Secondaries are a relatively new part of the private equity sector, but they already play an important role in private market investments. The ability to trade between private equity stakes creates liquidity in an otherwise rather illiquid market, offering investors both a good diversification option and the possibility of retrieving their money more quickly if needed.
Despite its relative size, the secondary market is still quite young. It emerged from the dot-com crash in the late 1990s, when many worried investors sought an early exit from their private equity investments.
What Are Secondaries?
Simply put, secondaries in the private market are transactions in which a private equity firm or an alternative assets fund purchases an investment from another private equity firm or alternative investor.
Similar to the public capital market, this is referred to as the “secondary market” to distinguish it from the primary market, where private equity firms purchase investments from the original owners of a company. In the secondary market, the buyer (or investor) agrees to take on the acquired investment, including any outstanding obligations, such as company financing.
Sellers in the secondary market sell their shares to raise capital, avoid further investment funding, meet regulatory requirements, or rebalance their portfolio by reducing exposure to a particular asset class or sector.
What Are the Benefits of Secondaries for Investors?
Access to Liquidity
Secondaries provide sellers with important access to liquidity. Primary private equity investments are illiquid, subject to long lock-up periods, and can be difficult to sell quickly. In the secondary market, however, private equity investors can sell their stakes to free up cash, which can then be reinvested elsewhere or used to meet immediate cash needs.
Risk Reduction
Another benefit of secondaries is risk reduction through portfolio diversification. Investors can diversify their portfolios by investing in a wide range of assets in various lifecycle stages and across different sectors and regions.
Secondaries also mitigate the so-called “blind pool risk” associated with investments in private equity portfolios where planned investments are still future prospects outlined in the fund prospectus (thus “blind”). With secondaries, investors can invest in already established companies with higher transparency regarding their performance and valuation.
Higher, Faster Returns
Investors can often purchase private equity secondary market stakes at a substantial discount, opening the opportunity to realize higher returns upon resale than the initial investment cost. This is usually because sellers exiting private equity funds early via the secondary market often sell their assets at a discount below their net asset value (NAV).
Secondary investors can thus make a bargain and have the potential to achieve higher returns upon exit, particularly if demand is high, pushing the resale price up.
Compliance and Regulatory Benefits
Under certain circumstances, secondaries can also serve as a compliance tool. For example, banks that invest in private equity are required to hold a certain amount of capital to cover potential losses from such investments. By using the secondary market, banks can sell a portion of their private equity positions, thus achieving the required capital coverage level.
Growth Market: The Secondary Market
The secondary market is experiencing high demand. According to alternative assets data provider Preqin, private equity secondaries fundraising reached a record high of USD 93.8 billion in 2023, representing a 159% increase compared to 2022.
In an April 2024 survey of LPs (limited partners), secondaries topped the list of the most attractive private equity strategies for the next 12 months, according to Preqin. 64% of LPs stated they were convinced of secondary investments.
Market observers like Preqin expect the share of secondary strategies in the overall market to continue to grow as the private equity market matures, as secondaries are an increasingly important source of liquidity, portfolio diversification, and early exit opportunities.
More investment opportunities are also opening up for private investors due to the growing number of ELTIFs that focus on secondary strategies.