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In private equity (PE) investing, exiting an investment is rarely as simple as clicking “Sell.”
These investments are associated with long lock-up periods. During this time, investors are typically unable to exit their positions. If the investment remains promising throughout its lifecycle, you could benefit from a 100% or even 1000% return on investment. If not… Well, that’s where the “high-risk” component comes in.
Many investors are hesitant to commit to private equity for this very reason. However, a growing market is beginning to allow for enhanced buy-in and exit opportunities: private equity secondaries.
Private equity secondaries provide an opportunity for PE investors to buy and sell existing commitments in private equity funds. This unlocks opportunities for investors to exit their positions earlier than the traditional lock-up period would allow, returning liquidity to their investing funds.
In this article, we’ll explore the growing significance of private equity secondaries. We’ll examine their role in providing newfound avenues for managing risk and potentially maximizing returns.
Table of Contents
- What Are Private Equity Secondaries?
- An Example of Private Equity Secondaries
- Types of Secondary Transactions
- Private Equity Secondary Benefits
- Things to Consider Before Investing in PE Secondaries
- Investing in PE Secondaries with Your IRA Funds
- Conduct Due Diligence on All PE Opportunities
What Are Private Equity Secondaries?
Private equity secondaries refer to transactions where investors buy and sell pre-existing investor commitments to private equity funds, rather than investing directly into the funds when they are first raised. These “secondaries” provide liquidity to investors looking to exit their positions before the funds have matured.
Ideally, secondary transactions can benefit both sellers and buyers. Sellers gain liquidity while buyers gain access to mature assets with potentially shorter times to return realization.
Many investors value the liquidity that the secondary markets provide. In 2021, the private equity secondary market volume crested $134 billion. While the market has contracted slightly since then, some estimate that the market may grow exponentially over the next few years.
An Example of Private Equity Secondaries
If you’re unfamiliar with this market, it may be helpful to explore an example of how private equity secondaries work:
Sarah commits $1 million to a private equity fund that invests in technology startups. The fund has a planned life of 10 years, during which the fund managers buy, manage, and eventually sell stakes in various companies.
Five years into the fund’s operation, Sarah decides she wants to free up capital for other investments. The fund has made several successful investments and has a promising portfolio, but Sarah can't withdraw her money directly from the fund because it's locked in until the fund's maturity.
Instead, Sarah decides to sell her stake in the private equity fund on the secondary market. She finds another investor, John, who is interested in purchasing her position in the fund. John is attracted to this investment because the fund is mature, reducing uncertainty and potentially shortening the time to realize a return on his investment.
John agrees to buy Sarah’s stake for $1.4 million, reflecting the current value and performance of the investments held by the fund.
Sarah receives liquidity from her original investment before the fund’s closure, enabling her to redirect her capital as needed. Meanwhile, John acquires an interest in a high-performing private equity fund without having to wait for a new fund to launch and go through its early, riskier phase of investment.
Types of Secondary Transactions
Secondary transactions generally fall into two main categories: limited partner (LP) secondaries and general partner-led (GP-led) secondaries.
Limited Partner (LP) Secondaries
Limited partner (LP) secondaries involve the sale of existing investments in private equity funds from one investor (the seller) to another (the buyer).
As illustrated in the previous example with Sarah, this transaction is driven by the limited partner who wishes to liquidate their stake in the fund before the fund's term ends. Reasons for selling can vary, including the need for liquidity, portfolio rebalancing, or changes in investment strategy.
The LP selling their interest typically works with a broker or directly with buyers to transfer their shares in the fund. The transaction requires approval from the fund’s general partner. Buyers in LP secondary markets can be individual investors, dedicated secondary funds, or institutions seeking exposure to private equity without the initial lock-up periods.
Note: Many PE funds do not allow for secondary trading. Before investing in private equity, ask the general partner whether secondary trading is allowed under the fund’s structure and governing documents.
General Partner-Led Secondaries
GP-led secondaries are initiated by the general partner, or management team, of the fund. These usually involve fund restructuring or the creation of a continuation vehicle to hold one or more existing fund assets.
This type allows GPs to manage portfolio assets beyond the life of the original fund, often to maximize value or allow more time for growth.
For example, let’s say the Olympus Fund has invested in a high-performing company, BioTech Inc., but the asset is nearing the end of its investment term. Some investors in Olympus want to cash out, but the fund managers want to capitalize on remaining growth potential.
So, Olympus creates a new fund, Everest, otherwise known as a continuation vehicle. Everest raises fresh capital from new investors to purchase BioTech Inc.. Meanwhile, existing Olympus investors can either cash out or maintain their stake in BioTech Inc. through the new fund.
GP-led secondaries allow all investors and fund managers to get what they want – the fund managers maintain their investment, some investors are able to exit, and new investors have the opportunity to hop on board.
Private Equity Secondary Benefits
Investing in private equity secondaries can offer several benefits:
- Quicker Liquidity and Shorter Holding Periods: Secondaries provide the opportunity to invest in funds or companies that are midway through their life cycles. This often leads to shorter holding periods and quicker returns compared to primary PE investments that typically have longer gestation periods.
- Potential for Discounted Purchases: Secondary investments can often be acquired at a discount to their net asset value (NAV), particularly if the seller is motivated by a need for liquidity. This discount can potentially enhance the return on investment.
- Reduced J-Curve Effect: The J-curve effect in private equity describes the initial negative returns followed by a significant rise as the investments mature. Secondary investments typically bypass the initial developmental stages of the J-curve, entering at a point where the curve begins to ascend, potentially leading to quicker positive returns.
Things to Consider Before Investing in PE Secondaries
Investing in private equity secondaries can offer several benefits, but it also comes with its own set of challenges and potential drawbacks:
- Valuation Complexity: Determining the fair market value of secondary assets can be complex due to the lack of publicly available pricing information. This can lead to discrepancies in valuation and potentially result in buying assets at higher than their intrinsic value.
- Management Continuity Risks: In cases where GP-led transactions are involved, there may be risks associated with changes in management or strategy. Such changes can affect the underlying assets' performance.
- Potential for Lower Returns: Although secondaries can sometimes be acquired at a discount to net asset value, they may also carry the risk of lower returns. The assets are typically nearer to maturity, and some of the highest growth phases may have already passed.
Investing in PE Secondaries with Your IRA Funds
Many investors may be intrigued by the prospects of private equity investments but lack the necessary funds. Fortunately, there may be a source of untapped capital hiding in plain sight – their 401(k) or IRA funds.
Retirement funds can be invested in more than just stocks, bonds, and mutual funds. That is, as long as you have a self-directed IRA (SDIRA).
This powerful type of investment account is identical to an IRA from a bank or brokerage barring one crucial exception – you’re able to invest in any asset the IRS allows, including real estate, promissory notes, and private equity.
Thousands of Entrust clients have taken the opportunity to invest their retirement funds in private equity, pairing tax-advantaged growth with a potentially high-growth asset class. However, some may have concerns about extended hold-up periods and potential implications on required minimum distributions (RMDs).
For those investors, private equity secondaries may present a compelling solution.
Investors can gain exposure to private equity assets with a potential exit before the full duration of the original investment term. Or, investors may be able to purchase secondaries of existing funds, offering a shorter lock-up period in exchange for a (generally) lower growth potential.
Conduct Due Diligence on All PE Opportunities
Like many alternative assets, the key to success in private equity secondaries lies in thorough due diligence. Understanding the nuances of each deal, the valuation metrics, and the market dynamics is crucial to making informed decisions that align with your long-term financial goals.
To help you navigate this complex investment landscape, we've developed a Due Diligence Guide. This guide is designed to provide you with the insights and tools needed to evaluate opportunities effectively, understand the specific risks involved, and strategize to optimize your investment outcomes.
Self-Directed IRA Due Diligence Guide
Or, if you’re interested in learning more about how to invest in private equity with your retirement funds, check out our How to Invest in Private Equity blog post.
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