should tighten and allow the secondaries market to continue to grow.

In 2022, deal activity has slowed as secondaries buyers have become more cautious in light of economic concerns and a challenging fundraising environment. While transaction volume is likely to decline year-on-year, it is still expected to be more than $100 billion – 10 times the volume in 2009. As demonstrated in prior crises, the secondaries market is resilient and sees the most innovation in challenging times.

The industry has reached the scale of key importance to GPs and LPs, and we expect the trends we have seen over the past few years to continue. While a trillion-dollar market may be some way away, the secondaries industry has cemented itself as an intrinsic part of the private markets and is here to stay.

Nigel Dawn is a senior managing director and head of Evercore’s private capital advisory group; Dale Addeo is a senior managing director; and Chase Johnson is a vice-president.