A decline in mergers and acquisitions and exit activity has led private equity limited partners to turn to secondaries as a tool for portfolio management and liquidity.z_wei/iStockPhoto / Getty Images
A slowdown in mergers and acquisitions and in exit activity is contributing to the private equity secondary market, a growing option for investors in the alternatives space.
More private equity funds are becoming available to qualified investors, and several of these funds tap into the “secondary” market – that is, private equity firms selling a chunk of their funds to secondary investors. Those secondary investors can then offer exposure to those assets to individuals through investment funds of their own.
“In the past two years, we’ve seen a decline in mergers and acquisitions and public market exit activity, reducing distributions to private equity limited partners (LPs),” says Nadim Vasanji, managing director at Northleaf Capital Partners in Toronto. “As a result, LPs are increasingly turning to secondaries as a tool for portfolio management and liquidity generation.”
As more companies choose to stay private, there are more opportunities to invest in private market investments such as secondaries, Mr. Vasanji says. In addition to creating liquidity, LPs can use secondary sales to free up cash flow to pursue new investment opportunities, rebalance exposures, and manage risks.
“At the same time, many general partners (GPs) are not as keen to exit an investment after the usual three- to five-year holding period,” he says. “Rather than sell, they’re creating special-purpose vehicles to hold their investments for longer.”
To do that, GPs need to raise capital from the secondary market to provide liquidity for their LPs and to buy more shares in new and existing operations. All that adds up to more opportunities in the secondary market.
“The secondary market presents a highly attractive opportunity for adding alpha to an investment portfolio, particularly in volatile market environments,” Mr. Vasanji says.
Northleaf has been involved in global private markets for more than 20 years. It recently partnered with Mackenzie Investments to create private market-based products for individual investors. Secondary investments form a key part of the Mackenzie Northleaf Global Private Equity Fund.
“There’s a growing recognition that this is a really attractive way to invest in private equity,” says Sean O’Hara, co-founder and chief investment officer at Obsiido Alternative Investments Inc. in Toronto. Among other services, Obsiido offers two portfolios that invest across private market asset classes.
More individual investors are looking to invest in private equity, Mr. O’Hara says, but it’s a difficult area for advisors to access. Historically, most of the market for secondaries has been institutional investors, such as pension funds, he says. Now, the demand from individual investors is rising, while institutional investors look for liquidity.
Over the past 20 years, secondary market volumes have tripled approximately every six years, Mr. Vasanji says. The growth in private equity net asset value, the growing number of assets, and extended hold periods are all driving demand for secondary transactions. According to some projections, the global private equity secondary market is projected to exceed US$140-billion by the end of 2024, according to a September report from Mackenzie and Northleaf.
Mr. Vasanji says that while initial public offerings and deal activity could increase when interest rates decline, there is still a long way to go before markets approach peak levels again. “We believe that as interest rates moderate and inflation eases, more private equity deals will get done and translate into even more private market opportunities.”
As far as performance goes, vehicles that hold secondary assets have historically provided top-quartile returns, according to the report from Mackenzie and Northleaf, with lower downside risk compared with other private market investment strategies.
While the opportunities in this area are attractive, investors should be aware of the risks.
“These are alternative investments, so at the general level, they can be considered higher risk,” says Steve Balaban, chief investment officer at Mink Capital in Toronto and a lecturer at the University of Waterloo.
Although these funds hold a range of assets, they may be more concentrated than funds based on public markets, he says, and may have more volatility and risk. Also, there may be less liquidity, with some restrictions on redemptions.
There is also the issue of fees, as these funds usually charge a performance fee on top of a management fee. The originating private equity fund will also be applying its own fees, he says, although the funds’ performance measures will be net of all fees.
Mr. Balaban says the value of private equity secondary funds depends on the quality of the assets in the fund and what else is in an investor’s portfolio.
“As well, the stated value of the funds doesn’t fluctuate as much, which may be reassuring to some people,” he says. “It’s another tool that can be used to create a diversified portfolio.”