The Secondary Market Evolution
If you look at the secondary market today compared to a little over a decade ago in 2010, there was about $10 billion in secondary volume. We were coming out of the Global Financial Crisis, and people were using the secondary market when they were distressed. It was a small industry and there was barely any press around secondaries.
At the same time, we saw a tendency for pension plans and other organizations to massively overallocate to private equity. They had very thin bands of targets for their private equity allocations, which created a wave of secondary selling in 2011 and 2012. And if you recall, the government was also doing stress tests at banks during those years. The conclusion was that banks could no longer own commitments to private equity firms. That had a name: the Volcker Rule. Banks had to sell their commitments, which created more volume. More LPs (limited partners) saw that occurring and realized they, too, could use the secondary market to their benefit.
Fast forward to today, it is a much different environment. The secondary market has grown into an exciting area with over $100 billion in volume, demonstrating the maturation of the asset class over the last two decades.
Secondary Market Themes in 2023
Just a few months ago, Hamilton Lane’s Secondary team hosted a webinar, Trends & Opportunities in the Secondary Market, to look at the factors fueling the secondary market opportunity set. The webinar provided insights on pricing, supply/demand dynamics, and the impact of the macro backdrop. Many things can change in a few months, especially in the secondary market. So, let’s look at the key themes for 2023, considering the evolution over the last decade and what we learned in 2022.
1. What is affecting market pricing?
When you rewind to 2021, pricing on the secondary market was fairly high. It was at or near an all-time high. Buying a four or five-year-old vintage buyout fund, for example, saw pricing close to par. Fast forward to 2022, and there is volatility and macro uncertainty. Distributions were not robust, and NAVs (net asset value) were not being written up. As a result, buyers placed a risk premium in their secondary underwriting. What you saw were pricing improvements, or bigger discounts. Take that same fund that you could have bought in 2021 for near par – you’re likely buying that for $0.80, $0.85, $0.87 – at a much better discount.
2. How have secondary market transactions shifted?
A second theme revolves around volume and the undercapitalized industry that we are in right now. In 2022, we saw over $250 billion of secondary transactions. The industry closed about $100 billion, so there's a massive undercapitalization and need for more dry powder. Now, certainly, there are reasons why a lot of those deals did not close, but if you look at the unfunded ratio-to-deal volume, it is at a historical low, at around 1x. A few years ago, it was 2x. So, you have such a wave of volume of selling among LPs and GPs (general partners), and not a lot of secondary capital has been raised to keep up with that growth, which creates a massive opportunity.
3. Are there new entrants into the secondary market?
There has been a lot of talk about new entrants coming into the secondary market, but we have not seen it at Hamilton Lane. There are inherent barriers to entry. If you don't have information, for example, how are you going to price private assets? There is also a talent shortage. New organizations want to be on the buy side of secondaries, but there are not a lot of secondary professionals who have been around long enough to drive that.
4. Do we expect to see Limited Partners continue to allocate to this strategy in 2023?
In short, yes. Anytime there is an undercapitalized segment within private markets, GPs have done a particularly excellent job of raising capital over the years to take advantage of that. There are a decent amount of secondary funds out there that are fundraising, Hamilton Lane included. Undercapitalization is real, and the thinking is that LPs generally like the secondary story in any cycle and feel now is a good time to lean into secondaries, given the dislocation, better pricing and growth potential. It does feel as though LPs like this story of secondaries, and that trend will continue.
5. What are the main types of secondary deals?
We break it down into three types of deals.
- LP interest deals: You become a replacement for a limited partner in a fund.
- GP-led secondary transactions: A general partner works with the secondary buyer on a solution, creating a vehicle to buy an asset – or assets – from an old fund.
- Complex deals: The bucket for everything else – preferred equity, team spinouts, carveouts and secondary directs, etc.
As you break down the volume, about half of the volume today is LP interest deals and half of the volume is in GP-led and complex secondaries. If you look back to 2021, the deal volume that closed in the GP-led category was bigger than the entire secondary market was just four years ago. That gives you a sense of how much the industry has evolved.
6. What is driving Limited Partners to sell?
What is driving LPs to sell today is the overallocation issue. Some LPs are way above their private equity targets, even though those targets are much wider, forcing them to sell. Given where pricing is today, you tend to see LPs selling because they have to or need to, rather than as part of portfolio management. It’s a good time to be a buyer, because discounts have widened, and buyers can be much more selective over the types of funds you want to buy into.
Last year, of all the LPs that sold, about half of them were first-time sellers. That is phenomenal, right? It just gives you a sense of how new this industry is in the grand scheme of things. If you are a first-time seller, you can hire an investment banker or broker, or chances are someone has called you to source a secondary. The question is, who do you go with? Do you hire someone to sell your interests, or do you go direct with a buyer like Hamilton Lane? There are things to consider. But the industry is becoming mature enough that at least you have options now in terms of what you want to do.
7. What is a buyer looking for from an LP seller today?
We're looking to find the best returning funds that we can buy. Timing is less relevant to the buyer; they can transact at any time. Sellers, however, do have some timing concerns because LP interests trade at quarter end. You tend to see more volume near quarter end, particularly in direct dialogs with the hope of getting a transaction closed by then.
What we saw historically, 10+ years ago, was that the fourth quarter was by far the busiest quarter because LPs wanted to sell before year end, and that first quarter of the calendar year tended to be pretty light in deal volume. That is because many sold in the prior quarter and others were waiting for 12/31 numbers to come out before they transacted. As the market has matured, the volume has become less cyclical. Some LPs wait to bring to market portfolios in January and February, at times when there is less volume, with the belief that one might get more attention from buyers in February versus November or December when the market is busy.
8. Have buyers priced off of very high valuations?
Some of our peers have used leverage to buy portfolios of LP interests when NAVs are declining or flat, or when distributions are slowing. Combine that with a rising interest rate environment and some of those trades may become painful.
Very few venture funds were sold in the back half of 2022. The reality is a lot of the venture managers are carrying their assets at rounds that were raised in 2020 and 2021. Secondary market buyers view some of them as largely overvalued, or the assets will require a lot of time to grow back into some of those valuations. You have to compensate for that with a higher discount. We saw pricing in venture funds range from buyers not pricing to $0.50 to $0.60, maybe. That price is generally way too low for LPs to take to their board to get approval to sell. So, very little venture funds are traded.
Growth equity was a mixed bag. It was the same dynamic as venture. We saw a lot of growth equity funds invest in companies in 2020 and 2021, and carry those investments at recent rounds, which again may or may not be overvalued. Other growth equity managers had more conservative approaches to valuation, and maybe didn't carry them as high as other managers in the same asset. You might be able to get value arbitrage there. At Hamilton Lane, we saw growth equity funds price from $0.40 to $0.50 to $0.70, maybe $0.80. We did see a few more growth equity funds traded, but not many. The bulk of what traded was buyout funds. And some of those funds were pricing at $0.50, some at $0.90 or $0.95. We would say on average, pricing is down 10 to 20% from where it was a year ago.
We’ve seen some real assets funds trade in the $0.90s, which is tremendous. There are buyers of real assets funds and infrastructure funds, there are buyers of credit funds. They tend to be dedicated funds raised for those strategies and they tend to be SMAs. The cost of capital there might be different than a secondary fund’s cost of capital.
9. What about GP-led strategies?
There are some funds that were raised just to do GP-led transactions and just to do single-asset deals within GP-led transactions. Those types of funds, for example, may invest in 10, 15, 20 single-asset deals, like a co-investment fund. A fund with that profile has a much different risk profile than a secondary fund that invests in LP interests only, for example. The way that we look at it, adding both LP interest and GP-led transactions into one fund can provide nice diversification benefits, and also allows you the flexibility to toggle into and out of LP deals or GP deals, whatever the market gives you. So, if you look at buying an LP interest in a fund at a price of $0.80 today and compare that to a GP-led deal where all GPs want to take a price of par of their LPs with no discount, we're seeing many more opportunities in the LP interest market today that are attractive. Two years ago, it was the opposite. And that may change two years from now. Having both types of transactions and being able to do both gives you the benefit and it doesn't force you to do every deal in the GP-led market that comes across your desk.
We looked at some of the GP-led deals that were launched from March through August of last year – a total of 50 transactions launched, 25 of them have been pulled. Eleven of them are still in flux – they might get pulled, they're going through iteration two or three of that GP-led and may never get done. It gives you a sense of the deal failure rate in the GP market today and a lot of those were not completed because of either price or quality.
What we have seen in GP-led deals is 80% of LPs usually sell into the transaction and there are a lot of reasons for that. For most LPs, it is a new investment decision, and you have to take it to your committee, you have to ramp up and complete diligence and a lot of LPs aren’t staffed to do so. It becomes very difficult to roll into a transaction. For many of these deals, what we have found is GP-led deals are some of the best-performing assets in the fund. And when you look at the returns those deals have made, on average, they're better than the returns the fund has made. For that reason, LPs just want to de-risk and take liquidity because it's an option in the fund that has performed very well.
10. What is the secondary market opportunity set in 2023?
When you look at volume history, 2021 saw $135 billion in deals and 2022 saw about $105 billion. We think 2023 will be up again from 2022 – so, down in ‘22 up in ‘23. The first quarter feels slow, but there are a lot of demand drivers in the background. You have LPs that need to sell. You have GPs that are fundraising and want to show distributions. M&A markets aren't great. IPO windows are closed. The GP-led market provides an option to create liquidity for LPs to show DPI for fundraising. The reasons for sale haven't changed, they're only getting stronger. Our opinion is as we enter Q3 and Q4, maybe even as early as Q2, you will tend to see market volume increase if things stay relatively flat from a macro perspective.
There are a lot of conversations with GPs around different types of transactions. It is unclear how much volume will be actionable, but there are things to do. One of the trends we are seeing across the secondary landscape is the tender staple. That has always been around. That is where a GP works with the secondary buyer to price up their fund. The GP then takes that price to all LPs in their fund to offer them that price to sell their LP interest. Nothing about the fund changes; LPA, economics, they all stay the same. The buyer will then staple primary commitment into the GP's new fund.
You tend to see GPs doing this in fundraising. It is largely a fundraising exercise for GPs. At Hamilton Lane, we have seen more of these over the past 12 months than we have over the past couple of years. It is unclear how many GPs actually do this, but there are conversations going on around that type of secondary.
It feels like the biggest threat to growth in the secondary market in 2023 would be fundraising not being able to keep up with the opportunity set. It has not been able to so far. And the question is, can it? That will depend on a lot of things. It will depend on secondary funds’ returns, the opportunity set and the demand drivers translating into actionable secondary deals. The fundraising aspect could limit growth of the opportunity set.
Over the next five years things should shake out in terms of performance. Some secondary funds may be massively concentrated and if a few things go wrong, those returns are going to fall tremendously. We've been saying this every five-year period, it feels like when we look back on the last five years, there will be a massive differentiation among secondary funds. And we still believe that in five years when we look back, you will see some winners and some losers.