Inflation and central bank policies are affecting corporate earnings, growth, and the returns from the market investments in stocks and bonds. This has made institutional and individual investors weigh their chances and consider alternatives to diversify their portfolios. Despite the investment demands of significant capital for private equity, investors can get exposure to the market in a few ways, including secondary private equity investments.
The Surge in Secondary Deal Flow: A Reflection of Liquidity Demand
There has been a surge in the secondary market. According to Pregin's report, fundraising for secondary private equity investment hit $93.8 billion in 2023, an increase of 159% from 2022. Nearly 64% of the limited partners (LPs) surveyed said secondary private equity is the best opportunity and is more popular than small—to mid-market buyouts, 49%, and special situations, 48%.
Let’s examine the factors contributing to its constant growth and possible implications.
Contributing Factors:
Liquidity Crunch: Market volatility and a tightening macroeconomic environment significantly increase GPs' reliance on the secondary market for solutions. Growing rates and economic uncertainty have slowed down M&A activity and IPO exits, forcing GPs to have fewer cash-out options. This resulted in GP-led secondaries, like continuation funds, allowing GPs to extend holding periods while offering liquidity to existing investors.
Simultaneously, Limited Partners (LPs), facing capital constraints and overallocation to private equity, are increasingly selling their fund stakes in the LP-led secondary market to free up cash. With limited traditional exit options, secondary transactions are essential for investors to unlock capital and maintain portfolio flexibility. With the persistent challenges, the secondary private equity market continues to expand, providing much-needed liquidity solutions in the tight and constrained financial market.
Inflationary Pressure and Interest Rate Hikes: Higher interest rates have increased the cost of debt financing, limited leveraged buyout activity, and slowed traditional exit routes. This has forced GPs to turn to continuation funds and structured liquidity solutions to keep high-quality assets without disposing of them at a discount.
Inflation has increased operating costs for portfolio companies, squeezing margins and affecting valuation. LPs, facing cash constraints and overallocation to PE, are offloading fund stakes in the LP-led secondary market at a 15-25% discount to net asset value. The discounted price attracts a record amount of capital from secondary fund managers aiming to acquire mature assets at an attractive valuation. With inflationary pressures and uncertain interest rates, the secondary private equity market remains a crucial liquidity source, providing flexibility to GPs and LPs.
LPs De-risking Portfolios: Pension Funds, endowments, and institutional investors are increasingly turning their secondary private equity investments to de-risk their portfolio and raise liquidity amid economic uncertainty. Market volatility, increasing interest rates, and inflationary pressures impact overall asset performance. Many LPs overallocate to private equity due to the denominator effect, where declining public market values make their private equity exposure disproportionately large. Selling funds stake in the secondary market is the right option to rebalance their portfolio and free up capital. They often do it at a discount to net asset value.
In 2023, LP-led transactions amounted to close to $16 billion. It was also observed that 50%+ of LP-led portfolio pricing remained around 80-95%+ net value asset, firm pricing across buyout, credit and infrastructure strategies in developed markets.
Implications
Opportunity to Source Discounted Positions : LPs face liquidity pressures and are looking to exit their private equity holdings; they sell fund stakes at a discount to net asset value, which ranged around 16% in 2023.
This allowed secondary investors to gain exposure to seasoned, high-performing assets with a shorter time horizon to liquidity compared to primary investments. Additionally, GPs launch contribution funds to hold onto strong-performing portfolio companies. With this, secondary investors can access top-tier assets at an attractive valuation and benefit from GP-led strategies designed to maximize value. With current market dislocation, secondary private equity buyers can strategically build diversified portfolios at a discount, thus enhancing portfolio returns while mitigating risk.
Valuation Challenges : With persistent valuation challenges, the secondary market needs to assess funds’ health critically. Inflation, rising interest rates, and economic uncertainty affect portfolio company performance. Secondary investors must conduct thorough due diligence before inquiring about fund stakes. Buyers must evaluate asset quality, exit potential, leverage levels, and the resilience of portfolio companies to determine whether the net asset value discounts accurately reflect the underlying risks.
In addition, discrepancies between GP-report valuations and market pricing require secondary investors to implement rigorous valuation methodologies and stress-test different exit scenarios. Investors must critically assess whether GPs are rolling over assets due to genuine value creation opportunities or simply to avoid exiting at lower multiples. In such an environment, detailed financial analysis, historical performance tracing, and stress testing have become essential tools for investors to make informed decisions, capitalize on undervalued opportunities, and mitigate downside risks.
Dynamic Pricing Models : The secondary private equity market uses a dynamic pricing model to account for macroeconomic headwinds, such as rising interest rates, inflation, and market volatility. The model incorporates real-time market data, scenario analysis, and risk-adjusted discounting to present fair pricing for secondary transactions. With LPs selling fund states at a discounted rate and GPs launching continuation funds, secondary investors must consider liquidity constraints, exit timelines, and portfolio company performance when pricing deals.
Portfolio Repositioning : Funds nearing exit cycles have a unique opportunity for portfolio repositioning in the secondary private equity markets. With LPs looking at liquidity and GPs managing aging assets, secondary investors can acquire stakes in funds approaching exit events, such as IPOs, strategic sales, or recapitalizations. These transactions allow secondary buyers to gain exposure to maute, de-risk assets with shorter holding periods, providing potential for strong risk-adjusted returns.
The secondary private equity market has undergone notable institutionalization change, characterized by increased participation of institutional investors, leading to greater professionalization and mainstream adoption. In 2024, investors sold a record $162 billion worth of private equity stakes on secondary markets, a 45% increase from the previous year and over 20% higher than the last peak in 2021.
Institutional investors, including pension plans and sovereign wealth funds, treat private equity as a strategic investment avenue. They are establishing long-term commitments to secondary markets, transforming them and reinforcing their credibility and stability.
Implications
Liquidity Diversification: As mentioned above, institutional investors increasingly turn to secondary private equity markets to manage liquidity needs and diversify their portfolios. Several factors are driving this shift, including the denominator effect. In addition, a significant distribution slowdown has led investors to seek liquidity through secondary markets.
This trend underscores the growing importance of secondary markets as a strategic tool for institutional investors to enhance liquidity and achieve portfolio diversification. By engaging in secondary markets, investors can adjust their private equity exposures more effectively, aligning them with their evolving investment strategies and risk tolerances.
Rise of Secondary Fund-of-Funds : Secondary fund-of-funds and specialist firms offer investors diversified exposures across multiple funds and vintages. The secondary fund-of-fund pool capital acquires stakes in various private equity funds available on the secondary market, allowing investors to bypass the traditional ‘J-Curve’ effect and gain access to mature assets with immediate returns. This structure mitigates the risk of investing in individual funds by offering exposure to various investment cycles, strategies, and managers.
There has been a significant shift in the private equity market towards bulk acquisitions. This latest trend involves private equity firms acquiring portfolios of assets in bulk or even entire fund families, letting them rapidly scale their investments and spread risk across various sectors and geographies.
In 2004, the US private equity sector experienced increased activity, with total deal value reaching $838.5 billion across 8,473 deals, up from $703 billion across 7,515 deals in 2023. Additionally, add-on acquisitions, which involve purchasing additional companies to complement existing portfolio companies, accounted for 76.1% of buyout deal counts through the first three quarters of 2023, making it the second-highest percentage since 2008. These data demonstrate the growing prominence of bulk acquisition strategies within the private equity sector, reflecting a broader move towards portfolio diversification and consolidation.
Implications
Risk Mitigation : Institutional investors are increasingly turning to the secondary private equity investment market to mitigate risks associated with individual fund performance. By acquiring diversified portfolios of fund stakes, they reduce exposure to underperforming managers, market downturns, and sector-specific volatility. This enables investors to smooth out returns across different investment strategies, fund vintages, and economic cycles, ensuring more excellent stability over time.
Access to Top-Tier Fund Manager: Investing in secondary private equity markets allows institutional investors to gain experience with top-tier fund managers across various asset classes. This allows instant diversification. This mitigates risks associated with individual fund performance. In 2021, the secondary market reached a record volume of $134 billion, highlighting its significance in private equity portfolio management.
Institutional investors can diversify their portfolio by participating in secondary transactions, accessing high-quality assets managed by reputable GPs across multiple sectors and areas. It enhances potential returns and reduces exposure to underperforming assets, thus contributing to more stable and resilient investment outcomes.
Balanced Portfolio Approach : A balanced portfolio includes both mature and active funds. It helps smooth out volatility and enhances risk-adjusted returns. Diversification across various parameters - vintage years, industries, geographies, managers, and funds - can reduce portfolio risk. As per EQT Group, picking a private equity fund at random could result in performance variations of at least 17% in a year, underscoring the importance of careful selection and diversification
Over the past decades, transaction volumes have tripled to over $130 billion annually, driven by institutional investors seeking portfolio diversification and liquidity management. This growth has increased competition, compelling private equity firms to differentiate themselves through value creation strategies.
Simultaneously, the increasing institutional presence has driven demand for greater transparency. Organizations like the Institutional Limited Partners Association (ILPA) have introduced standardized reporting guidelines to improve performance metrics and fee disclosures, enhancing investor confidence and decision-making.
Implications
Increased Competition: The secondary private equity market has witnessed a significant surge in activity, leading to increased competition for top-tier secondary deals. In 2024, the market reached a new record of $162 billion in transactions, marking a 45% increase from the previous year and surpassing the peak of $132 billion in 2021.
Pricing Discipline: The competitive secondary private equity market must maintain pricing discipline to avoid overpaying for assets. In recent years, the US Securities and Exchange Commission (SEC) has identified and addressed valuation deficiencies among private fund advisers. In September 2024, Macquire Investment Management Business Trust agreed to pay nearly $80 million to settle charges related to the overvaluation of approximately 4,900 illiquid collateralized mortgage obligations across 20 advisory accounts between January 2017 and April 2021.
Market Data Utilization: External data sources allow investors to validate assumptions about target companies and their competitors, leading to more accurate and informed decisions. Engaging reputable third-party valuation providers before launching new funds is a prerequisite for attracting capital. These valuations enhance the credibility of investor reporting and provide benchmarks for fundraising and management fee calculations. Today, financial institutions are adopting AI to process vast amounts of data, which empowers them to make more accurate predictions and timely decisions.
Competitive Advantage Through Big Data: Leading financial institutions increasingly leverage big data analytics to gain strategic insights and enhance operational efficiency. Adopting AI models allows these firms to identify patterns, predict market movements, and optimize asset allocation. Additionally, utilizing alternative data sources, like credit card transactions and consumer sentiment surveys, allows firms to understand better and predict retailer performance, thereby informing investment decisions.
In recent years, secondary private equity investment has undergone a profound transformation. The participation of institutional investors drove this, as did enhanced data transparency and integration of AI and advanced analytics tools. As competition intensifies, investors must adapt by leveraging sophisticated valuation models, AI-driven insights, and automated alternative investment fund data processing to ensure accurate pricing and robust due diligence. These advancements are not only to improve efficiency but also to help optimize long-term value for institutional portfolios. Those managing multi-asset class portfolios must embrace these innovations to stay ahead and capitalize on the secondary market’s growing institutionalization and data-driven evolution.