Private Market Blogs

Secondary Markets: Buying and Selling Private Fund Stakes

Mark John

• 6 min read
Secondary Markets: Buying and Selling Private Fund Stakes

The world of private equity (PE) has long been synonymous with long-term investments, high returns, and a certain level of illiquidity. However, an evolving trend is giving investors greater flexibility: the rise of secondary markets for private fund stakes. The secondary market provides an avenue for investors to buy and sell interests in private equity funds, offering liquidity in an otherwise illiquid asset class.

In this blog, we will explore the concept of secondary markets, how they function, their benefits and risks, and why they are becoming increasingly important in today’s investment landscape.

What is the Secondary Market in Private Equity?

In simple terms, the secondary market for private equity refers to the buying and selling of existing interests in private equity funds. This allows investors, whether they are limited partners (LPs) or other stakeholders, to exit or enter private equity investments before the fund’s term ends, offering more liquidity than traditional private equity investments.

  • Primary Market: In a typical private equity transaction, a limited partner commits capital to a private equity fund, which is then invested over time in portfolio companies. This is considered the primary market, where new investments are made.
  • Secondary Market: In the secondary market, existing LPs who have already committed capital to a fund can sell their stake to other investors. These transactions typically take place after the fund has started making investments, meaning that the buyer of the stake gains exposure to the fund’s existing portfolio and performance history.

Secondary markets exist in both private equity and venture capital markets, and the investors in the secondary market can be other private equity firms, institutional investors, or accredited high-net-worth individuals.

Why is the Secondary Market Gaining Popularity?

The private equity secondary market has experienced explosive growth in recent years. According to Preqin, the global secondary market for private equity transactions reached $88 billion in 2021, driven by several factors:

1. Increased Demand for Liquidity

Private equity investments are inherently illiquid, typically requiring investors to commit capital for long periods (often 7–10 years). However, as the market matures, both investors and fund managers are seeking ways to address the need for more liquidity. Secondary markets provide a means for investors to sell their stakes and free up capital without waiting for the fund to reach its conclusion.

In volatile markets or uncertain economic conditions, investors may seek to reduce their exposure to illiquid assets and rebalance their portfolios. The secondary market allows them to achieve this without waiting for the fund to sell its portfolio companies or exit investments.

2. Diversification and Access to Established Funds

For new investors, the secondary market provides an opportunity to invest in established private equity funds without having to go through the entire fundraising process. Buyers in the secondary market can gain access to funds that have already made investments, giving them exposure to existing portfolio companies and the potential for future returns.

Investors can also gain access to specific sectors, geographic regions, or fund types through secondary market transactions. For example, a buyer may choose to purchase a stake in a technology-focused private equity fund if they want to gain exposure to that specific industry.

3. Flexibility in Fund Management

Fund managers are increasingly turning to secondary markets to manage their fund’s capital structure. For instance, a GP-led secondary transaction involves the general partner (GP) offering the existing LPs an option to sell their stakes to a new group of investors. This can help provide liquidity to the current investors while allowing the GP to continue managing the assets and potentially extend the life of the fund. This option is often used when the GP sees strong potential for future growth but needs to provide an exit opportunity for current LPs.

How Do Secondary Market Transactions Work?

Secondary market transactions typically follow a structured process that involves the identification of potential buyers and sellers, negotiation of terms, and the execution of the transfer. The process generally includes the following steps:

1. Identifying a Buyer and Seller

The first step in any secondary transaction is identifying a potential buyer and seller. Sellers in the secondary market may include institutional investors, family offices, or individuals who want to exit their investments before the fund reaches maturity. Buyers, often private equity firms, institutional investors, or secondary market funds, are looking for opportunities to gain exposure to existing funds.

2. Due Diligence

Once the buyer and seller have been identified, the next step is conducting due diligence. This process involves the buyer evaluating the underlying portfolio of the private equity fund, assessing the performance history of the fund, understanding the value of existing investments, and examining the terms of the partnership agreement.

For the seller, due diligence can include confirming their ownership of the stake, understanding the terms under which they can sell, and ensuring compliance with any restrictions on secondary market transactions, which are often outlined in the limited partnership agreement (LPA).

3. Valuation

Valuing a private equity stake in the secondary market can be complex, as it depends on several factors, including the current value of the underlying portfolio companies, the timing of potential exits, and the overall market conditions. Valuations may also be influenced by the liquidity of the specific fund or sector, as well as the length of time until the fund is expected to distribute returns.

4. Transaction Agreement

Once the due diligence and valuation have been completed, the buyer and seller agree on the terms of the transaction. This includes the price of the stake being sold, any transfer fees, and the timeline for the transfer. Both parties also need to ensure that the transaction complies with the terms set out in the LPA.

5. Transfer and Closing

The final step is the transfer of the private equity stake, which is executed once all conditions are met. This process often involves legal documentation, and the transaction is closed once the buyer has completed the payment, and the seller has transferred their interest in the fund.

Benefits of Secondary Markets

  • Liquidity for LPs: The primary advantage of the secondary market is that it provides liquidity to investors who want to exit an illiquid asset class. This is particularly valuable for investors who need to raise cash or diversify their portfolios without waiting for the fund to make an exit.
  • Access to Established Funds: Investors can enter private equity investments at a later stage, gaining exposure to existing portfolio companies and a clearer view of potential returns.
  • Flexibility for Fund Managers: GP-led secondary transactions provide flexibility for fund managers to manage capital efficiently and continue managing assets while providing liquidity to existing investors.
  • Reduced Risk for Buyers: Secondary market buyers have the advantage of acquiring stakes in funds with existing investments, reducing some of the risks associated with early-stage investing in startups.

Risks and Challenges

  • Valuation Uncertainty: Accurate valuation of private equity stakes in the secondary market can be challenging, as it involves assessing both tangible and intangible assets. Pricing discrepancies can arise, and the valuation process can sometimes be opaque.
  • Liquidity Constraints: While the secondary market offers liquidity, it is still a niche market and not as liquid as public markets. Buyers and sellers may face challenges in finding the right counterparties, especially for smaller or more specialized funds.
  • Transfer Restrictions: Many private equity funds include restrictions on secondary market transactions. These restrictions may require the GP’s approval or limit the types of buyers who can purchase a stake in the fund. It’s important to review the LPA to understand these conditions.

1. Increased Activity During Volatile Markets

The secondary market has become more active in recent years, particularly during times of market volatility. Investors seeking liquidity during market downturns or economic uncertainty often turn to the secondary market as a way to exit investments without waiting for the fund’s term to end.

2. Growth of GP-Led Transactions

GP-led secondary transactions have seen significant growth, with GPs offering existing LPs an opportunity to sell their stakes to a new group of investors while continuing to manage the portfolio. This allows funds to extend their life and continue to maximize value in the underlying assets.

3. Emergence of Dedicated Secondary Market Funds

A growing number of dedicated secondary funds are emerging, focusing specifically on acquiring stakes in private equity funds. These funds are well-positioned to provide liquidity to sellers and capitalize on investment opportunities in the secondary market.

Conclusion

The secondary market for private equity offers investors greater flexibility, liquidity, and access to high-quality investment opportunities. It provides a valuable solution to the inherent illiquidity of private equity investments by allowing investors to buy and sell stakes in existing funds. However, due diligence, accurate valuation, and understanding of fund-specific restrictions are essential for navigating the secondary market successfully.

For both buyers and sellers, the secondary market presents a unique opportunity to adjust portfolio allocations, gain exposure to high-performing funds, and maximize returns in the growing private equity landscape.

FAQs

1. What is the secondary market in private equity?
The secondary market for private equity allows investors to buy and sell existing stakes in private equity funds before the fund reaches maturity.

2. How does the secondary market benefit investors?
The secondary market provides liquidity to investors who wish to exit their investments early, offers access to established funds for new investors, and enables flexibility in managing capital.

3. What are GP-led secondary transactions?
GP-led secondary transactions involve the general partner offering existing LPs the option to sell their stakes to new investors, while the GP continues to manage the assets.

4. How are private equity stakes valued in the secondary market?
Valuing private equity stakes in the secondary market involves assessing the underlying portfolio companies, the timing of exits, and market conditions. It can be a complex process and may involve pricing discrepancies.

5. Are there risks in the secondary market?
Yes, the secondary market carries risks, including valuation uncertainty, limited liquidity, and transfer restrictions outlined in the limited partnership agreement (LPA). It’s essential to conduct thorough due diligence.