What is the outlook for secondaries in private equity?
In the realm of finance, the private-equity secondary market, also commonly referred to as private-equity secondaries or simply secondaries, plays a crucial role. This market segment is primarily concerned with the trading of pre-existing investor commitments to private-equity funds, as well as other forms of alternative investment funds. The secondary market for private equity provides liquidity in a realm that is typically characterized by longer holding periods and limited liquidity options.
The landscape of private-equity secondaries is on the cusp of a transformative growth phase, with long-term forecasts painting a promising picture of this market segment’s potential. Industry projections suggest that by 2030, the volume of transactions in the private-equity secondary market could escalate to an impressive range of $200 billion to $500 billion. This significant upsurge not only underscores the robustness of the secondary market but also indicates its evolving role as a fundamental component in the strategies of mature private market portfolios.
In a recent shift, secondary fund offerings have marked a significant return, as detailed in PitchBook’s latest Global Fund Performance report by Jessica Hamlin.
After a period of underperformance, these funds are navigating a changing landscape, marked by fluctuating asset valuations and evolving market dynamics.
The Performance Dip and Its Underpinnings
Secondary funds, a crucial component of private equity, experienced a notable dip in performance, particularly in the second quarter of 2003. This period marked the first time since 2021 that these funds lagged behind the overall private market fund performance. The one-year Internal Rate of Return (IRR) for secondary funds stood at a modest 0.2%, a stark contrast to the 10-year IRR of 13.5% and a significant decline from the 24.9% in Q2 2022.
This downturn is partly attributed to a continuation of the dip that began in Q3 2021, following substantial Net Asset Value (NAV) markups and favorable secondary sales returns. The historical performance of these funds reflects a challenging deal-making environment, with asset valuations plummeting post-pandemic peak, leading to a marked decrease in mergers and acquisitions (M&A) activities.
What has been the impact on deal flow and valuations?
The years 2022 and 2023 witnessed some of the lowest levels of M&A deal activities in the past decade. This decline directly impacted secondary funds, with the quarterly returns of Q1 and Q3 2022 falling below median NAV benchmarks. Consequently, the unrealized investments in these funds underwent significant markdowns, affecting overall fund performance.
During this period, many clients opted to retain assets rather than sell them in the secondary market at lower valuations. This strategy resulted in reduced capital distributions to Limited Partners (LPs) since Q2 2022, contributing to the funds’ underperformance.
In response to suppressed valuations, General Partners (GPs) extended their asset exit timelines, adapting to the unfavorable pricing environment!
Despite this, the obligation to generate periodic distributions for LPs remained, leading managers to explore alternative liquidity solutions, including secondary offerings.
These funds, which facilitate the buying and selling of portfolio assets by GPs or LPs, have become a key liquidity driver in challenging exit environments. For instance, the decline in US private equity (PE) exit activity began in Q1 2022 and plummeted by 75% by Q2 2023. Nonetheless, the global secondary market remained robust, generating $108 billion in total deal volume in 2022, the second-largest year after 2021’s record $132 billion.
Anticipated Market Revival?
Market analysts are optimistic about the resurgence in secondary fund performance. Juliet Clemens, a fund strategies analyst at PitchBook Data, notes that while hesitation marked the first half of 2023, the second half saw a rebound in deals as sellers gained confidence in market stabilization.
Early signs of this revival were evident in Q4 2022, with quarterly fund returns aligning with median NAV components, a trend that continued into 2023. Scott Conners, president of FlowStone Partners, a GP specializing in private equity secondaries, reported an increase in deals in the latter part of 2023, culminating in a bustling first quarter of 2024.
The return of secondary offerings in the private equity landscape marks a pivotal moment in the industry. As valuations stabilize and the bid-ask spread compresses, secondary funds are poised for a resurgence, offering renewed opportunities for investors and fund managers alike. This evolving landscape promises to reinvigorate deal flow and enhance overall fund performance, signaling a promising future for secondary offerings in private equity.
