Secondaries – Another Way of Accessing the Leaders of Tomorrow

Years of historically low interest rates have sustainably driven up equity valuations, creating a favorable climate both for private and public market investors. The effect peaked during the global pandemic, with massive government stimulus packages and central bank intervention to keep companies afloat. This influx of money allowed market participants to engage in a record number of deals. Looking at it from a wider perspective, during the last decade we have witnessed a tectonic shift from public to private markets that took place almost in the shadows of a historic public market bull run. For some the party in private markets, and particularly in venture and growth capital seems to be over. Professional investors look at it much more strategically: While 2022 needs another quarter to come to a close, it has already produced 265 new unicorns (startups valued at USD 1b or more) worth a total of USD 489.7b[i]. It is true that this figure represents only 50% in terms of volume compared to 2021, a historical outlier. However, it still is significantly more that in any of the previous five years. In other words, innovation and money continue to attract each other, against all odds. For traditional investors, regardless if they are institutionals or private individuals, the challenge remains how to allocate to the most promising venture capital and growth companies. Investing into the segment usually meant committing to fund investments into little-known companies with often not more than a business idea. It involved justifying money outflows in the draw-down phase of a fund to an investment committee, accountant, or spouse. A phenomenon often described by a so-called J-curve. Those capital calls can be unpredictable and require careful cash management and planning. Not to mention taking painful write-offs as some of the investments went sour (startups fail early, and fast). This list of challenges is far from complete. General lack of access to good deals, high investment minimums, cumbersome administrative overhead, and holding periods of 12 years or more are often cited as additional barriers to entry to the private markets segment. So-called private market secondaries mitigate many of those challenges. Secondaries are characterized by the buying and selling of pre-existing investor commitments. These can be entire fund interests and their remaining unfunded commitments, or single-line positions, i.e. company shares. Secondary markets used to be the last resort for investors. Traditional market participants include investment managers (i.e. General Partners, or GPs) and institutional, private markets-focused investors like university endowments, and pension funds. Fuelled by a steady stream of such deal opportunities and phenomenal buyer demand, the secondary market has grown up since, with deal volume reaching USD 130 billion by the end of 2021, which translates into a 120% year-on-year increase[ii]. In addition to allowing secondary market sellers to lock in returns on their private equity investments, secondary markets enable investors to achieve liquidity early, rebalance their portfolios, and respond to changes in investor preferences. In recent years, so-called GP-led secondaries have become a very popular way for investment managers to transfer some of their best performing positions into the next fund generation. We’ve touched on the various motivations for selling into the secondary market. This, in turn, translates into exciting opportunities for buyers of secondaries and has attracted new types of investors such as asset managers, family offices, and independent wealth managers acting on behalf of their clients. Secondary buyers generally value the increased transparency, faster (and thus more predictable) capital deployment, and significantly shorter holding periods and often sizable discounts compared to the last funding round. And they have come to appreciate the fact that, mostly due to survivorship bias, secondaries significantly outperformed so-called primary investments both on an absolute and risk-adjusted basis. After all, the early startup failures never make it into a secondary transaction as most secondaries only occur after successful larger funding rounds at a later stage.

Secondaries perform better overall, but also per unit of risk

There is yet another observation with far reaching implications: Secondary investors need to worry a less about market timing. Since the reduced liquidity in private markets mitigates both missteps and exacerbates missed re-entries, it is comforting to know that the private equity secondary market generally appears to have been delivering downside protection without sacrificing upside returns. Using the Cambridge Global Private Equity Index and the Cambridge Secondary Funds Index as a proxy, private market secondaries outperformed primaries and the S&P 500 index during eight of the worst S&P 500 draw-downs since 2000.

In the secondaries market, winners appear to be easier to pick

As if that were not enough, the narrower performance dispersion (i.e. the difference between the best-performing top quartile and the worst-performing bottom quartile investments) between secondaries and other private markets primary segments meant that, even if one was less fortunate in terms of the quality of the investment one picked, one enjoyed decent performance.

Private Capital Funds IRR Dispersion by Strategy (Vintage Years 2004 – 2016)

Professionals are back in the market

Incidentally, some of the best-performing secondary vintages were those that started during or right after downturns. This can be explained by opportunities that arise from distressed sales at significant discounts, lower multiples, and untapped value creation. Equally comforting to know is that the private equity secondary market generally appears to have been delivering downside protection without sacrificing upside returns.

A healthy secondaries market emerges for venture and growth capital

Until a few years ago, the private secondaries ecosystem was dominated by buyouts and distressed investments, i.e. privately held mature companies in a generational transition or turnaround situation. Only recently have secondaries become an effective way to invest in earlier company stages such as venture capital and growth equity. This is driven by the fact that, as companies remain private for longer, and that founders, former employees and early startup investors wish to generate partial liquidity without having to rush their firms toward ill-timed exits. As a result, a healthy market for growth and venture secondaries has emerged. While buyers can expect to benefit from the structural advantages of secondaries outlined above, it would be naive to assume that private market secondaries will deliver returns in autopilot mode. On the contrary: improperly handled, they may even lead to losses. Rather, is important to remain selective both in terms of the industries and verticals one approaches, and also how the actual transactions are sourced and executed.

Focusing on resilient companies and industries

In addition to staying as immune as possible to short-term macro and (monetary) policy decisions, investors should focus on identifying companies with positive unit economics, strong, resilient, and capital-efficient business models, and those who adopt or set trends. In short, qualities that help firms flourish during growth periods and help them survive or even thrive during recessions and stagflationary economic scenarios. Investors better intensely look at all existing and emerging spaces across sectors such as Consumer, Fintech, B2B SaaS, and Mobility, which may include areas such as Software as a Service (SaaS), artificial intelligence (AI) and machine learning (ML), among many other emerging technologies to disrupt stale business models. Likewise, blockchain and payments as part of fintech, mobility, or emerging consumer trends such as alternative protein or the creator economy should remain on everyone’s radar.

Deal sourcing and execution will be critical again

While it appears that, in the past, selecting performing private market secondaries was relatively easy, there is no guarantee that this will continue. On a deal-by-deal basis, it means that picking average-performing companies in a segment might not lead to the anticipated returns. Financial services providers who simply run after the popular big-name at any cost will struggle. Investors looking to tap into the future unicorns of this world will have to put significant effort in identifying and allocating to companies, themes, and industries at an earlier stage. This requires institutional-type in-house investment capabilities and outstanding deal-sourcing networks, which will allow them to work directly with entrepreneurs, companies, intermediaries, and shareholders to identify the best deals. Another challenge is properly assessing the deals currently offered on the secondary market. It takes expertise and access to company fundamentals, as well as a deep understanding of market dynamics and knowledge about public-private valuation comparisons, to determine how close the offered discount is to the « true » value and potential of a company. As we’ve seen, downturns like the one we have been witnessing this year can become a ‘buyer’s market’. If implemented correctly, venture and growth capital secondaries are an increasingly popular way to access tomorrow’s leading companies.

[i] https://pitchbook.com/news/articles/unicorn-startups-list-trends, accessed on 29 Sep 2022 [ii] https://www.secondariesinvestor.com/deal-volume-topped-130bn-last-year-say-jefferies-greenhill/