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Unlocking Liquidity: How Secondary Markets Are Changing Private Equity Investing

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Unlocking Liquidity: How Secondary Markets Are Changing Private Equity Investing

VerifyInvestor.com

For investments, the concept of “liquidity” refers to how easily an investment can be converted to cash. Assets that can be quickly converted to cash, for example, publicly traded stocks, are considered “liquid” assets. Other assets which may require a longer time to dispose of, for example, real estate, are considered to be “illiquid.” 

Because most private equity (PE) investments generally require an investor to hold onto an investment for years, (often 10 or more years), PE investments have historically been considered “illiquid.” This illiquidity frequently creates tension between PE investors, (i.e., Limited Partners (LPs)), who may want to get out of an investment early, and PE fund managers, (i.e., General Partners (GPs)), who want to hold onto high-performing investments to maximize returns.

Secondary markets, however, are easing this tension and changing private equity investing by providing liquidity options for PE investors. 

Once considered a “niche” within the alternative investments arena, the PE secondary market has been growing rapidly over the last few years — reaching a record $134 billion in 2021. It is now considered to be a central part of the PE industry. Plus, experts believe that the PE secondary market will continue to grow and innovate — reshaping the entire PE investment industry.

So let’s take a closer look at secondary markets to get a better understanding of what they are and how they work.

Secondary Market Basics

In private equity investment, the secondary market refers to the buying and selling of one investor’s PE investment assets to another investor during the lifetime of a fund. 

There are basically two types of secondary markets (also referred to as “secondaries”) in this area: 

  1. transactions led by a Limited Partner (“LP-led transactions”), and

  2. transactions led by a General Partner (“GP-led transactions”).

In an LP-led transaction, an individual or institutional investor sells all of his/its entire stake in a larger fund — liabilities and all — to another investor. Essentially, the secondary buyer simply “steps into the shoes” of the LP selling his/its original (primary) investment.

In a GP-led transaction, (also referred to as “single-asset” or “continuation transaction”), the general partner or fund manager sells part or all of the fund to a secondary investor. Thus, the GP may sell an entire portfolio company, or just part of it, to a new investor or investment vehicle. Typically, the original investors (i.e., the LPs) can either exit by taking the liquidity offered, or they can roll over their interests into the new investment vehicle. 

Single-asset transactions are the fastest-growing area within secondaries because they create an opportunity for GPs to hang onto profitable assets and create liquidity for investors while at the same time gaining more time and capital to potentially generate profits.  

The volume of GP-led transactions in the secondary market has grown dramatically in the past few years — increasing 100% from 2020 to 2021 to reach $68 billion globally. While the structuring of these transactions is unique to each situation, they do afford more flexibility for both LPs and GPs in a PE fund. Of course, these transactions also present unique challenges — including (not limited to), issues of transparency, timing, and conflict of interest.

Nevertheless, the secondary market is a pivotal part of the financial system. It creates a place where investors can conduct transactions, and it creates liquidity for historically illiquid PE assets.

Who Stands to Benefit from Secondary Private Equity Markets? 

As might be expected, both sellers and buyers benefit from the secondary market.

How?

Well, LPs who sell on the secondary market benefit by:

  • obtaining increased liquidity, and

  • being able to actively manage their portfolios.

Investors who buy assets on the secondary market benefit by:

  • being able to participate in investment opportunities that would not otherwise exist.

The PE secondary market benefits GPs in that it:

  • gives GPs the flexibility to provide liquidity to LPs and financial sponsors,

  • provides a means of creating strategic PE exits,

  • can be used as a portfolio management tool,

  • allows GPs to raise capital,

  • allows GPs to hold onto valuable assets and gain more time to maximize returns or potentially raise capital.

Finally, secondary PE markets reduce volatility because they have the potential to produce consistent returns for investors

Some PE Secondary Market Considerations for Investors: Pricing, Transparency, and Regulatory Oversight. 

Single-asset transactions are unique and highly complex transactions. Everything from their structure to negotiation is unique to the particular transaction — requiring considerable skill and experience to formulate or participate in. Given their complexity, while PE secondary market transactions have practically exploded in popularity and are expected to continue to drive opportunities in the secondary market, they are not without their challenges.

Transparency, in particular, is a major problem in this area. Because private equity deals are generally open only to accredited investors and are not publicly-traded, they do not offer as many disclosures as publicly-traded investments — leading to less transparency than public offerings. The PE secondary market is no different. Secondary market transactions in the private equity arena do not have the same level of disclosures that public trades do. Therefore, investors must be careful to conduct their own due diligence. Since these transactions are also very complex, it is important for investors to carefully examine the qualifications of any GP-led PE secondary market transaction.

Riding on the back of the transparency problem is pricing. Again, because PE secondary market transactions are not fully transparent, it can be difficult to appropriately price assets. Plus, LPs and GPs do not always agree on pricing

Another major concern is that of high transaction expenses. Buying and selling private equity assets often come with legal and administrative expenses, or costs associated with private brokers — making them quite expensive.

Finally, as this area continues to grow and influence the secondary market arena, it is expected to draw more and more close attention from regulators.

The PE secondary market is an industry that continues to expand and evolve — providing benefits for GPs and LPs alike. While it may not be without its challenges, experts believe that the PE secondary market’s benefits outweigh its detriments and that this market will continue to remain a strong and viable one.

Whether it concerns issues around finding accredited investors or choosing the right accredited investor program, understanding the securities laws and their requirements is critical for primary and secondary investors alike. The securities laws touch on a vast number of financial and investment issues of importance to all investors and issuers. VerifyInvestor.com makes verifying accredited investors easy, cost-effective, secure, and reliable. Our services (which also include AML/KYC checks, qualified purchaser, and qualified client verification), are always code-compliant and confidential. We help companies fully and easily comply with their legal obligations to verify accredited investors.