Introductory Content Secondaries

What Are Secondary Investments?

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Private equity secondary investments are a transfer of a private equity interest from one investor to another. Even if a private equity fund has been fully subscribed, investors have several options to access previously illiquid assets. One strategy uses secondaries whereby a new investor, or secondary buyer, purchases an existing investor’s commitment to a private equity fund and effectively becomes a replacement investor as a limited partner (LP).  

Private equity secondary funds provide an opportunity for LPs to sell their commitment in a private equity fund before the fund’s underlying investments have fully matured. Secondary buyers assume the investment’s rights and obligations, including future distributions from the underlying portfolio companies and unfunded liabilities. 

The Anatomy of a Secondary Transaction

Why do investors sell their private equity interest in a fund via a secondary investment?

LPs may choose to sell their positions for many reasons, including: 

1. Liquidity: One of the key considerations that every investor must keep in mind is liquidity – the ability to buy or sell interest in a fund without significantly changing valuation – and LPs are no different. An LP may sell their interest in a fund simply because they need cash and don’t want to stay invested for the fund’s entire life cycle. 
2. Allocation: Sometimes unforeseen overcommitments or changes in market valuations require an LP to modify their investment strategy and/or rebalance allocations. 
3. Portfolio Management: An LP may want to reduce their unfunded commitment balance or sell their interests in older funds to reduce the number of their general partner (GP) relationships. 

Why do investors buy an interest in a private equity fund via a secondary investment?

For investors looking to optimize their portfolio strategy, secondaries may be attractive for several reasons: 

1. Diversification: Secondary funds allow buyers to gain exposure to a diversified portfolio across multiple strategies, sectors, vintage years, geographies and GPs, potentially reducing risk. Buyers may also use secondaries to strategically manage their portfolios, tailoring their private equity exposure to complement their existing portfolios, target specific themes or risk profiles. 
2. J-Curve Mitigation: The term “J-Curve” refers to the typical pattern of returns for private equity investments – named because it resembles the letter “J.” This pattern shows initial negative returns followed by positive returns in later years, reflecting the process of investing capital and creating value. By investing in a secondary fund, buyers can potentially avoid or reduce the impact of the J-Curve. (To learn more, see our introduction to J-Curves piece here). 
3. Liquidity: Secondary funds provide access to a relatively more liquid market for private equity investments. Buyers can sell their interests in the secondary market to achieve liquidity and manage their portfolio more effectively.  
4. Reduced Uncertainty: Secondary funds offer buyers visibility into the underlying fund assets. Buyers can evaluate historical financials, track records and valuations of the portfolio companies, providing a more informed decision-making process compared to investing in “blind-pool” primary funds.¹ 
5. Pricing Efficiency: Secondary buyers generally acquire private equity investments at a discount to their net asset value (NAV) compared to their primary market counterparts. Secondary market pricing inefficiencies can provide attractive investment opportunities and potentially enhance overall risk-adjusted returns, including the potential for downside protection. 

How can secondary investments fit in your portfolio? 

Secondary investments may not be top of mind when liquidity is ample. But, when liquidity is at a premium, secondary investments may provide sought-after optionality. Additionally, secondaries bring with them the ability to diversify exposure across different vintage years, industries, geographies or even fund managers, so LPs can balance portfolios selectively and optimize for performance. Overall, this translates into more efficient portfolio pricing and better cash flow. 

Benefits of Secondary Investments in a Portfolio

For investors looking to optimize their portfolio strategy, secondaries may be attractive for several reasons.

With historical returns for secondary funds performing similarly to (if not better than) primary private equity investments, the benefits are worth considering.

To learn more, please see our primer on secondaries.