Private equity funds have emerged as a significant player in the primary market, finding their place in a diversified investment portfolio. With adaptable investment strategies and methodologies, these funds offer distinctive and promising investment prospects. Tsinghua University's "2018 China Wealth Report" reveals that over 90% of China's high-net-worth individuals choose to incorporate private equity funds into their asset allocation.

In recent years, the private equity secondary market has witnessed significant growth, riding on the wave of a flourishing private equity market, particularly in mature markets like the United States. In 2023, the global transaction volume in the private equity secondary market reached $112 billion.This market's ascent presents investors with the enticing prospect of shorter investment payback periods and the potential to reap substantial investment returns. In this edition of Poseidon Market Foresight, we will embark on a comprehensive exploration of the private equity secondary market, providing an in-depth analysis of its market development and deciphering the investment advantages it brings to investors.

The Evolution of the Private Equity Secondary Market

In 1982, the Venture Capital Fund of America (VCFA) launched the first fund focused on the acquisition of interests in private equity funds on a secondary basis. Its primary objective was to provide liquidity and exit opportunities forLimited Partners (LPs). LPs, primarily composed of institutional investors such as pension funds and insurance companies, as well as high-net-worth individuals, play a pivotal role in private equity funds as the primary capital providers. However, LPs often encounter various restrictions when it comes to realizing their investments. For instance, private equity funds typically impose lock-up periods on LPs' capital, requiring them to keep their invested amounts locked for 3 to 7 years or even longer. Prior to the emergence of the private equity secondary market, LPs had relatively limited options for cashing out their investments, often needing to negotiate with private equity fund managers and incur penalty fees to retrieve their investments. The rise of the private equity secondary market has provided these investors with new avenues, enabling them to flexibly redeem their holdings within the lock-up period.

In its early stage, the secondary market for private equity investments lagged behind the primary market and venture capital in terms of capital raised. VCFA’s inaugural secondary market private equity fund, raised a total of $6 million. From 1991 to 2000, the secondary market amassed a total of $10.4 billion. By comparison, Blackstone's Strategy Partners Fund IX, the largest private equity secondary fund to date, raised $22.2 billion, more than double the total amount raised in the 1990s secondary market. By the late 1990s, regulatory changes to capital requirements for investment banks and insurance companies compelled these institutions to allocate more capital to support their private equity investment. Amid a more stringent regulatory landscape, major investment banks opted to sell their stakes in private equity funds. Chase Capital Partners, for instance, sold over $500 million worth of private equity investments in 2000, followed by similar divestment strategies by UBS and Deutsche Bank in 2003. Furthermore, the burst of the dot-com bubble in 2000 spurred many private equity investors to seek redemption of their equity investments, further driving the market's liquidity demand and fueling the rapid growth of the private equity secondary market. During this period, secondary market transaction prices exhibited a notable discount compared to the assets’ fair value, attracting a multitude of new participants to enter the market.

The secondary market for private equity experienced a period of gradual maturation and increased efficiency from 2004 to 2008. During this time, transaction prices in the secondary market reached fair value for the first time, market liquidity significantly improved, and deal activity was highly active. For example, in 2007, the California Public Employees' Retirement System (CalPERS) offloaded its private equity investment portfolio worth $2.1 billion to secondary market private equity funds, setting a record for transaction price at that time. By 2008, the annual transaction volume in the secondary market surpassed $20 billion, doubling the amount from 2006.

The global financial crisis in 2008 caused a temporary decline in secondary market transactions as a result of the economic downturn. However, post-crisis regulatory reforms, particularly the Dodd-Frank Act, imposed stricter limitations on investment banks' capital investments in private equity. The new regulations stipulated that investment banks could allocate only 3% of their Tier 1 Capital to private equity, down from the previous 8%. As a result, major investment banks were compelled to divest their private equity investments. AXA Private Equity, for instance, acquired private equity portfolios from Bank of America, Citigroup, and Barclays for $1.9 billion, $1.7 billion, and $740 million, respectively.

Meanwhile, General Partners (GPs), private equity fund managers, have assumed an increasingly influential role in the private equity secondary market. Secondary transactions led by GPs have bestowed them with greater flexibility inoptimizing their fund portfolios by selling assets from existing investment pool. Simultaneously, these transactions offer LPs a range of options, including the opportunity to liquidate their current fund interests or transfer them to new portfolios. This transaction model has empowered both LPs and GPs, granting them enhanced control over various aspects such as asset selection, fund term extensions, long-term ownership of high-quality assets, fee structure adjustments, and cashflow distributions. Consequently, this model has emerged as a primary catalyst for the overall growth observed in the secondary market.

According to Jefferies, the total transaction volume in the global private equity secondary market reached $112 billion in 2023, nearly doubling the $58 billion recorded in 2017. In particular, GP-led transactions experienced a substantial surge in their share of total transaction volume, rising from 24% in 2017 to an impressive 46% in 2023. Meanwhile, LP-led transactions, the more traditional transaction type, have consistently maintained a high level of transaction volume. Sellers in these transactions primarily consist of pension funds and sovereign wealth funds, accounting for 62% of the total transaction volume. By divesting their private equity shares in the secondary market, these funds effectively mobilize capital, providing funding support for their new investment commitments. Furthermore, LPs benefit from greater flexibility in these transactions as they retain control over the transaction timeline, better aligning with their cashflow management requirements.

Asia's secondary market has gained prominence in tandem with the rapid growth of the private equity market following the global financial crisis of 2008. According to statistics from Bain & Company, secondary market transactions in Asia comprised 22% of the overall transaction volume in 2022, emerging as a crucial avenue for investors seeking liquidity. In China, fundraising for private equity funds has experienced a decline in recent years, resulting in limited market liquidity and diminished interest from institutional investors. This market environment provides favorable conditions for buyers in secondary market negotiations. To facilitate transactions, sellers frequently offer appealing discounts on their portfolios, leading to secondary market transaction prices that are significantly below the assets' fair value.

Characteristics of Private Equity Secondary Funds

In traditional private equity secondary market, sellers primarily fall into two categories: those grappling with financial distress and seeking immediate liquidity, and those dissatisfied with the fund's performance and eager to divest underperforming assets. As the secondary market transaction volume continues to grow and liquidity strengthens, an array of factors is spurring private equity investors to contemplate selling their equity holdings. Firstly, certain investors opt to sell their private equity to optimize their portfolios, strategically adjusting the allocation of alternative assets or shifting their investment focus towards different strategies, regions, or industries. Secondly, when private equity fund performance exceeds expectations, investors may prefer to capitalize on their investments, obtaining liquidity and securing locked-in returns through secondary market transactions. Additionally, the advent of new regulatory frameworks, such as Basel III for banks, has compelled financial institutions to divest their private equity stakes to ensure compliance with legal requirements. Anticipated shifts in future regulatory environments could ignite a fresh wave of sales in the secondary market for private equity.

As for buyers in thesecondary market, in addition to private equity funds that focused on secondary market investing, an increasing number of institutional investors, such as pension funds and sovereign wealth funds, are increasingly recognizing secondary private equity investments as an important alternative investment strategy. Compared to primary market private equity funds, secondary funds offer several advantages that better cater to the specific needs of investors:

• Enhanced transparency and reduced risk: In primary market private equity investments, investors often encounter challenges in obtaining detailed information about the underlying assets within the fund and lacking crucial data, such as historical investment returns, to steer their investment decisions. In contrast, the secondary market offers greater clarity as investors can gain insights into the specific composition of private equity fund portfolios. Fund managers can thoroughly assess the portfolios' past performance, analyze potential risks and returns, and make well-informed investment decisions, thereby mitigating overall investment risk.
• Accelerated investment cycle: secondary private equity funds offer investors the advantage of shorter investment cycles by acquiring mature private equity assets that have entered the cashflow distribution phase. In the lifecycle of primary private equity funds, early-stage cash outflows, including equity investments, management fees, fund startup costs, and other expenses, typically result in negative returns in the early years. In comparison, by investing in secondary funds, investors can potentially bypass these negative returns and seize investment returns earlier.
• Opportunities to purchase equity at a discount: In situations where liquidity is constrained within the secondary market, buyers frequently come across alluring prospects to invest in equity at prices that are well below the assets' fair value. This presents investors with the potential to generate additional returns right from the outset of asset acquisition, thereby augmenting their overall investment returns.

Returns on Investment in the Private Equity Secondary Market

Private equity investments have captured the interest of institutional and high-net-worth investors, enticed by their potential to deliver impressive returns while exhibiting low correlation withthe public market. However, the illiquid nature of private equity investments often demands investors to exercise patience, waiting at least five years, if not longer, before reaping the investment returns. The emergence of thesecondary market provides private equity investors with a pathway to realize investment returns in a shorter time frame.

According to a report by Morgan Stanley, from 2005 to 2015, secondary private equity funds returned approximately 19% of LP capital within the first three years of their lifecycle, while primary funds only returned 6%. In terms of investment returns, the median internal rate of return (IRR) for secondary funds between 2005 and 2015 was 12.4%. The dispersion of returns between the top andbottom quartile performing funds amounted to around 9.6%. In comparison, primary private equity funds that focused on buyout and growth equity, achieved a slightly higher median return. However, the dispersion of returns between the top and bottom quartile funds in the primary market was 13.9%, indicating greater investment return volatility.

The lower return volatility observed in the secondary market can be attributed to several factors. Firstly, the acquired assets in the secondary market are typically more mature, allowing investors to receive cash flow within a shorter timeframe. Moreover, secondary private equity fund managers can leverage historical data, thereby gaining valuable insights into the assets and make informed decisions to mitigate potential capital losses associated with underperforming investments.

Conclusion

The private equity secondary market has become a significant source of liquidity for private equity investments. With attractive features like shorter investment cycles and improved transparency, this market is expected to maintain strong growth momentum. Investing in the private equity secondary market presents an opportunity for investors to diversify their portfolios and pursue potential excess returns. Nevertheless, prior to committing capital, it is imperative for investors to evaluate their current investment portfolio and assess their individual risk tolerance. This evaluation will enable them to determine the suitability of private equity secondary market investment and the appropriate allocation of funds within their broader investment portfolio.

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