Secondary Private Equity
The private equity secondaries market serves investors with an alternative to volatility in the stock and bond markets.
As concerns arise regarding the impact of inflation and hawkish central bank policies on corporate earnings, economic growth, and the performance of traditional stock and bond investments, investors are considering the potential benefits of incorporating alternative investments like private equity assets into their portfolios. These alternatives can offer diversification and the possibility of generating income with low correlation to public markets. While private equity investments typically require significant capital, there are avenues available for individual investors to gain exposure to this market through registered offerings.
Secondary funds, also known as secondaries or continuation transactions, facilitate the purchase of existing interests or assets from primary private equity fund investors. For instance, a primary private equity fund may acquire a stake in a private company and subsequently sell that interest to a secondary buyer. Such transactions provide liquidity to the sellers while offering attractive opportunities for buyers to diversify their portfolios or acquire specific assets.
The total volume of the secondaries market reached a record high of $134 billion in 2021. In the midst of the ongoing volatility witnessed in stocks and bonds, Joe Mathews, Portfolio Manager and Head of Private Markets Secondaries at Bridgefield, explores the opportunities presented by secondaries and highlights their attractiveness not only in challenging market cycles but also in the long run.
Q: Starting at the highest level, what are secondaries in private equity and what is their appeal?
Mathews: Private equity secondaries involve the purchase of existing interests or assets from primary private equity fund investors, also known as limited partners (LPs). These transactions can be structured in various ways to accommodate the needs of the stakeholders. The appeal of secondaries has grown in the private equity market due to the flexibility they offer to LPs who may want to liquidate or rebalance their portfolios. Buyers of secondaries can also benefit from several factors. Firstly, they may experience shorter duration and a faster return of capital compared to primary investments. Additionally, they may have access to potentially discounted opportunities and enhanced transparency into the underlying portfolio or assets they are acquiring. Investing in stable end markets and resilient businesses that provide essential products and services can help mitigate exposure to market volatility. In our portfolio, we focus on general partner-led, single-asset secondaries.
Q: What are secondaries led by general partners (GPs) vs. LPs?
Mathews: In an LP-led transaction, a limited partner sells its commitment in a fund to a secondary buyer, who then assumes the rights and obligations of that LP within the existing fund. Conversely, in a GP-led transaction, particularly in the case of a GP-led single-asset continuation transaction, an asset or portfolio company is transferred from one entity to another. This transfer allows for the potential infusion of additional capital and provides more time to execute a value-creation plan
Q: Why are single-asset secondaries, or continuation funds, attractive?
Mathews: In the realm of GP-led secondaries, the single-asset model has emerged as a distinct and rapidly growing segment. Single-asset transactions offer compelling advantages in all market conditions due to the flexibility they provide to general partners (GPs) in holding onto their most promising assets for longer periods and exploring additional exit options.
Unlike traditional LP-led transactions, which involve exposure to multiple assets within a portfolio, single-asset secondaries can help mitigate broader portfolio risks. These deals often unlock untapped value that would otherwise be forfeited due to limited funding or premature exits influenced by external factors unrelated to the specific asset.
Compared to other segments of the secondaries market, single-asset deals stand out for their potential returns. Recent research indicates that nearly 62% of secondaries investors are targeting net internal rates of return of 20% or higher specifically in single-asset secondaries. In contrast, return expectations for multi-asset GP-led and LP-led segments are comparatively lower, with only 40% and 16% of investors targeting returns of 20% or more, respectively.
Q: Why are GP-led secondaries overall attractive in this environment?
Mathews: Despite the challenges posed by the current macroeconomic environment, the economic headwinds have not hindered deal activity for continuation transactions, particularly in the case of GP-led deals, especially single-asset transactions. The appeal of GP-led secondaries lies in the reluctance of general partners (GPs) to divest their prized blue-chip assets while comparable businesses are experiencing a downturn. Continuation funds offer an attractive solution by acquiring assets from private equity funds approaching the end of their lifespans, enabling GPs to retain their best-performing assets. We have observed high-performing, low-leverage, and resilient PE-owned businesses that possess the potential to outperform and capitalize on opportunities, even in a downturn. For instance, buy-and-build businesses, such as retail chains or health service providers with ample capital, can act as consolidators by acquiring add-on businesses at attractive prices, capturing synergies, and reducing average acquisition costs.
The impact of this opportunity is evident. In 2021, the deal volume in the GP-led secondary market globally reached $68 billion, accounting for approximately half of the overall secondaries market and representing an almost 100% increase from the previous year. Around 44% of GP-led secondaries were invested in single-asset continuation funds, as investors gravitated towards concentrated exposure to managers and portfolio companies they are familiar with and consider to be top performers.
Q: What are the risks and other considerations that private equity secondaries investors should account for?
Mathews: Private equity secondaries investors face various risks and considerations that they should take into account. One of the key factors is the complexity involved in sourcing, conducting due diligence, and executing single-asset secondaries deals. This complexity offers an opportunity for investors to earn a premium, but it also requires a specialized skillset and expertise. To source high-quality opportunities, Bridgefield establishes dedicated teams focused on deal origination. These teams build networks with general partners (GPs) and engage in regular meetings to develop a proprietary pipeline of potential investments. Due diligence is a crucial step that involves in-depth analysis of financial statements, understanding the target asset's end markets, and assessing the quality of earnings reports. Market studies are commissioned, and conversations with customers, suppliers, and industry experts provide valuable insights into the fundamentals of the asset. Single-asset transactions involve a complex negotiation process that can span three to six months. Multiple stakeholders are typically involved, including the GPs, rolling limited partners (LPs), selling LPs, and the new buyer group. Successfully navigating potential conflicts requires a specialized skillset and experience in dealing with such complexities. The resource-intensive nature of this space creates barriers to entry that discourage casual or inexperienced investors. Therefore, it is crucial for investors to seek a dedicated and expert team with experience in single-asset dealcraft. Having a team that understands the intricacies of the GP-led single asset space increases the chances of success and mitigates the risks associated with these transactions.