Why Secondaries Could Be a Victim of Their Own Success

With $125bn of dry powder to deploy, secondaries investors will need to be creative to continue to deliver outperformance

For more than a decade secondaries funds have outperformed other alternative asset classes, attracting vast amounts of capital that has become increasingly concentrated in the hands of a small number of fund managers. The first six months of 2020 saw $44bn raised, more than double the $21bn raised in the whole of 2019, with all but one of the 11 funds capitalizing on strong investor demand to close above their initial targets, as Fig. 1 shows. 

The two largest funds – Ardian’s record-breaking ASF VIII ($19bn) and Lexington Capital Partners IX ($14bn) – helped propel average fund size from $1.03bn in 2019 to $3.97bn in H1 2020. According to Preqin Pro there are currently 73 secondaries vehicles in market seeking a total of $69bn, and 16 managers are targeting more than $1bn each.

Is the segment in danger of becoming a victim of its success? The high fundraising total for H1 2020 was mostly down to the normal fundraising cycle, with Ardian and Lexington both closing their funds in the first quarter, rather than in an opportunistic response to market turbulence as the COVID-19 pandemic unfolded. An expected increase in deals in the second quarter has not materialized, with the number of deals completed in H1 2020 down 30% on the same period a year earlier, though market participants remain optimistic that activity will begin to pick up over the summer as Q2 2020 valuations come in.

This has led to an excess supply of capital: Preqin estimates that secondaries funds are sitting on $125bn of dry powder as of the end of June 2020. Just 181 of 1,082 sellers tracked by Preqin are “highly likely” to sell fund interests in the coming 12-24 months, with the sizable majority taking an opportunistic approach. In contrast to the immediate aftermath of the Global Financial Crisis, nearly three-quarters (73%) of LPs do not expect to have difficulties meeting capital calls, a belief validated by the Preqin-FRG Pandemic Cash Flow Model, which predicts a reduction in capital calls from 2016-2020 vintage primary funds.

GPs hoping to take advantage of market conditions to hoover up assets at bargain prices are likely to be disappointed, though it should be noted that it has been many, many years since such a time existed, if it ever did. Instead, the success of fund managers will be their ability to structure creative transactions that meet the needs of vendors. A proxy for the increasing complexity is the rising proportion of intermediated deals, which accounted for 66% of all secondaries transactions in 2019, according to London-based advisor Campbell Lutyens¹.

While the established asset class of private equity & venture capital is likely to dominate activity in the most developed markets of North America and Europe over the next two years (Fig. 2), an increasing number of investors are looking to sell positions in infrastructure, real estate, mezzanine, distressed debt, and natural resources, which will likely drive the establishment of more specialized vehicles.

GP-led transactions, which have been a hot topic among secondary market participants for years, are finally converting into deals, with New York-based adviser Greenhill & Co. saying they now account for a third of all transactions². This highlights how the secondary market is increasingly being used for strategic reasons, rather than purely as source of liquidity. These include portfolio rebalancing, shifting investment strategies, re-investing in higher-growth opportunities, reducing the number of GP relationships and focusing on ones that allow co-investment, and validating asset valuations. 

For more information on the impact of COVID-19 on the secondary market, read the Preqin Secondary Market Update, H1 2020.

¹2020 Campbell Lutyens Secondary Market Overview.
²Greenhill – Global Secondary Market Trends & Outlook, January 2020.