Private Equity Secondaries Launched into Financial Market Stress Tend to Outperform

Investors have been targeting secondaries funds in expectation of a bumper year

Secondaries funds launched at times of financial market stress exhibit a clear tendency to outperform. Preqin data shows that median secondaries fund returns of Global Financial Crisis (GFC) and European Debt Crisis vintages have outperformed broader private equity funds by up to 216bps per year. This may go some way to explaining the record amount of fundraising allocated to secondaries, as investors anticipate a bumper year for returns. 

Indeed, investors have poured $43bn into private equity secondaries funds so far this year, already higher than the record $42bn raised in 2017. This has been achieved through a smaller number of much larger funds. Among them is Ardian’s ASF VIII, which secured $19bn (including $5bn allocated to co-investments) in June, up from an initial target of $12bn set at the fund’s launch in May 2018. Funds on this scale have lifted average fund size to $2.9bn among the 15 funds closed so far this year, compared to just over $1bn in 2019.

Dry Powder Builds to Record Levels
So far, capital raised appears to have exceeded the amount absorbed by the market. Dry powder held in private equity secondaries currently stands at $106bn, up from $105bn at the end of 2019. It’s worth noting that dry powder increased markedly in the aftermath of the GFC, from $23bn in 2008 to $37bn in 2009, as freshly raised funds took time to deploy. Now that Q2 2020 valuations are being finalized, conditions may prove ideal for dry powder to be more aggressively deployed.

Secondaries investors are anticipating that financial market dislocations triggered by COVID-19 will put pressure on LP liquidity. This should increase the supply of assets available at discounts to fair value. The sharp drop in public market indices earlier in the year may have left some investors too heavily exposed to private equity on a relative basis. While this may have boosted the supply of investors looking to trim existing positions, the effect was short lived due to the sharp rebound in public markets. In addition, secondaries asset pricing hit its lowest level since 2012, according to Greenhill data. This is likely to have kept sellers at bay. Secondaries funds will still be on the lookout for distressed sellers that need to raise cash. University endowments and corporate pension funds may prove the more likely source of deals as they grapple with more acute liquidity challenges in the face of COVID-19.

Comparing Performance across Vintages
Comparing returns in the early years of a fund’s life remains challenging as IRRs can be meaningfully overstated. For instance, private equity secondaries of vintage 2017 currently have a median IRR of 30.2%, which is unlikely to be maintained throughout the life of these funds. This is because fund holdings are typically purchased at a discount before being promptly marked back to fair value. This discount is effectively the compensation that secondaries funds earn in return for their role as a provider of liquidity. As a time-weighted measure, IRR can therefore be overstated given that the time it takes to realize these returns is not fully considered. For these reasons, we focus on vintages from before the GFC until 2014 to provide enough time for this effect to be minimized. Funds focusing on more sophisticated or complex transactions can also provide additional capital where required, extend investment periods, and aid portfolio management.

As seen in the chart above, vintages 2008, 2009, and 2011 show median returns that are materially higher than the broader benchmark of private equity funds of the same vintages. The weakest relative performance for secondaries funds over the period was prior to the GFC, in vintage 2006, for which median IRR returns were 194bps lower than the benchmark. At this point, the secondary market was less mature than it is today, with many sole-fund transactions. The sector is now more complex and has matured along with the rest of the private equity market. 

Now that the initial shock of the COVID-19 pandemic and its impact on financial markets have been digested, an initial phase of distressed selling of LP interests may already be drawing to a close. With Q2 valuations currently being published, LPs may begin a new phase of more measured portfolio rebalancing, which will provide deal flow for secondaries funds and allow dry powder to be deployed. History suggests that the 2020 vintage has a good chance of delivering superior returns and outperforming private equity funds as a whole. 

For more expert insights on the secondary market, read Preqin's H1 2020 Secondary Market Update.