Investment in private equity funds is a long-term investment and is considered illiquid because you generally have to hold your investment for a period longer than 5 years.
This is because the funds need some time to carry out their growth plans and increase the value of the company they have invested in, in order to sell it later and deliver the profits to you through distributions.
Depending on when they buy the companies, there are primary funds and secondary funds. Primary funds are those that acquire a company for the first time, while secondary funds buy that company from another fund (in the secondary market).
In summary, the secondary market is a market where already issued financial assets are bought or sold. Investors can go to this market to seek opportunities or offer their own if they do not want to continue investing, meaning that the secondary market provides private equity investors with a liquidity opportunity.
Mainly, we distinguish between two types of transactions in the secondary market depending on who carries them out: the fund participant (LP) or the manager (GP).
The latter, those carried out by the GP, occur when an asset or assets are transferred from one fund to another. This usually happens when a fund reaches the end of its life, but the GP believes that not all the potential value has been realized yet, so they transfer it to another fund to continue the value generation plan.
These types of funds that acquire these stakes are the secondary funds, and since they are companies where value appreciation plans have already been initiated, the investment periods are shorter.
Limited Partner (LP) transactions occur when a participant does not want to continue investing in the private equity fund in which they have committed an investment and turns to the secondary market to sell their stake. The buyer will take the seller's positions and replace them in the fund, acquiring their rights and obligations. The seller may dispose of all or just a part of their stakes.
Secondary funds specialize in acquiring already active positions in existing funds. The main advantage of these transactions is that the acquired assets are often at a more advanced stage in their lifecycle. This means that the underlying company has already passed the initial stages of development, which reduces the associated uncertainty.
In Crescenta's portfolios, we allocate a certain exposure (around 20%) to secondary funds, which allow us to reduce the J-curve and provide more liquidity to the portfolio.
Reduction of the J-curve: By purchasing a more mature stake or asset, the value generation period is accelerated, allowing investors to sell within a shorter timeframe. This has a direct impact on the performance of the secondary fund, as investment periods are shortened and time-adjusted returns are improved.
For this reason, including secondary funds in a portfolio helps mitigate the J-curve effect. The J-curve refers to the negative returns that private equity funds typically experience in their early years due to initial costs and lack of early returns. With secondary funds, this initial phase is significantly shortened, optimizing the portfolio's return profile.
However, it is important to note that the closer a fund is to receiving distributions, the higher its price in the secondary market will be. Additionally, entering at a later stage may mean that some of the value generation has already been realized.
New opportunities: The secondary market opens a wider range of possibilities for investors, allowing them to build more diversified portfolios tailored to their objectives.
Lower risk of "Blind Pool": One of the key advantages of investing in secondary funds is greater clarity about the underlying assets. Unlike a traditional private equity fund, where investments are typically made after the initial commitment, secondary funds offer much greater visibility, thus reducing this type of uncertainty.
Growing market: The secondary market is gaining ground as a solution to one of the typical challenges of Private Equity: illiquidity. However, it is still in the process of consolidation, and aspects such as access to information, speed, and efficiency have room for improvement.
Discounts: This market not only facilitates liquidity for sellers but also allows buyers to access quality assets at attractive discounts. Discounts vary depending on strategies and investment horizons: the longer the investment horizon, the larger the discount tends to be. For example, Venture Capital (VC) positions typically transact with discounts between 20% and 30%, while Buyout positions generally have smaller discounts, below 10%.
Costs and fees: Like in listed markets, secondary transactions typically involve fees and other associated costs, which are important to consider when analyzing expected returns.
Author
Sofía Cisneros
Communication and content - Crescenta
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When you click on any underlined term, you can see a definition and example of each concept
When you click on any underlined term, you can see a definition and example of each concept
When you click on any underlined term, you can see a definition and example of each concept
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