Private Equity Indigestion Relief Is Meant to Hurt

Helping an investor cash out of a gummed-up buyout fund used to be a niche business. Now it’s mainstream. So-called secondary funds, which offer to buy unwanted private equity holdings, have become widely accepted. It would be a shame if normalization overshadowed one of the key reasons they have flourished — to remedy seemingly ill-disciplined investment in private markets during the era of easy money.

Secondaries enable existing private equity investors — or “limited partners” — to liquidate some or all of their holding in a fund. It’s a welcome service if that fund is struggling to return cash by selling its underlying investments. Secondaries can also take direct stakes in buyouts lacking decent exit options. The private equity manager then gets to achieve a partial gain and secures extra time to complete the buyout strategy.

This isn’t a new phenomenon. Secondaries performed a similar role in the financial crisis. But fund managers have become much more willing to let their LPs use them, and activity has boomed.

Step Change

Hence the secondaries market is bringing together two categories of private equity investor. On one side are seasoned LPs who want to raise cash. Their private-market assets may be a disproportionately large slice of their portfolios, a problem exacerbated by valuations lagging declines in public markets. On the other are newer dabblers in the asset class who are tempted by the chance to build exposure rapidly to a variety of private assets by buying a secondhand fund stake.

The supply-demand dynamics seemingly favor buyers: Transactions are typically conducted at a discount to the net asset value of the fund (although the true haircut depends on whether the NAV is accurate).