Many institutional and individual investors are currently evaluating how hawkish central bank policies and investments, such as private equity, can provide portfolio diversification and potential income with a lower correlation to public markets. While private equity often requires substantial capital, individual investors can still gain market exposure through registered offerings.
Secondary funds, often called secondaries or continuation transactions, involve the purchase of existing assets or interests from primary private equity investors. For instance, a primary private equity fund might acquire a stake in a private company and subsequently sell that interest to a secondary buyer. Sellers benefit from increased liquidity, while buyers may find the specific assets or portfolio claims appealing for various reasons.
The total volume of the secondaries market climbed to a record $134 billion in 2021. Against the current backdrop of volatility in bond and stock markets, Nash Waterman, Portfolio Manager and Head of Private Markets Secondaries at Morgan Stanley Investment Management, discusses the opportunities in secondaries and why they may prove attractive during a down cycle and beyond.
Q: Starting at the highest level, what are secondaries in private equity and what is their appeal?
Waterman: Private equity secondaries refer to transactions in which an investor is buying an existing interest or asset from primary private equity fund investors, known as limited partners (LPs). These transactions can be structured in a number of different ways based on the needs of the stakeholders involved. Secondaries have become an increasingly appealing segment of the private equity market, as they allow flexibility for LPs who may want to liquidate or rebalance a portfolio. Buyers of secondaries, meanwhile, may benefit from shorter duration and faster return of capital, potentially discounted access and enhanced transparency into the underlying portfolio or assets.
Q: What are secondaries led by general partners (GPs) vs. LPs?
Waterman: In a LP-led transaction, a limited partner sells its commitment in a fund to a secondary buyer, who then takes on the rights and obligations of that LP in the existing fund. In a GP-led transaction, specifically a GP-led single-asset continuation transaction, an asset or portfolio company is transferred from one vehicle to another vehicle, which can offer access to both additional capital and additional time to execute a value-creation plan.
Q: Why are single-asset secondaries, or continuation funds, attractive?
Waterman: Within GP-led secondaries, the single-asset model now stands as a functionally distinct segment, and single-asset transactions are the fastest-growing area within secondaries. GP-led single-asset secondaries can offer attractive benefits in all market conditions because of the flexibility for GPs to hold their most promising assets longer and the possibility of added exit options.
Unlike traditional LP-led transactions, where secondaries investments involve exposure to multiple assets at the portfolio level, single-asset secondaries may help mitigate unwanted broader portfolio risk. Often, single-asset deals can unlock potential value that would otherwise be sacrificed due to a lack of additional funding or a premature exit driven by forces extraneous to that particular asset.
Relative to other segments of the secondaries market, single-asset deals stand out for their return potential. According to recent research, nearly 62% of secondaries investors are targeting net internal rates of return of 20% or more in single-asset secondaries. In comparison, return thresholds for the multi-asset GP- and LP-led segments are much lower, with only 40% and 16% of investors targeting returns as high as 20% or more, respectively.
Q: Why are GP-led secondaries overall attractive in this environment?
Waterman: While the current macroeconomic environment has become more challenging, economic headwinds are not necessarily acting as an impediment to deal activity for continuation transactions. That’s especially true for GP-led deals, specifically single-asset transactions, as I mentioned. GPs’ reluctance to divest prized blue-chip assets at a time when comparable businesses remain in a trough make continuation funds particularly attractive, as they are set up to acquire assets from private equity funds nearing the end of their lifespans, and allow GPs to hold on to their best-performing assets. We continue to see high-performing, low-leverage and resilient PE-owned businesses that, in our view, have the potential to outperform and capitalize on opportunities, even in a down cycle. For example, buy-and-build businesses such as retail chains or health service providers with sufficient capital can act as consolidators; they purchase attractively priced add-on businesses to capture synergies, while bringing down average acquisition costs.
We’re seeing the impact of this opportunity. Deal volume in the GP-led secondary market reached $68 billion globally in 2021, about half of the overall secondaries market, and an almost 100% increase from the year prior. About 44% of GP-led secondaries were invested in single-asset continuation funds in 2021, as investors gravitated toward highly concentrated exposure to managers and portfolio companies they know and see as top performers.
Q: What are the risks and other considerations that private equity secondaries investors should account for?
Waterman: The intricacies involved in sourcing, undertaking due diligence and executing on single-asset secondaries explain precisely why investors can earn a complexity premium in the space.
We built a dedicated sourcing subgroup focused exclusively on deal origination. Our team members meet regularly with GPs to develop networks that will sustain a proprietary pipeline of high-quality opportunities. Due diligence entails deep work in analyzing financial statements, understanding end markets and assessing the quality of earnings reports. We commission market studies and speak with customers, suppliers and industry experts to gain a real insight into the fundamentals of a given asset.
Single-asset transactions involve an incredibly complex negotiation process that can take three to six months to conclude with a wide array of stakeholders. Success requires a specialized skillset to navigate potential conflicts, as transactions can include the GPs, rolling LP investors, selling LP investors as well as the new buyer group. The resource-intensive nature of this space creates barriers to entry that preclude investor ‘tourism’. Investors should seek a dedicated and expert team experienced in single-asset dealcraft that can achieve success in the GP-led single asset space.
