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A secondary private equity transaction is where a stake in a private company or a PE fund changes hands mid-cycle, from investor to investor. This allows PE investors to exit a position early, before the investment’s normal exit period. The life cycle of a PE investment is usually around 5 to 10 years.
Sellers’ motivations are various. They may, for example, want to restructure their portfolio, liquidate their assets or de-risk. For buyers, a secondary transaction enables them to participate in the desirable PE market, sometimes at a discount.
Secondary transactions are a major part of the private equity landscape, and the market is growing. For more details on secondary transactions, you can check out our article on this topic.
How Does the Private Equity Secondary Market Compare with the Public Market?
Differences in Accessibility and Liquidity
The biggest difference between the private and public markets for shares is market access. With public shares, anyone can buy, but companies can only be traded if they’re allowed onto the exchange by the regulator. The market is extremely liquid, volumes are high and shares change hands frequently. In contrast, in the private market, sellers don’t need to disclose as much information to buyers and can choose to whom they sell. As such, the market is less liquid.
What Mechanics Are Involved in Secondary Transactions?
Secondary transactions are facilitated by advisors who guide both sides through the process. Because sellers don’t need to publish company information, buyers carry out due diligence to make sure they’re happy with the deal. Each deal is different – the underlying shares may have restrictions attached to them, and how they have been priced will be a major consideration.
Types of Secondary Transactions
Selling a Fund’s Interest:
- Limited Partner Secondary Transactions: Sales of Limited Partnership Interests
This is where one limited partner sells its stake in a PE fund to another limited partner, usually because they want to realize their asset early. The new LP steps into the shoes of the seller, with the same rights and duties.
- General Partner-Led Transactions: Fund Restructuring and Continuation Strategies
In this situation, a general partner sells all or part of its fund to a secondary investor. Existing LPs in the fund can either roll over their interest to the second fund or cash out.
Selling a Company’s Interest:
- Direct Secondary Transactions: Sales of Portfolio Assets
In this scenario, investors sell their interest in an ongoing business. The seller may be a founder or an early investor who wants to get out early. Another case might see employees wanting to cash in shares issued under a share incentive scheme.
Pricing Issues
Factors Influencing Pricing
The pricing of shares in a secondary transaction is affected by the performance of the company or fund, the state of the market for secondary transactions at the time, and transaction costs.
Pricing Complexities and Valuation Methodologies
Secondary pricing hinges on reported valuations expressed as a percentage of the reported net asset value (assets minus liabilities). The seller and the buyer agree on a reference date on which to base the price of the asset. The reference date price will then go up or down, depending on the settlement of cash flows (distributions and capital calls) before completion of the deal.
Benefits of Secondary Transactions
For Sellers
Secondary transactions enable sellers to cash out of positions they no longer want to hold. For example, they may have been an early investor in a company when its performance was not yet known. If the company has been successful, they can realize gains quicker than normal. Sellers may want to change the focus of their portfolio or would simply like to access the capital to use for other projects. Employee sellers’ ability to dispose of shares forms a valuable part of their compensation package.
For Buyers
Buyers like secondary transactions because they provide access to assets they may have otherwise been excluded from. An example of this is where a fund is oversubscribed at the beginning. Buyers may profit immediately if the transaction is priced at a discount, and they stand to gain over time when the asset increases in value.
Companies and funds also benefit from secondary transactions, as fresh participants may bring a new focus and strategic shift to the underlying asset.
Growth Drivers
Fund Life Cycle Considerations
According to the Economist, as of 2021, the volume of private equity transactions was around three times larger than it was a decade prior. 1 And secondary transactions have also flourished. The main reason for this is the length of the funding life cycle – sellers may not wish to sit out the full period before liquidating their assets. Or, the exit milestone for an asset may be delayed if, for example, the IPO market is weak.
Market Demand
In addition, if the market for publicly traded securities is not doing well, private investors may look to add private equity to their portfolio, pushing up demand for secondary transactions. Returns on PE stakes can be spectacular, although this comes with additional risk.
Venture Capital Secondary Transactions
Structured Liquidity Programs: Providing Liquidity to Early-Stage Investors
A structured liquidity event is where investors’ equity holdings are converted into cash at the instigation of the company. There are two types: tender offers and auctions.
Tender Offers and Auctions: Facilitating Exits for Venture-Backed Companies
A tender offer is where investors sell their shares, either to the company or to other investors at a set price following a certain period. Participants are invited by the issuer, and the sale price is predetermined.
With an auction, the price is determined by supply and demand, with buyers and sellers entering bids and offers for prices, sometimes with the intervention of a third-party broker.
Direct Secondary Sales: Sales of Venture Portfolios
Sometimes investors choose to offload an entire venture portfolio mid-cycle, often to achieve liquidity.
Companies providing secondary transactions in the VC space include Semper, NotSoLiquid, and Caption.
Comparative Analysis and Future Outlook
Contrast With Other Financial Markets
The main secondary market for shares is the public stock market. This operates through exchanges such as the London Stock Exchange. In contrast to public markets, private secondary transactions don’t have a centralized platform on which shares are traded. Public secondary markets are highly transparent, and share prices are advertized widely. The market is also very democratic – anyone can purchase shares or open a brokerage account.
Differences in Transaction Types and Liquidity
Securities offered on the private market are different in that prices are opaque. Shares may have inherent restrictions, such as rights of pre-emption or restrictions on transfer. In addition, transactions can take longer and be more costly, so the market is much less liquid. Normally, only accredited investors have access to private markets.
Projected Growth and Trends in Secondary Market Activity
Secondary transactions become highly relevant during challenging economic conditions, where investors look to ditch assets earlier than they normally would. And, where IPOs are more difficult to come by, secondary transactions are a way to achieve liquidity earlier than projected. In 2021, the secondary market grew to a record $134 billion. 2
The Impact of Regulatory Changes and Technological Advancements
In addition to economic headwinds, certain international and local regulatory restrictions such as Basel III and the Volcker Rule have made it trickier for some PE investors to continue their holdings, leading to an increase in transactions.
The advance of technology has also impacted the PE secondary market. Firms find it easier to source potential deals thanks to new platforms and databases. New analytical tools make it easier to assess an investment’s potential, with AI and machine learning adding to the mix.
Improved data analysis has also had an impact on the way firms evaluate their portfolios, enabling them to better identify poorly performing assets. Better communication tools and new technologies have also allowed firms to become more productive and improve relations with investors.
Conclusion
The private equity secondary market is continuing to develop and evolve as an asset class, with transactions increasing year on year. Technological advancements promise to accelerate this trend, making the market more transparent and efficient, and offering investors the chance to diversify their portfolios and manage their liquidity.
References
[1] https://www.economist.com/special-report/2022/02/23/private-markets-have-grown-exponentially
[2] https://www.morganstanley.com/ideas/private-equity-secondaries-volatile-markets#F1
[4] https://www.morganstanley.com/ideas/private-equity-secondaries-volatile-markets
[6] https://fastercapital.com/topics/the-mechanics-of-secondary-market-transactions.html
[8] https://fastercapital.com/topics/how-has-technology-impacted-the-private-equity-industry.html
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