We are now mid-way through 2023, so we caught up with Head of Secondary Investments Tom Kerr to gain his perspective on the current secondary market environment.
Looking back, 2021 was a record year in the secondary market with $130 billion of transaction volume.1 We then saw a slightly different environment in 2022, during which we saw plenty of LPs coming to market looking to sell, trying to alleviate some of those challenges they were facing. They were met with a significant number of buyers that were cautious, so volume dipped.
Secondary Market Annual Capital Overhang
What is the supply story so far this year?
If you look at what we'll likely see from the brokers and the market participants releasing their 1H 2023 results, our early indications are that relative to 1H 2022, supply is probably going to be down a bit or perhaps even flat. 1H 2022 was a pretty robust period, so I don’t think that's alarming, generally speaking. I think what continues to be the case, and was the theme in 2022, is that the actual activity levels are much higher than the volumes suggest, so there is still a large gap between supply of deal flow and converted activity. Part of that is price expectation and bid-ask spread. Part of that is motivation, frankly.
When you look at 2023, what you've seen is a rising public market environment that has taken a little bit of pressure away from some of those LPs that were looking at denominator issues and other potential challenges in their portfolios. We think that has dampened some of the urgency, but we believe in 2H 2023 we will see a strong pipeline. There's a huge amount of LP demand for liquidity and supply that will be coming to market. That doesn't even touch the GP-led side, which continues to be very active but also a market where we’re not seeing the level of activity that we saw in 2021.
Where is liquidity most needed today?
I actually had a conversation with someone recently who runs a U.S. foundation. We talk to institutions and investors all over the globe on a regular basis to check in on their liquidity needs. This particular conversation was an enlightening one and one that we hear quite often. They shared that they didn’t have anything that they were looking to sell and they didn’t have any liquidity needs as a foundation. This is a group that didn’t have flow challenges per se, but they used the secondary market quite frequently to rebalance their portfolio to create optionality and flexibility, and to reposition their portfolio.
If you think about what is driving some of the activity, those with mature portfolios have come to the understanding that this is a good liquidity mechanism for generating flexibility in the portfolio and that continues to be a driver of activity. Obviously, there are certain pockets of perhaps a little more concern around liquidity needs where people are over-allocated or distributions are slower. Certainly on the GP side, that is an issue. The exit markets are pretty challenging right now. M&A markets, IPO markets and even strategics are a little bit tighter with their dollars, so for those who are looking to create liquidity for their funds for GPs, the secondary market is a good alternative. I think that's what drives the activity levels and is the catalyst for transforming that activity level into deal activity and closed deals. That is what we're waiting for.
Where do you think the next wave of institutional supply is going to come from in this market?
I think it’ll be coming from everywhere. Both corporate and public pensions continue to be those with mature portfolios that are looking to actively manage. A couple of the areas where you'll probably see an increase in overall activity is banks and financial institutions. Obviously, the higher cost of capital creates some instability within those types of institutions. In the U.S., there is continued discussion around increasing capital requirements, which could really change the paradigm. The same thing goes for insurance companies. They are large investors in private market assets. Broadly speaking, when you have such an accelerated rise in interest rates, that impacts groups that are matching assets and liabilities and creates a need for liquidity. We think that will be a key theme in terms of net increase relative to what we've seen in the last couple of years.
What does secondary market pricing look like today?
We can point to two factors that have really impacted pricing over the last 12 to 18 months. One is volatility and the other is cautious buyers. We've also talked a lot about macro perceptions impacting pricing in this market, but when you look at what we've experienced so far this year, the public markets are up 15%.
I think you have to segment the market into different sections: the LP secondaries with people trading funds, and GPs looking to create optionality and whole fund solutions. Those are different markets as it relates to pricing and as such are different drivers.
On the LP side, we saw in 2022 that pricing had declined overall. On average it was low-to-mid 80s, much of which was the view that valuations were declining and some funds in effect were coming down. Overall funds didn't decline quite as much as people thought they might. Plus there was a built-up urgency on LPs to create liquidity to offset what was a declining public market. The denominator effect, a slowdown of capital distributions, offsetting capital calls, and unfunded commitments were all drivers of a little bit of a lower pricing threshold on average.
While we haven’t seen the statistics for 1H 2023 yet, we’re likely going to see that the pricing has crept back up into the mid- to high-80s – and perhaps even into the 90% threshold. Part of that is stability in valuations. Part of that is the investors understanding what the higher interest rates mean for private market assets and ultimately how those are impacting businesses. Yes, part of that is the public markets. The indices are certainly up and that is reflected in a mindset that says, “My denominator effect is less impacted and overall I have a little bit less urgency, so I'm going to demand higher pricing.” Therefore, some buyers are stretching for higher pricing, some buyers are being more cautious. I think that is muting volumes a little bit relative to the supply.
On the GP side, it's actually a little bit different in that I think when we look at the phenomenon of GP-leds taking off in 2020 and 2021, this was largely a market where deals were done at the NAV. In 2022 the NAVs were very much in question because of all the factors that I mentioned. Therefore, the expectations were for buyers to receive discounts and GPs not willing to take them. We're starting to see that change in terms of GPs being more conservative in their valuation as well as having an expectation that in order to generate the type of liquidity and optionality they're looking for, there might need to be some capitulation on pricing.
That describes the current pricing environment. It is still all very situation-dependent and asset-dependent. If you want to liquidate a portfolio of venture capital assets and funds, you'll likely have to expect to take a pretty big discount. That alone is not something that most investors want to do; therefore, there's not a lot of that trading in the market.
1Jefferies Secondary Update (January 2022)
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