5 Questions: The secondary market for private equity
- December 1, 2020: Vol. 7, Number 11

5 Questions: The secondary market for private equity

by Michael Granoff

The secondaries market can sound a bit esoteric until you consider that — with the exception of new stock shares created by IPOs, follow-on offerings and such — the world’s stock exchanges are secondary markets. With regard to private equity, the secondary market is the only way for investors to make an early exit from their private equity investments as their situations and strategies change over time, while simultaneously creating opportunities for incoming investors to buy those positions several years into their performance cycle and generally at a discounted price.

Michael Granoff, CEO of Pomona Capital, touts more than 33 years of equity experience and is well schooled in the PE secondary market.

What is the current state of the private equity secondary market?

The current market uncertainty caused by the COVID-19 pandemic is sowing the seeds for a significant potential secondary market investment opportunity in the months and years ahead. The opportunity for secondary interests in private equity funds is primarily a function of two variables: 1) the volume of capital invested in private equity partnerships and companies over time, and 2) the rate of turnover of those interests. Recent years have seen record capital inflows to PE. More than $7 trillion has been raised in private equity funds over the past 10 years; by comparison, $3 trillion was raised in the 10 years prior to the great financial crisis. Today’s market unpredictability adds to investor pressures and may spur their need to sell assets, typically if something is happening to their financial situations. Deal flow is increasing significantly, and activity during the second half of 2020 may potentially approach 2019 levels.

How should investors think about PE in the context of asset allocation?

Private equity has played an increasingly important role in asset allocation. PE has historically produced attractive returns with fairly low principal risk over long periods of time. And while there is correlation between private and public markets, private equity in general has exhibited less volatility. Perhaps more relevant today is the fact that traditionally, PE has generally demonstrated less downside performance than conventional investments during periods of market dislocation. Benefits of adding secondaries to an investor’s portfolio typically may include a value approach to private equity investing without blind pool risk, immediate diversification, J-curve mitigation and an accelerated liquidity profile compared to primary investments.

How should investors regard PE from a valuation and risk perspective?

As discussed, private equity has historically delivered attractive returns with low principal risk and lower correlation to public markets. One of the advantages of secondaries investing is the ability to buy into mature funds several years into their investment life and generally at a discount to NAV. Secondaries managers are able to analyze and underwrite underlying portfolio companies with the benefit of hindsight, and therefore, can typically avoid investing in assets at current valuations.

What role does PE play within a portfolio during periods of uncertainty and market dislocation?

There is a greater dispersion of returns between funds during times of market dislocation, placing increased emphasis on the quality of assets. Secondaries may be particularly attractive today given their ability to purchase mature funds with transparency into underlying portfolio companies at a potential discount to NAV. Private equity secondaries managers are typically able to assess the quality and track record of the private equity general partner, and perform due diligence on underlying assets prior to investing. Further decreasing risk, secondaries may provide immediate portfolio diversification across vintage, strategy, geography, general partners and industry.

As 2020 draws to a close, what are expectations for secondaries deal flow going forward?

We anticipate secondaries deal flow to be robust going into 2021, with second-half 2020 deal flow potentially on pace to match that of 2019, which was a record year for secondaries. This is a combination of private equity capital raised and turnover of those assets as investors enter the secondary market for a variety of reasons, including portfolio management, regulatory and liquidity needs. Limited partners interested in adding a PE secondaries allocation to their portfolio should seek managers with a track record of disciplined, bottom-up investing with a margin of safety across multiple economic cycles. All-weather managers will be particularly well positioned to take advantage of opportunities and navigate the years ahead.

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