The appeal of private equity versus public stocks is well documented. Preqin data demonstrates that PE’s core, buyout funds, have outperformed the S&P 500 by five percentage points per annum since 2000. A range of surveys indicate that most investors expect private equity’s superior returns to continue for years, fueled by the activist approach to asset management that is PE’s hallmark. I’m almost obsessive about this latter point. The common thread of private equity, the active transformation and structuring of assets of any type, makes it a style of investment rather than an asset class. Private equity funds’ active management of investments means PE is more likely to produce large rewards for little risk than mostly passive buy-and-hold stock and bond funds.
The desire to latch onto the promise of outperformance, and the likely pace of private equity’s future growth, have been hugely amplified by PE’s transformation over the last decade from an illiquid investment category (investors were typically forced to hold funds more than 10 years to final liquidation), into one where funds can be sold quickly and, most crucially, at attractive prices.
Volume in the secondary market for used private equity funds – the thriving release valve for no longer wanted PE investments and what’s giving many investors the confidence they need to invest – was an unprecedented $66 billion in 2018, according to Triago, the fund advisory I founded 27 years ago. That exceeds by 47 percent the former annual record of $45 billion set in 2017 and represents a five-and-a-half-fold increase over a decade.
In a tongue-and-cheek piece in January, 10 Outrageous Predictions for Private Equity in 2019, I forecast 2019 secondary volume at $120 billion, close to double last year’s record. To hit that in 12 months is a stretch, but it’s not really that outrageous, particularly since it’s totally plausible over a slightly longer time period.
We certainly seem to be on the way to a new annual record, with some $18 billion in secondary transactions in the first three months of this year, an all-time high for the first quarter, according to Triago. Given that over 60 percent of transactions typically occur in the second half of the year and that there is as much as $200 billion in funds currently earmarked for secondary investments, we could easily see $90 billion in volume this year. If such growth continues, the market – even if delayed a year or two by a recession – could surpass the $120 billion mark in two to four years.
While secondary sales can be motived by underwhelming fund performance they frequently aren’t. Disposals are also explained by strategic overlap with other funds in a portfolio; a decision to cut back on the overall number of funds in a portfolio; shifting investment focus by geography or specialty; or the desire to unload funds that are approaching – or that have exceeded – their ten-year liquidation target. On the flipside, the appeal of buying on the secondary market is two-fold: secondaries can offer a shorter time frame for receiving fund distributions from investments, boosting annual returns; and they can involve less risk than committing to blind pool fundraisings, which do not yet hold assets that can be evaluated.
Beyond foundational appeal for sellers and buyers, the real catalyst for growth in the secondary market is attractive pricing for sellers. Five-year average pricing in the secondary market for all private equity funds, including harder to evaluate categories like venture capital, stands at 94 percent of net asset value, according to Triago. For larger, generally easier to analyze buyout funds, the five-year average price is 97 percent of NAV. Such consistently attractive pricing is mainly driven by three trends:
- Ever larger specialist funds devoted to buying secondaries and corresponding pressure to deploy capital. The largest secondary fund ten years ago was the $4.8 billion Coller International Capital Partners V (raised in 2007); this year, Ardian is expected to close an $18 billion secondary fund, which will be the sixth largest private equity fund ever, all categories combined.
- Increasing leverage. Leverage in the form of loans, deferred payments and preferred equity now stands at 38 percent of annual secondary market volume, up from just 4 percent in 2013, according to Triago. Reasonable amounts of leverage increase buyers’ potential returns, allowing them to offer sellers more attractive pricing than would otherwise be the case. This holds true not just in bull markets, but also during periods where asset values are declining. With 51 percent of last year’s secondary volume transacting in the bear market of the fourth quarter, secondary pricing barely budged. But use of leverage, in tandem with volume, rose.
- The rise of non-traditional buyers. Such buyers encompass family offices, insurers, sovereign wealth funds, endowments, foundations and pension funds who’ve historically focused mainly on primary fundraising, yet who are increasingly drawn to secondary transactions. In addition to accessing rapid distributions at relatively low risk, secondaries allow these buyers to gain exposure, or dial up exposure, to fund managers they’ve found appealing as primary opportunities. Non-traditional buyers put a greater accent on potential appreciation of funds and so frequently pay higher relative prices, while specialists like secondary funds (all things being equal) focus more on current net asset value, near-term liquidity and the ability to buy at discount. Non-traditional buyers account for some 22 percent of volume today, up from 4 percent a decade ago.
While the rapid growth of the secondary market over the last decade has increased private equity liquidity and encouraged private equity investment, these are still early days. Secondary volume last year amounted to less than 1.3 percent of total private equity net asset value. New private equity investors, attracted by the category’s growing liquidity, will undoubtedly push this percentage considerably higher over the next decade.