Liquidity in private markets: part one – secondaries

The last two years have seen a dramatic about-turn in the private markets industry. In 2021, at the peak, private markets raised a record $1.7 trillion, according to Bain & Co. However, by 2022, managers found themselves operating against a completely different macro-economic environment, as the Ukraine war, rising inflation and climbing interest rates brought the private market bull-run to a sudden halt.

More than two years on and investors who had upped allocations to private markets in 2020 and 2021, fully expecting to have received some distributions back from these commitments by now, have found that assets are still very much in the ground with limited visibility on when realizations will materialize.

This has left a liquidity problem. According to Bain & Co analysis of Preqin data, buyout managers alone were sitting on $3.2 trillion of unexited companies in their portfolios- an all-time high. Extended hold periods and limited exit pathways have seen the average number of companies in portfolios double over the last decade.

Liquidity, once taken for granted, is now front of mind. For many managers and investors DPI (distributed-to-paid in capital), rather than internal rate of return (IRR), has become the new priority.

With the main exit funnels of M&A, secondary buyouts and IPOs still jammed, managers have had to explore other options to realize value and start getting capital back to investors. At Alter Domus, this is something we have seen firsthand from our clients.

In the first of a four-part series exploring the alternative routes to liquidity that managers have available, Alter Domus looks into how the secondaries industry is stepping up to give managers and investors optionality when mainstream transactional volumes are at a low ebb.

Part 1: Secondaries

The private markets secondaries industry is the original provider of liquidity in an asset class that by nature and structure is illiquid.

The current liquidity bottleneck facing investors and managers has made this the secondaries market’s moment shine.

The industry has come a long way from its beginnings, when the sale of an LP-stake in a fund was often seen as a blot on manager’s track record and the last option for investors that had run out of ideas.

Attitudes have changed, and as the secondaries industry has matured, evolved and innovated, managers and investors have recognized the value it adds as a tool to reconfigure investor portfolios, release capital for allocations to new funds and tweak asset allocations.

Indeed, the value and flexibility that secondaries offer the private markets ecosystem have been on full display during the market dislocation of the last 24 months. As primary deal activity and fundraising has dipped, the secondaries industry has moved in the opposite direction.

In the most recent Jefferies Global Secondary Market Review, secondaries deal value for H1 2024 was recorded at a high of $68 billion, a 58 percent increase on figures for the same period in 2023, putting the industry on course to deliver forecast deal value in excess of $140 billion by the end of 2024.

With some $253 billion of capital still available to deploy, the secondaries managers are well-positioned to continue playing a key role in keeping liquidity cogs turning across private markets strategies.

A broad suite of options

Secondaries managers have been there to provide both LPs and GPs with liquidity pathways, and the strong demand has sustained robust levels of activity in both LP-led and GP-led transactions.

According to Jefferies LP-deal activity accounted for 59 percent of overall activity to come in at $40 billion for H1 2024.

The increase in LP-led deal volumes has been driven by myriad factors, with LPs using the secondaries market not only to manage the impact of the denominator effect (where private asset allocations exceed preset thresholds) on their target asset allocations, but also to free up and reallocate capital to favored managers who are coming to market with new fundraisings.

LP willingness to pursue LP-stake deals has been underpinned by relatively moderate discounts to NAV. Investors have not panicked and dumped assets at fire sale prices, with secondaries pricing remaining stable and narrow enough to make an LP-deal reasonable for selling investors.

According to Jefferies, LP-deals traded at almost 90 percent of NAV through H1 2024, and with equity markets stabilizing and interest rates coming down, pricing is expected to improve even further through the rest of 2024.

This has allowed LPs to sell stakes without leaving too much value on the table, and when considering the growth on NAV that private markets portfolios have delivered over the mid-to-long term even when selling at a ten percent discount, LPs can still be realizing reasonable returns on investment as they take liquidity in secondaries trades.

GP-stakes deals on the up

GP-led deals, meanwhile, accounting for around 40 percent of the overall secondaries market, have also delivered strong transaction volume growth, with deal value up 56 percent year-on-year to reach US$28 billion for the first half of 2024, according to Jefferies.

GP-led deals and continuation fund transactions, where sponsors roll-assets into a new vehicle, with backing from a secondaries investor, and offer LPs the option to either take liquidity or roll-over their stakes into the new structure, are now firmly established as a credible alternative to an exit by an M&A transactions or IPO.

Indeed, Jefferies notes that in H1 2024 continuation fund deals represented 14 percent of sponsor-backed exits, the highest share on record.

Rather than selling their best assets at sub-optimal valuations in flat M&A and IPO markets, continuation funds have given managers a pathway to release liquidity without letting go of top performing portfolio companies.

Putting the building blocks in place

Secondaries managers are providing much needed liquidity for private markets, and managers with high quality back-office infrastructure and best-in-class fund reporting and technology will be positioned to take advantage of the flexibility and liquidity that secondaries investment can offer.

Administering and accounting for secondaries has become a more complex, demanding task for manager back-office teams as the secondaries industry has grown and evolved.

Alter Domus has helped a number of managers to upgrade operational models and put the foundations in place to handle rising secondaries volumes while being in a position to take advantage of the liquidity on offer in the secondaries market.

There are a higher volume of secondaries trades for back-office teams to track in the first instance, and deals will not just include LP-led deals, but also GP-led transactions, single asset deals and continuation funds, which introduce additional fund reporting and governance obligations for each and every continuation fund vehicle.
A mix of secondaries deal asset classes, which have broadened out beyond buyout funds to include private debt and real assets, require further accounting and reporting bandwidth.

For back-office teams that are already stretched and are adapting to rising regulatory and investor reporting requirements on a day-to-day basis, the additional demands that come with monitoring assets alongside commitments that have traded in secondaries transactions, demand investment in operational infrastructure.

Alter Domus’ Workflows Application, an AI-powered tool that can automate high volume back-office tasks, making it easier for managers to keep track of growing and increasingly complex secondaries transactions in their funds, as well as continuation funds orchestrated by managers themselves.

A digital link between manager and fund administrator leadx to greater accuracy in data, as well as transparency, improved efficiency of data collation and higher-quality analysis.

Managers can also turn to Alter Domus for more general outsourcing, co-sourcing and technology support to build back-office capability that can be scaled at pace and adapted to unlock secondaries liquidity.

In markets where liquidity is tight, having the infrastructure in place to assist and facilitate secondaries deal flow helps managers and investors to keep capital flowing in through a challenging period in the cycle.