Consider a market where there is $2 of supply for every $1 of demand. Or more specifically, a market with more than $200 billion in assets on offer in 2022, with only $100 billion having transacted in the same year. One where there are forced sellers owing to structural, non-economic reasons, like fund lives ending or overallocations that can be addressed only via divestiture — where the world’s largest asset owners can deploy material capital and earn compelling returns, and smaller ones can do so at even higher returns.
Where can you find such supply/demand imbalances and market dynamics? Private equity secondaries.
As great value investors like Seth Klarman and David Einhorn might ask: Why does this opportunity exist? One key reason is the dramatic outperformance of private equity thanks to lagged marks and flat or marginally down valuations in 2022, which caused asset owners to become overweight PE as public equity markets declined materially.
These asset owners — such as pensions, endowments, and foundations — became forced sellers of private equity stakes to return to their strategic weights. As the largest buyers of primary PE, they should be the logical buyers of PE secondaries — but instead they’ve found themselves in a catch-22. The PE secondary funds and positions may be superb investments with excess ex ante return expectations. However, because of illiquidity, overhang, supply/demand imbalance, and forced selling, buyers require a material discount to transact.
Another source of forced supply is general partner sellers of PE positions. It may be the end of their fund lives, or sales could be driven by LPs clamoring for capital return, by unattractive M&A and IPO markets, or by an inability to launch a continuation fund. Last, there may be so-called zombie PE funds or firms where a position or vintage went awry, necessitating the unwinding of positions or entire funds, irrespective of the prospects.
What type of discount can asset owners expect from investments in PE secondaries? The answer ranges from the low single digits — for the best, top-decile, proven funds — to material double-digit discounts, for lower-quartile funds.
As a practitioner and an investor in such funds, I have recently seen an average of approximately 0.8x for PE secondaries, corroborated by at least two third-party sources. The positions are seasoned and not public. One can gain insight from the underlying PE firms about their historic successes and their prospects. New clients, deals, partnerships, and growth opportunities are not material nonpublic information. This circumstance provides a favorable information asymmetry and a greater margin of safety.
And data indicates potentially higher risk-adjusted returns from PE secondaries versus primary PE. As secondaries make up a fractional subset of the PE market, there is massive unbid supply, and buyers would have a bias toward the highest-returning assets. Other benefits include elimination of the J-curve, diminished fund life, faster capital return, and elimination of blind pool risk.
Any smart investor may ask: What are the downsides? Aside from bad potential underwriting of PE secondary positions or funds, valuation contraction, or a weakened macroeconomic outlook, the main downside is fees. When one buys PE secondary funds, one must still pay fees to the underlying GP. If an asset owner is smaller and not buying the secondaries directly, but instead investing in a third-party fund of secondaries, there is an additional layer of fees. The solution for larger, sophisticated asset owners is to go direct, as we publicly did at APG Asset Management. Smaller asset owners should invest only with higher ex ante returns and a sufficient margin of safety to overcome the added fees.
In conclusion, I believe that for the aforementioned reasons — including 1) a material supply/demand imbalance of roughly 2:1, which is likely to persist; 2) a scalable market where both larger and smaller asset owners can invest either directly or via a third party; 3) forced sellers owing to understandable structural and non-economic reasons; and 4) information asymmetry — savvy investors may conservatively underwrite investments to a midteens net return with an attractive risk profile. To quote George Soros, the time is right for asset owners to “sharpen their pencils,” research, and invest in private equity secondaries.
Michael Oliver Weinberg is an adjunct professor of economics and finance at Columbia Business School, where he teaches institutional investing. He is also a special adviser to the Tokyo University of Science Endowment. Previously, he worked in alternative assets at First Republic, a $290 billion private wealth manager, and APG Asset Management, a €600 billion ($660 billion) pensions provider.
