Today’s CIO Weekly Perspectives comes from guest contributors Peter Bock, Philipp Patschkowski and Ben Perl.
The private equity secondary market, which initially evolved to enable limited partners (LPs) to raise cash by selling a fund or portfolio of funds before they had matured and made their final distributions, has become an increasingly important part of the private equity ecosystem since the global financial crisis. As the private markets grew from around $2 trillion to $10 trillion between 2010 and 2022, secondary market transactions went from $20 billion a year to well over $100 billion, according to Jefferies.
Alongside this growth, we see three notable trends in the world of secondaries. One is the rise of general partner (GP)-led secondaries—a now well-established trend that continues to gain momentum. More recently, we have seen a drop in the “dry powder” available to the secondaries market relative to annual transaction volumes, and a significant rise in the proportion of secondaries transactions that are so-called mosaic deals, in just one or two funds rather than entire portfolios.
In our view, all three of these trends are creating a landscape that is particularly attractive for well-capitalized secondary investors that don’t need to use leverage and can be highly selective in targeting quality assets.
Since 2020, three waves have caused a substantial increase in demand for secondary market liquidity while also creating a shortage of dry powder.
The first wave, in 2020 – 21, was the “numerator effect.” Private equity investments performed so well, and capital calls were made so rapidly, that many LPs found themselves overallocated to the asset class relative to the value of their overall investment portfolio.
The second wave, in 2022, was the “denominator effect.” Public equity and bond market valuations plummeted, while there was generally a much smaller decline, if any, in investors’ private equity fund portfolios. LPs were now even more severely overallocated.
Finally, through 2022 and into 2023, exit routes closed, leaving LPs still invested in funds that they had expected to mature. Furthermore, as private equity firms continued to call capital for new investments even as distributions dried up, net investor cash flows turned negative for the first time in many years. This exacerbated the overallocation problem still further.
The secondary market is the most obvious solution for realizing liquidity and bringing allocations back into line. The other side of that coin, however, is that the same group of investors who are overallocated to private equity are also potentially constrained in their ability to invest in private equity secondaries.
As such, we do not believe that fundraising across the secondary asset class has been able to keep pace with the potential transaction volumes. Industry data suggests that, even if we added all of the expected pipeline of secondaries fundraising and an estimate for leverage, the total dry powder in the secondaries market would still meet only two years or less of current selling demand—an exceptionally low level.
That means well-capitalized firms that are able to raise funds potentially face much less competition for assets, just as LP and GP demand for liquidity is rising.
Index Buyers vs. Targeted Buyers
What about the rise of mosaic deals?
According to Greenhill’s 2022 Global Secondary Market Review, mosaic transactions in specifically targeted funds amounted to 21% of a $132 billion secondaries market in 2021, rising to 50% of a $108 billion market in 2022.
To understand why, one can think of the market as being split between bigger “index” buyers (who bulk-buy entire portfolios of funds and apply another layer of leverage) and “targeted” buyers (who look for specific, high-quality funds with embedded value, and buy them with no additional leverage).
Index buyers acknowledge that not every fund they buy in a portfolio will be high quality, but they generally assume that they will also be sufficiently diversified to manage that risk. While we remain optimistic about private equity’s long-term prospects and performance, we also suspect there may be greater dispersion in the returns of legacy portfolios, given the changes of the past two years in the economy and capital markets. Index buyers could therefore be picking up more mixed and lesser-quality assets than the classical top-down models of estimated return might indicate. Alongside the higher cost of their leverage, this is leading many to lower their estimated portfolio returns—and, in an attempt to counteract that, lower their bids for portfolios to give themselves a valuation buffer.
As a result, it is now much more difficult than it was for LPs to sell entire portfolios to leveraged index buyers at minimal discounts to NAV, and they have become more likely to consider selling select assets to more targeted buyers to realize liquidity—hence the rise in mosaic transactions.
Whereas index buyers try to mitigate risk via diversification, targeted buyers try to reduce risk via selectivity and a focus on quality. As such, the rise in mosaic transactions reflects not only the expanded opportunity set for targeted secondary investors described above, but also the opportunity to be even more selective than usual, which in turn implies more potential to reduce risk and generate attractive returns.
And this is where the rise in GP-led secondaries also comes in.
GP-led secondary transactions involve placing prized mature companies into “continuation funds” that are sold to new secondary-market investors alongside some of the existing LPs.
These transactions solve two critical challenges that many LPs currently face. At a time when the traditional exit routes are closed, the secondary investors’ capital provides liquidity to any LPs who need it, while the continuation fund enables the rest to stay invested as the GP continues to grow their best businesses.
On the other side of the transaction, GP-led secondaries enable targeted secondaries buyers with the requisite due diligence capabilities to take their selectivity to another level. Index buyers transact whole portfolios; targeted secondaries buyers transact individual funds; GP-led secondaries buyers transact individual businesses from individual funds.
Moreover, these are individual businesses in a continuation fund to which the underlying GP typically makes a substantial commitment: Investors often expect the GPs to roll substantially all their carry proceeds into the new fund, as well as a meaningful additional commitment. This represents a strong vote of confidence from those who know the underlying businesses better than anyone.
In our view, this is why GP-led transactions, while operationally demanding, represent one of the clearest alignments of interest between sellers, GPs and buyers in the private equity secondary market.
In less uncertain times, the high-quality funds and underlying businesses that targeted secondary-market buyers like Neuberger Berman look for often get sucked up into bulk portfolio sales to index buyers. Now, with index buyers a less dominant force and a less attractive option for sellers as leverage costs rise and risk management comes to the fore, the choice of quality assets is much more abundant. That allows investors like us to be even more selective than usual, getting our pick of the very highest-quality funds, and the highest-quality companies—and providing our investors the attractive attributes of the secondaries market in an even more pronounced manner.
In other words, macroeconomic uncertainty and the private markets liquidity squeeze are not just reducing competition for assets in general, but for high-quality assets in particular. As a result, we regard current secondary-market conditions to be among the most favorable we have seen for targeted buyers.
In Case You Missed It
- U.S. Consumer Confidence: -5.7 to 103.0 in September
- U.S. New Home Sales: -8.7% to SAAR of 675,000 units in August
- S&P Case-Shiller Home Price Index: July home prices increased 0.6% month-over-month and increased 0.1% year-over-year (NSA); +0.9% month-over-month (SA)
- U.S. Durable Goods Orders: +0.2% in August (excluding transportation, durable goods orders increased +0.4%)
- U.S. 2Q GDP (Final): +2.1% quarter-over-quarter SAAR
- U.S. Personal Income and Outlays: Personal spending increased 0.4%, income increased 0.4%, and the savings rate decreased to 3.9% in August
- Eurozone Consumer Price Index: +4.3% year-over-year in September
What to Watch For
- Monday, October 2:
- ISM Manufacturing Index
- Tuesday, October 3:
- JOLTS Job Openings
- Wednesday, October 4:
- ISM Services Index
- Eurozone Producer Price Index
- Friday, October 6:
- U.S. Employment Report