Insight Article Desktop Banner
 
 
Insight Article
  •  
June 07, 2023

Looking Beyond Private Equity Secondary Markets

Insight Video Mobile Banner
 
June 07, 2023

Looking Beyond Private Equity Secondary Markets


Insight Article

Looking Beyond Private Equity Secondary Markets

Share Icon

June 07, 2023

 
 

The private equity secondary market is fairly well known to investors but other secondary markets—such as those for hedge funds and private credit—may be less familiar. While smaller, transactions in these markets can still offer compelling returns. With the majority of return coming from realization of discount to net asset value (NAV), these investments can offer important risk mitigation benefits as well. This may be of particular interest today, against a backdrop of quantitative tightening and declining liquidity.

 
 

Private equity fund investors seeking to sell interests on the secondary market have been met with robust demand. According to Preqin, the private equity secondary market has grown over five times in the last decade. Today, private equity secondary buyers collectively manage almost $400 billion with $141 billion of dry powder.1 (Display 1) This has resulted in high transaction volumes at limited discounts to net asset value for traditional private equity secondaries, serving to bring an element of liquidity to an otherwise illiquid asset.

 
 
DISPLAY 1
 
Private Equity Secondaries Assets Under Management ($bn)
 

Source: Preqin Quarterly Update: Private Equity Q2, 2022 data pack

 
 

In contrast, alternative fund investors seeking to sell illiquid assets not comprised of private equity have not been met with this same level of demand. Despite 2022 being characterized by an almost 40% reduction in secondary transaction volumes, private equity secondaries continued to dominate, accounting for more than 90% of all alternative fund secondaries in 2022,2 leaving less than 10% in hedge funds, infrastructure, real estate, real asset and private credit funds combined (Display 2).

 
 
DISPLAY 2
 
Secondary Volume Across Alternative Asset Classes
 

Source: "Volume Report FY 2022". Setter Capital. February 2023.

 
 

The private equity secondary market is characterized by large intermediaries, transparent processes, cooperative general partners, standardized settlement mechanics and many well-capitalized buyers. In contrast, these favorable conditions are absent for other types of alternative fund secondary markets. We believe this vastly different demand dynamic presents a rich opportunity set for buyers who are willing and able to look beyond private equity and pursue these “undiscovered” secondary markets. Buyers may find they can benefit from less efficient pricing and secure greater discounts to NAV. Compared to private equity secondaries, these higher discounts provide greater downside protection and make the strategy less reliant on growth in asset values and leverage to achieve returns. Below we delve into reasons why the demand dynamic differs—why we think they will persist—and why the dry powder within the private equity secondary market has not yet reached other alternative asset categories, notably hedge funds and private credit.

Transaction and Market Size

The average size of private equity secondary funds raised in 1H 2022 was $5.8 billion.3 To efficiently deploy that capital, focusing due diligence on material position sizes and avoiding excessive line items, these private equity buyers tend to target average transaction sizes exceeding $100 million. While the total hedge fund market is $3.8 trillion,4 the majority of that capital is redeemable at NAV and unlikely to require a secondary sale. When secondary needs do arise in illiquid hedge funds, the transaction size infrequently exceeds $50 million. Similarly, while private credit assets under management have grown substantially over the last decade, at $1.4 trillion5 the industry remains a fraction of the size of the $5.2 trillion6 private equity market (Display 3). As is the case for hedge funds, this leads to lower transaction volumes and smaller transaction sizes for private credit secondaries. Given private equity secondary players need to traffic in fairly large size transactions to deploy their substantial dry powder, they have largely avoided hedge fund and private credit secondaries which can’t supply large scale transactions.

 
 
DISPLAY 3
 
Private Debt Assets under Management and Forecast, 2010 – 2027*
 

Source: 2022 Preqin Global Report 2023: Private Debt Report. December 2022.

 
 

Asset Class

By mandate and experience, private equity secondary players focus on funds that contain control private equity positions. Secondaries that arise in other types of alternative funds may include private equity, but typically span several asset classes including credit, litigation, real estate and real assets. Furthermore, the fund manager (or sponsor) may or may not have a control position. Private equity secondary buyers are not apt to traffic outside of their core asset class mandate, leaving these other alternative categories without a natural incumbent buyer.

Structure

Private equity fund structures are fairly homogeneous. They are generally closed-ended with a capital deployment and investment period, a harvest period and extension options. In terms of fee arrangements, they usually charge a management fee and carried interest over a preferred return. Investors typically own a pro-rata portion of all investments in the fund. When secondary opportunities arise in hedge funds, the structures are quite disparate. For instance, illiquidity could be the result of an initial lock-up, a side pocket, a suspension in redemptions or myriad of other reasons. Depending on the structure, hedge fund secondary investors could own a pro-rata portion of the fund or they could own underlying assets in differing portions. Additionally, fee structures are frequently modified and may differ between liquid and illiquid assets. These variables require nuanced due diligence, presenting a barrier to entry for potential buyers unaccustomed to such complexities.

Relationships and Alignment of Interests

While there are a small number of asset managers that span alternatives, for the most part the universes of private equity managers and hedge fund managers are distinct. Private equity secondary players tend to have relationships with private equity managers, but little familiarity with hedge fund managers. Hedge fund managers have no particular incentive to cultivate relationships with private equity secondary buyers. While private equity managers have the incentive to find buyers able to meet unfunded commitments, hedge fund investments are fully funded, and as such hedge fund managers have no particular incentive to cultivate relationships with private equity secondary buyers—particularly buyers unlikely to support growth in the liquid side of their businesses.

Process and Transparency

A traditional private equity secondary transaction entails multiple rounds of bids organized by an intermediary with a well-populated data room and access to the sponsor. Once the winning bidder is determined, the closing mechanics are fairly uniform. Financing is typically available to the buyer, if desired. In contrast, buyers and sellers of illiquid funds in other alternative categories are not typically able to engage in the same process. Due to a combination of lack of size, motivation and secondary experience, information is not as readily accessible. Buyers with historical knowledge of the assets and an existing relationship with the asset manager are better-positioned to overcome this barrier to entry.

Discounts Are Worth the Effort

We believe that secondary investors should expand their focus beyond the well-trodden private equity secondary market. While shifting into undiscovered secondary markets has challenges, it can be rewarding. For buyers who are able to navigate this more opaque terrain and are willing to deploy less capital per opportunity, the discounts to NAV can be much greater. In a period of declining equity and fixed income valuations, the greater discount to NAV can provide portfolios with much-needed downside protection, shifting the driver of return toward liquidity provision versus growth in asset prices.

 
 

1 Preqin Quarterly Update: Private Equity Q2, 2022 data pack
2 “Volume Report FY 2022”. Setter Capital. February 2023.
3 Preqin Quarterly Update: Private Equity Q2 2022 data pack
4 “HFR Global Hedge Fund Industry Report – First Quarter 2023”. Hedge Fund Research Inc. March 2023.
5 As of December 31, 2022. Bloomberg.
6 Preqin Quarterly Update: Private Equity Q1 2023 data pack. April 2022

 
jarrod.quigley
Managing Director
AIP Hedge Fund Team
 
 
 
 

DEFINITIONS

HFRI 500 Fund Weighted Composite Index: global, equal-weighted index of the largest hedge funds that report to the HFR Database which are open to new investments and offer quarterly liquidity or better. The index constituents are classified into Equity Hedge, Event Driven, Macro or Relative Value strategies.

HFRI Equity Hedge (Total) Index: Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.

HFRI Event-Driven (Total) Index: Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

HFRI Macro (Total) Index: Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.

HFRI Relative Value (Total) Index: Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

MSCI World Index: a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term “free float” represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends.

IMPORTANT INFORMATION

Risk Considerations

Diversification does not eliminate the risk of loss.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

This material is not a product of Morgan Stanley’s Research Department and should not be regarded as a research material or a recommendation.

The Firm has not authorised financial intermediaries to use and to distribute this material, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s circumstances and purpose. The Firm shall not be liable for, and accepts no liability for, the use or misuse of this material by any such financial intermediary.

This material may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this material in another language, the English version shall prevail.

The whole or any part of this material may not be directly or indirectly reproduced, copied, modified, used to create a derivative work, performed, displayed, published, posted, licensed, framed, distributed or transmitted or any of its contents disclosed to third parties without the Firm’s express written consent. This material may not be linked to unless such hyperlink is for personal and non-commercial use. All information contained herein is proprietary and is protected under copyright and other applicable law.

DISTRIBUTION

This material is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

MSIM, the asset management division of Morgan Stanley (NYSE: MS), and its affiliates have arrangements in place to market each other’s products and services. Each MSIM affiliate is regulated as appropriate in the jurisdiction it operates. MSIM’s affiliates are: Eaton Vance Management (International) Limited, Eaton Vance Advisers International Ltd, Calvert Research and Management, Eaton Vance Management, Parametric Portfolio Associates LLC, and Atlanta Capital Management LLC.

This material has been issued by any one or more of the following entities:

EMEA

This material is for Professional Clients/Accredited Investors only.

In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at The Observatory, 7-11 Sir John Rogerson’s Quay, Dublin 2, D02 VC42, Ireland.

Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.

Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority.

Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain. Germany: MSIM FMIL Frankfurt Branch, Große Gallusstraße 18, 60312 Frankfurt am Main, Germany (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Denmark: MSIM FMIL (Copenhagen Branch), Gorrissen Federspiel, Axel Towers, Axeltorv2, 1609 Copenhagen V, Denmark.

MIDDLE EAST

Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158).

U.S.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

ASIA PACIFIC

Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than to (i) an accredited investor (ii) an expert investor or (iii) an institutional investor as defined in Section 4A of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); or (iv) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore. Australia: This material is provided by Morgan Stanley Investment Management (Australia) Pty Ltd ABN 22122040037, AFSL No. 314182 and its affiliates and does not constitute an offer of interests. Morgan Stanley Investment Management (Australia) Pty Limited arranges for MSIM affiliates to provide financial services to Australian wholesale clients. Interests will only be offered in circumstances under which no disclosure is required under the Corporations Act 2001 (Cth) (the “Corporations Act”). Any offer of interests will not purport to be an offer of interests in circumstances under which disclosure is required under the Corporations Act and will only be made to persons who qualify as a “wholesale client” (as defined in the Corporations Act). This material will not be lodged with the Australian Securities and Investments Commission.

Japan

This material may not be circulated or distributed, whether directly or indirectly, to persons in Japan other than to (i) a professional investor as defined in Article 2 of the Financial Instruments and Exchange Act (“FIEA”) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other allocable provision of the FIEA. This material is disseminated in Japan by Morgan Stanley Investment Management (Japan) Co., Ltd., Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

 

This is a Marketing Communication.

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Subscriptions    •    Privacy & Cookies    •    Your Privacy Choices Your Privacy Choices Icon    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.