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Can you illustrate the growth of the secondary market over the last 15 years?
The 10 top secondary funds raised in 2004 aggregated to $13 billion. Fast forward to 2018 and the total rises to around $77 billion, again for the top 10 funds. That’s greater than five times growth and also a significant amount of capital. This growth is being driven by very strong investment results and, worth noting from an IRR perspective, secondary returns are surprisingly close to what has been achieved in the primary buyout market.
In 2004, there was a relatively small group of secondary investors. In 2018, as an advisor, we’ve sold assets to over 100 investors. That’s a dramatic change in the number of secondary investors compared with 2004.
Finally in 2004, there wasn’t a single secondary fund in the top 10 private equity funds raised. In 2018, five of the top 10 funds are secondary funds. This provides clear evidence of the significant increase in the importance and scale of the secondary market.
What do you think has remained stable in the secondary market?
The amount of dry powder in the market is still very concentrated in a few hands. Fourteen buyers represent 80 percent of the dry powder. Even though there are many more secondary investors, the capital that’s available to be deployed in the market is still highly concentrated.
Also, if one compares the top 10 secondary funds raised in 2004 with 2018, it is essentially the same group: nine of the 10 are the same firms. One has left, Paul Capital, and one investor has joined, Alpinvest. The remainder are the same. The order of the top 10 has changed as some groups have become more prominent.
A lot of capital has been raised by secondary investors. However, a significant amount of capital has also been raised in the overall private equity market. Therefore, on a relative basis, secondary sales volume as a percentage of all private equity assets has remained stable. The secondary market volume is roughly between 1 and 1.5 percent of the outstanding NAV.
What are some of the big changes?
The sellers have changed. This is a market that used to be driven by financial institutions. Banks and other financial institutions accounted for 35 to 45 percent of the market, followed by pension funds and asset managers.
If you compare 2014 and 2017, GP liquidity solutions has risen to become almost 25 percent of the market. Also, asset managers and primary fund of funds selling have generated a large tertiary market for secondary funds to participate in. This development is natural given the “bubble vintages” were from 2004 to 2008. During these years, funds of funds raised their largest funds. Therefore, it’s not surprising that vehicles that are 10 years or older are now being sold.
Public and private pensions continue to be very important, but the key change is GP liquidity solutions and asset managers as key sellers. In the first half of 2018, GP solutions and direct transactions accounted for 37 percent of the market, up from 19 percent in 2014. This year, we would expect GP liquidity solutions to take 35 to 40 percent of the total. That’s a huge increase over four years – one I just wouldn’t have imagined.
The other big change from 2004 is specialisation. In 2004, the transactions were all fairly vanilla: sales of portfolios of LP interests, that were highly mature. If you look at investors now, some specialise in early secondary positions or structured transactions, some use leverage, others will focus on staple transactions. There’s a big variety, even within LP positions. Some firms also specialise in GP-driven transactions. There is also the emergence of the preferred equity market which has developed in the last few years.
Specialisation within the secondary market is not surprising. As industries develop, the largest groups get larger and the smaller groups tend to be more specialised. It’s the groups in the middle that get squeezed.
What does this mean for return expectations?
I think there’s an expectation that the more complex the secondary transaction and the more concentrated the assets being purchased, the higher the expected returns should be. There’s probably more bifurcation in terms of returns for the sub-strategies. Most secondary groups invest across GP transactions and LP transactions. The relative mix of those strategies will determine the returns.
Is risk-taking going up in the secondary market?
The risks are very calibrated. In the more traditional businesses, LP portfolios are diversified across many companies. Perhaps the biggest single change is the common use of leverage as part of the capital structure. The risk is higher when investing in more concentrated portfolios or direct companies, such as in GP-led transactions, so one would expect returns to be higher for these transactions.
Where do you see the secondary market in 10 years?
The market will continue to grow. Market volume in 2018 should be between $65 billion and $70 billion. That compares with $8 billion in 2004. Within the next few years, I’d expect annual volumes to rise to $100 billion. Differentiation among secondary funds will also continue. There will be much more nuance among investors.
I would expect the GP-driven part of the market to reach 50 percent of volume in the next few years. This is a huge change. This is partially driven by GPs considering the secondary market as an exit option for individual companies. The market for single-asset secondaries is here to stay.
I spoke to a GP the other day about his plan for a company and he said: “We’re thinking about a trade sale, an IPO or a secondary.” One would have not heard that 18 months ago. It’s a fairly dramatic change in terms of the importance and profile of the secondary market.