Part 1: Pros and Cons
For years, secondary funds were the poor, forgotten cousin of alternative investment funds. The secondaries market had limited activity, mainly from limited partners (LP) trying to exit their investments in old closed-end funds. Transactions in the secondary market were typically at deep discounts.
The secondaries market today is very different. Institutional investors are pouring money into these funds. General partner (GP) restructurings, in addition to LPs trying to make an early exit from their commitments, have spurred growth in the secondaries market. Preqin reports that transactions in the secondary market have grown since 2013 at a compound annual growth rate of 40%, reaching an estimated $75 billion last year. The aggregate target size of 43 private equity secondary funds was $72 billion as of July 2019, with an average fund size of $757 million for funds that closed in 2018.
With the current strong fundraising market, compounded by the rise of GP-led transactions, LP deal flow, and more nontraditional buyers entering the fray than ever before, the future for secondary funds is looking bright.
What Makes Secondaries So Attractive?
For existing closed-end fund investors, selling their LP interest and remaining commitments in the secondary market is an opportunity to get liquidity. This is especially important given the long time horizons of the closed-end funds.
For investors seeking secondary deals, the advantages are numerous:
- Investments can be bought at a discount on the book value from an existing investor in a fund, which could result in a gain on investment as of the purchase date.
- Secondary investors can gain access to funds that are closed to new investors by buying existing LP interests in these funds from exiting LPs.
- These funds offer vintage year diversification and access to top quartile funds that have high subscription minimums.
- Since investors are buying at a later stage of the existing fund’s lifecycle, they can see how the existing portfolio has historically performed and price their investment accordingly. Buying a stake in an investment fund that is closer to an exit and further along the J curve gives the investor a higher internal rate of return (IRR). In some instances, a new secondary investor is able to start receiving distributions from the fund right away.
Of course, there are a few challenges as well when it comes to investing in secondaries:
- For investors that focus only on secondaries, the supply of good deals is currently limited, but that’s likely to change in the not-so-distant future.
- Given the scarcity of good deals, valuations are high and discounts are thin. The market five to ten years ago was very different than it is today, as more investors are flocking to the secondary market in pursuit of good deals.
- Although the IRR is sometimes higher for secondary investors, the multiple of invested capital tends to be lower since the investments are purchased further along a fund’s lifecycle, hence the time horizon is shorter.
If you have questions about the pros and cons of investing in secondary funds, contact Weaver to request a consultation. Our experienced audit, tax and valuation professionals have years of experience dealing with alternative investments and they are happy to answer your questions.
This is Part 1 of a two-part series discussing the current secondaries market. Part 2 explains operational and tax issues that potential investors should consider.
Investment Fund Best Practices, Part One
Identifying Advisors That Support You Throughout Your Fund Lifecycle…