Why PE secondaries may offer the best risk/reward in a down market
Private equity secondaries gained significant tailwinds in 2020, as market volatility led an increasing number of GP’s opt to transfer high performing assets to continuation funds versus pursuing sales via IPO or M&A.
In cases of funds nearing the end of their terms, a growing number of GP’s have been transferring high-performing assets to continuation funds, allowing them to hold onto these assets for a longer period while offering LP’s the option to crystallize their returns to date. Amid uncertain public and M&A markets, these types of transactions — commonly known as GP-led secondaries — grew by over 350% between 2020 and 2021 from $18bn to $65bn, according to Jefferies.
Despite the growing popularity of GP-led secondaries among private equity fund managers, fundraising among dedicated secondary funds has lagged the supply of transactions. In a recent interview with Secondaries Investor, Nigel Dawn, head of Evercore’s Private Capital Advisor group, observed that the buy-side is extremely capital constrained, to the extent that the amount of ‘dry powder’ available amounts to one year’s worth of deal volume, noting that the norm in private markets would typically be 3–4 x that level.
The effects of the current buy-side constraints are compounded by a combination of lower public market valuations, higher interest rates and reduced fund distributions. As a result, average pricing for buyout portfolios currently stands at 82–87 percent of reference value, according to a report by PJT Partners.
Current pricing levels for PE secondary transactions are worth viewing from the context of the types of assets offered. Based on GP-led deals marketed through Emerge9 in 2022, representing over $10bn in total transaction value, underlying assets have been predominantly free cash flow positive with expected exits within 2–5 years.
Given the combination of earlier cash flows and the returns profiles of underlying private equity assets, secondary PE funds have shown strong historical performance. According to Prequin, secondary PE funds for the 2005–2016 vintages saw a pooled average net IRR of 17.8% with 13.4% volatility versus net IRR of 12.7% and volatility of 28.7%, respectively, for venture funds.
Amid today’s buy-side limitations and broad liquidity constraints, the current PE secondary vintages are extremely well positioned.
