Alternative Allocations: The Growth and Diversification of Secondaries

Secondary funds, commonly referred to as secondaries or continuation transactions, purchase existing interests from limited partners (LPs) or assets from primary private equity fund investors. Although once considered a niche strategy, secondaries have matured and now represent a vital cog in the private equity ecosystem, according to Franklin Templeton Institute’s Tony Davidow.

In a traditional private equity fund, a pension plan, endowment, foundation, or family office (a privately held company that handles investment and wealth management for a wealthy family) commits to invest capital over a period of time (seven-10 years). They are considered limited partners in the fund (LPs). When the fund manager, also known as the general partner (GP), finds an attractive investment, they call for capital from the LPs’ (capital calls) original commitment.

The LPs understand that these are long-term investments, but sometimes they have liquidity needs, and they may seek a buyer for their ownership stake. These are referred to as secondary transactions since the original owner seeks a secondary buyer.

Secondary Pricing as a Percentage of Net Asset Value

As the data above illustrates, secondaries have traded at a discount to net asset value (NAV) since 2007, with more attractive pricing during periods of economic slowdowns. This is partially driven by the “denominator effect,” as public pension funds find themselves overallocated to alternative investments due to the decline in value of their public market positions. As institutional investors reduce or diversify their private equity, new investors have the ability to benefit through participating in secondaries and purchasing these positions at discounts.

According to PitchBook,1 secondary fundraising rose from US $20 billion in 2006, to US$100 billion in 2020. Up until 2022, most funds could exit their investments through acquisitions or initial public offerings (IPOs). This created a lot of cash flow and liquidity for LPs. In 2022, exits began to slow dramatically, and have essentially dried up since the collapse of Silicon Valley Bank. LPs will likely need some liquidity in the coming years to meet capital calls and diversify their holdings.

Secondaries Fundraising Activity