Many institutional investors suffering the denominator effect from falls in the value of their public market holdings may have found themselves with an overallocation to private equity and in need of rebalancing. Among individual investors, a combination of higher interest rates, inflation, market volatility and economic uncertainty may be prompting a desire to free up some cash.
But with portfolio firms staying private for longer amid a slowdown in global IPO markets, prospective exit strategies for investors are an understandable concern. The PE industry’s answer: a boom in secondary funds.
Secondaries come to the fore
Total private equity exits deal value plunged 66.3% year-over-year in 2022, according to PitchBook’s 2022 Annual US PE Breakdown. Exits fell in all regions and across channels, observed Bain, but most notably in the market for initial public offerings, where there was a 94% drop in exit value in 2022 compared to the year before. Faced with “less-than-favourable market conditions in 2022, many GPs were simply unwilling to part with promising assets that were coming under short-term pressure,” it noted. And “it’s likely that hold periods for exited companies will stretch in 2023 if the economy stalls out.”
As PitchBook senior financial writer Jessica Hamlin highlighted in a recent article, general partner-led continuation vehicles “offer an alternative exit option to traditional routes, like a public listing or a sale, and permit GPs to hold onto trophy assets they don’t want to sell at a discount in the current marketplace.”
Limited partners can then cash out or roll their capital into the new fund. “Continuation vehicles have gained momentum as a way to give investors liquidity as interest rates remain high and LPs apply pressure on their managers to show returns for their longer-term, private market commitments—a difficult mandate in a deteriorating exit environment,” added Hamlin. The exit-driven liquidity can also free LPs to fund new commitments.
And the strategies are proving popular. The secondaries market has more than tripled in size since 2011, “as sponsors seek solutions for longer hold periods, duration mismatch between investors, and additional capital to effectively implement value creation strategies,” noted Nash Waterman, Head of Morgan Stanley Private Equity Secondaries, in a statement announcing the February close of Morgan Stanley Investment Management’s Ashbridge Transformational Secondaries Fund II.
Morgan Stanley’s Fund II raised $2.5 billion, about four times more than Fund I (which closed in 2018 on $674 million), “providing yet more evidence of investor appetite for vehicles that offer LPs an exit avenue from their private equity commitments,” noted PitchBook’s Hamlin.
The Fund II close comes after alternatives behemoth Blackstone recently raised a record $25 billion for two funds focused on secondaries and co-investments.
Strategic Partners IX, Blackstone’s latest global secondaries strategy, has total commitments of $22.2 billion, making it the largest secondaries-focused vehicle since Paris-based private investment house Ardian closed its Ardian Secondary Fund VIII on $19 billion in 2020. Blackstone’s inaugural GP-led continuation fund strategy Strategic Partners GP Solutions attracted a further $2.7 billion.
With these vehicles, Blackstone is “well-positioned to capitalize on the vast, and growing, opportunities across the secondary market,” according to Strategic Partners Global Head Verdun Perry.
The latest PitchBook data underscores the case. While the one-year horizon internal rate of return (IRR) across all private capital asset classes slumped to 12.0% through Q2 2022, secondaries generated a rolling one-year IRR figure of 21.7%, outperforming the broader private capital fund universe by 9.7%.
For investors keen to sell, valuation calculations and secondary funds’ discount levels will be key. Private equity NAVs are an inexact science, and even more so in volatile markets. What constitutes a fair valuation may be open to dispute. Secondary interests also tend to be transacted at a sizable discount, depending on the original fund, its risks and the broader economic backdrop.
According to Rosenblatt Securities, the gap between buyer/seller expectations for private securities in the secondary market hit a record late last year, with buyers asking for a 52% discount from the last valuation while sellers were only willing to accept 32%. The gap has narrowed though in the last couple of months, “improving prospects for matching trades in the secondary market.”
All of which highlights a key message. Much of the investor and media focus around private equity tends to centre on the outsized returns on offer. And analysing a manager’s investment thesis – its industry and geographic focus, portfolio construction and governance, and deal sourcing against the investment cycle backdrop – is of course vital. Just don’t overlook the exit strategy. It could have just as much impact on the end returns investors achieve.
To learn more about the secondaries funds available on the Treble Peak platform, please get in touch with Anisa firstname.lastname@example.org
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