By Edward Younger
If you’re a parent whose kids play hockey, you know that every year the skates you paid dearly for a year ago no longer fit. Maybe you splurged on the CCM Jetspeed FT4 Pro Senior skates, shelling out $1,199 (plus taxes!) that your child loved — and has now outgrown.
Or perhaps you chose the (relatively) more affordable Bauer Vapor 3X Pro Senior Hockey Skates, which retail for the low price of $799 plus taxes.
Either way, you are left with a high-quality asset that is no longer of use to you — along with the need to open up your wallet and buy a new pair of skates for the season ahead.
But there’s good news: someone wants those skates and is willing to pay for them. So you list them for sale on Facebook Marketplace (or Kijiji or Craigslist), get an offer for 50 cents on the dollar, meet up and swap skates for cash. Both parties walk away satisfied.
This transaction, repeated countless times every year, is familiar to hockey parents. But it can also teach us a lot about private equity. How? Let’s now imagine that
• You aren’t a hockey parent, but a chief investment officer of a pension fund or endowment…
• You aren’t trying to unload skates, but are instead trying to sell a portion of your illiquid private equity investments that no longer fit your strategy,
• You need the cash flow to fund new investments.
Since you can’t create a post on Facebook Marketplace to sell your assets, where do you go? Answer: a marketplace called the Secondary Market. This is the market that Overbay transacts in, and where our firm acquires high quality portfolios of private investments at meaningful discounts. Here’s what you need to know about this little-known and less-understood market:
A Market That Provides Liquidity And Access
The Secondary Market is neither a physical market where people meet, nor a digital market like Facebook Marketplace. Instead, it is made up of relationships between buyers, sellers and intermediaries who have collectively built trust over decades of transactions.
This marketplace enables institutions to sell otherwise-illiquid portions of their portfolios; it also allows buyers to purchase high-quality assets that they otherwise would not have access to.
Back to our skating analogy: the secondary market could be likened to an informal market for buying and selling skates that pre-dated Facebook Marketplace. In effect, you knew someone who had a network of buyers and who matched your year-old skates up with a parent of a younger child. Everyone won, but you needed those relationships to make a transaction possible.
The Secondary Market: Surprisingly Large And Growing Rapidly
The private equity asset class today — as measured by the total capital cumulatively invested in private and venture capital — represents approximately $6 trillion in value. Every year a small but meaningful number of these assets, generally estimated at 1-2%, are sold in the secondary market.
The scale of the secondary market has increased dramatically in recent years. Early data is sparse, but the first meaningful measure of the total volume of transactions in the secondary market came in 2005 when Private Equity International measured it at $8B. For 2021, secondary market intermediary Greenhill estimated the annual volume to be $134B.
This rapid growth, in what has historically been a niche market, reflects a growing comfort with and/or desire of institutional investors to seek liquidity (for some reason or another). It also reflects a growing awareness, by investors, of the benefits that providing such liquidity brings.
A Market Where Access Is Limited
Unlike Facebook Marketplace, there are practical barriers that limit the universe of participants and ultimately what gets transacted on the secondary market.
While the secondary market has grown, there are still a relatively small number of secondary funds compared to sellers. As buyers can only focus on so many opportunities in a year, they look for transactions that have a minimum size and that are comprised of easy to evaluate assets. This means it is much easier for large institutions to sell than smaller ones.
In addition, secondary transactions are very labour-intensive and costly. So when sellers decide to sell, they tend to sell larger blocks of assets to warrant the time spent. In addition, they focus on counterparties with a proven ability to execute. This means the market favours buyers with significant capital and long track records of transacting.
And as there is no exchange for private equity assets, the secondary market remains relatively opaque so buyers and sellers for particular assets often have a challenging time finding one another.
Therefore buyers with good relationship networks and / or proactive sourcing programs can create a lot of value finding good deals.
Finally, private equity assets can only be sold to buyers that are approved by the fund managers. So it is important that a prospective secondary investor (like Overbay) is viewed as an attractive replacement investor.
Two Types Of Transactions
Broadly speaking there are two types of transactions — GP-leds and LP stakes — that occur in the secondary market.
A GP-led secondary transaction occurs when a fund manager (the general partner or GP) wishes to sell some or all of the remaining companies in an older fund to a new investor.
For example, let’s say a fund was raised 10 years ago and the manager initially invested in 12 companies. Over the past decade, the manager was able to successfully sell 7 of those companies but 5 remain. The fund investors have been happy with the fund’s performance so far but come year 10, they are starting to become a bit impatient to get their capital back. So, the GP finds a secondary buyer to purchase some or all of the remaining companies. As part of the transaction, the GP will manage the portfolio for the new investor over the subsequent 5 years. In this way, the manager can accelerate the wind-up of their old fund and provide cash to the original investors and at the same time, they can continue to manage the assets for the new investor for several more years.
For the secondary buyer, they have the advantage of being able to perform in depth due diligence on mature investments. If they find a good transaction, they can achieve a strong return over a relatively short time horizon (3-5 years vs. 7-12 years for traditional PE). However by their nature, GP-led secondary transactions have a higher risk profile as they tend to be concentrated in a small number of companies.
Now let’s examine LP stake transactions, which is what we at Overbay focus on.
Fund investors (also known as limited partners or LPs) such as pensions and endowments commit capital to private equity funds typically for 10-15+ years. Over this period, the fund managers use investor capital to acquire and ultimately sell private companies, hopefully at a profit. Now if the LP decides at some point, “these skates don’t fit my kid anymore, I want to sell them”, they cannot redeem their fund investments so they must find a buyer in the secondary market. If they do find a good buyer, they can free up liquidity to reallocate elsewhere.
Usually, an LP stake transaction is comprised of multiple fund interests so they offer buyers, like Overbay, access to many private companies that are close to achieving liquidity (e.g. the companies are about to be taken public or sold to another PE firm). In addition, the sellers usually have to accept a discount to their funds’ market value to achieve liquidity.
Given diversification and the discount purchase price, the risk profile therefore of an LP stake transaction tends to be much lower than GP-led secondary deals. Also as the LP stakes tend to be several years old at the point of sale, the hold time is much shorter for the secondary buyer.
In summary, the secondary market provides something compelling for both parties: sellers get liquidity for highly illiquid assets; while buyers get access to high-quality private businesses and funds, often at discounts. This is the market Overbay invests in, and our transaction track record and credibility enable us to find and execute secondary deals with institutions around the world.
While individual investors cannot participate in the secondary market directly, by investing with a firm like Overbay they have a chance to benefit from the unique access this market provides
Click here to learn more about what Overbay does…
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