For a risk-averse investor, Blackstone has what could be seen as an irresistible offer.
Back its flagship buyout fund and expect a paper return of 11 per cent after fees in six years. But opt for a vehicle that buys ostensibly safer, diverse pools of stakes in other private equity funds, and notch up a 19 per cent return in just four.
That discrepancy is core to the appeal of private capital’s exploding secondaries market, where investors back ageing assets rather than funding new deals.
Secondaries transactions reached $240bn globally last year according to investment bank Jefferies, a sixfold increase in the space of a decade. The amount of funding dedicated to the asset class has soared too: investors ploughed $166bn into secondaries funds last year.
Where elite private capital firms once shunned this second-hand market as beneath them, they are now piling in. In recent weeks, EQT struck a $3.7bn deal for Coller Capital and KKR agreed to buy Arctos Partners for $1.4bn, two firms established by secondaries pioneers. Ares, Apollo and CVC had already made similar moves.
“When I joined the secondaries business in 2000-ish, it was ‘what’s a secondary’?” said David Atterbury, managing director at HarbourVest, a big investor in the asset class. “In the last few years, it has grown into a mainstream and rapidly expanding part of private markets.”
Secondaries have gained popularity as a way for investors to cash in as buyout firms struggle to exit investments during a dealmaking downturn. But their rise has been cemented by the flood of money into private capital from individual retirement savers, prompting questions over whether such investors really understand what drives the high early returns.
Secondaries funds generally invest in the later stages of private equity deals, often as assets near an exit, and diversify across more deals than a traditional buyout fund. The funds juice returns by holding investments for short periods of time, by buying assets at slight discounts, and by using leverage.
Secondaries funds date back to the 1980s, when Venture Capital Fund of America established what is widely regarded as the first of its kind.
Britain’s Coller Capital and New York-based Lexington Partners then developed specialist expertise in the trade, but for years secondaries were shunned by more prestigious buyout firms who took pride in riskier direct investments in companies.
That changed as the first US private equity firms went public. Keen to show shareholders growth in assets, Carlyle agreed to buy secondaries group AlpInvest in 2011 and Blackstone acquired Credit Suisse’s dedicated unit soon after.
It was in 2021 that secondaries really took off, however. Disruption from the pandemic left a backlog of companies that private equity groups could not sell, and both funds and their investors needed to find ways to generate cash. When interest rates rose in 2022, that only exacerbated the problem.
Secondaries funds were the solution. Since then, investors have initiated almost $400bn of secondaries deals, according to Jefferies: for example, selling off a portfolio of their holdings in different funds. In the same period there have been $362bn worth of deals led by private equity fund managers themselves, largely so-called continuation vehicles.
Some of the growth has come through the expansion of the wider private capital industry, where assets under management increased from $14tn in 2020 to $24tn last year, according to McKinsey.
The secondaries market remains small in that context. But it is one of the fastest-growing parts of the market thanks to the liquidity it provides sellers and the returns on offer.
Secondaries deals for stakes in funds rely on three main techniques that involve borrowing or leverage-like effects to boost returns.
As well as borrowing from external lenders and overcommitting, secondaries funds also routinely borrow from sellers by deferring some of the payment. This allows them to delay calling cash from backers, bolstering the internal rate of return (IRR), a key performance metric in the industry.
Offering deferred payment allows the pension plans selling the stakes to negotiate a smaller discount than they would otherwise have to accept. But the time value of money — the concept that the same sum of money is worth more in the present than future because it can be invested and earn a return — means the loss for the pension plans will be bigger by receipt of the second instalment.
So-called continuation vehicles — established by private equity firms with backing from secondaries funds to buy companies from the firms’ older funds — can also deploy a lot of leverage. Such deals can be financed with about 50 per cent debt.
One private equity executive said that while borrowing had a place in diversified secondaries investments, “there is some over-reliance by many players on that leverage, which could end up working out poorly if you picked the wrong assets.”
The risk is that the underlying companies ultimately do not perform as expected or cannot be sold at the valuations that the secondaries funds had baked into their models. Just as leverage amplifies returns on the way up, it amplifies them on the way down.
Accounting rules around the valuations of the underlying companies can also mean the eventual returns of a secondaries fund often end up nowhere close to those reported early in a fund’s life.
Secondaries managers might buy hundreds of fund interests valued at $100mn at a 20 per cent discount, but accounting rules see them immediately mark those up to $100mn — producing a high early unrealised IRR.
If the buyout funds that own the underlying companies exit them at $100mn in a year’s time, the secondaries buyer will make a roughly $20mn gain. Even if they only sell for $90mn, the secondaries buyer will still make a profit.
But both scenarios would mean a lower realised IRR than what the fund originally reported as its unrealised figure. If the sales take longer than a year, the IRR drops further.
The falling overall IRRs of secondaries funds can be seen in Blackstone’s filings. Its 2021 vehicle that posted 20 per cent after fees in September, including realised and unrealised holdings, was marked at 24 per cent two years before. The firm’s seven-year-old vehicle reported 20 per cent in September, a dozen percentage points less than in 2023.
People familiar with Blackstone’s strategy said secondaries fund returns are expected to decrease over the funds’ lives because they were purchasing assets at substantial initial discounts.
Over time, they said, the impact of that initial discount and the use of leverage dissipated as the underlying companies it purchased grew in value and derived the majority of returns. Early annualised returns of 20 to 30 per cent are expected to be roughly 16 per cent over time, in line with fund return targets, the people added.
Secondaries deals can also offer some advantages relative to traditional buyouts. Buyers of existing fund stakes can put their investors’ cash to work more quickly across a more diverse portfolio and can see what companies they are investing in. Industry executives say leverage accounts for a small part of returns in the end.
Atterbury of secondaries investor HarbourVest said the final realised IRRs of top secondaries funds can be similar to buyout vehicles despite their lower risk, because more mature holdings that are closer to exit pay back cash faster. “This return profile has made the sector highly attractive to institutional investors,” he added.
Institutional backers of secondaries funds understand that returns will fall over time. But there are questions about whether retail investors do. In the race to accumulate assets and generate fees, private capital groups have been battling to attract individual investors to their products, using evergreen vehicles.
These vehicles allow wealthy individuals to deposit and withdraw cash regularly, unlike traditional closed-end funds in which institutions lock up money for a decade.
Secondaries deals are ideal for evergreen vehicles in many managers’ eyes, in that they allow investor cash to be deployed quickly and return cash faster.
Ares, Apollo and StepStone have all launched evergreen funds focused on secondaries, which invest in both fund stakes and continuation vehicles. Half of Hamilton Lane’s private equity evergreen fund is invested in secondaries deals, roughly 5 per cent of Blackstone’s and 17 per cent of Partners Group’s flagship US fund.
The fact that evergreen funds allow monthly deposits means retail investors may need to be mindful of potentially inflated early returns. “If you’re adding capital to an evergreen fund, you might think, ‘Wow this is great, the fund is up 20 to 25 per cent’,” said Euan Finlay, partner at Partners Capital, an investor in private markets funds.
But, he said, if that early return had been driven by buying secondaries at a discount and marking them up, “you will not benefit from that uplift” as a later investor.
There is also a risk that the driver of many recent secondaries deals becomes their downfall. “All the retail [vehicle managers] are stuffing [secondaries deals] in their funds because they need to deploy cash,” an experienced secondaries investor told the FT last autumn.
But the reason so many fund stakes were on the block in the first place, they added, was “the lack of exits”.
