The Little-Known Secret to the Success of Secondaries

A 2015 FASB rule allowed buyers to boost their performance, and the market has soared.


Illustration by II

Over the past decade the growth of the private equity market in secondaries — LP interests in funds sold to other investors — has skyrocketed, tripling to more than $130 billion in transactions each year. There are even funds dedicated solely to acquiring investor stakes in existing private equity portfolios, including a mammoth $22 billion one launched by Blackstone last year.

These secondaries have also posted the highest returns of any private asset class, according to one recent analysis. But critics suggest this action is due to a sleight of hand — the ability for buyers to mark up such assets almost immediately after purchase.

“Tens of billions of dollars are flowing into a particular private asset sector that’s relying on accounting gimmicks,” said Jeffrey Hooke, a senior finance lecturer at Johns Hopkins Carey Business School.

Private equity practitioners tout many advantages of secondaries. Investors, who are committed for years to a staying in a fund, can raise cash by selling their interests — even though they typically have to accept a discount to the fund’s net asset value. That discount has recently averaged around 9 percent, according to Jefferies. At the same time, buyers can get into the private equity market at a later stage of its portfolio companies’ development, theoretically speeding up the gains and providing more transparency.

But secondaries have another, little discussed, advantage for buyers since the market began to take off in 2015. That year, the Financial Accounting Standards Board decided in a new rule that after purchasing LP interests at a discount, investors can mark them up to the NAV of the private equity fund.

Those markups “can act as an enhancement to overall return,” Kunal Shah, the head of private asset research and model portfolios at iCapital, and Florence Leung, senior vice president on the research and education team at iCapital, wrote in a recent report.

And what an enhancement it is. In 2020 Cambridge Associates found that secondaries had the highest returns of any alternative investment of recent years. The trend appears to be continuing. According to a UBS report on secondaries, “The sky-high IRRs of more recent vintage years are driven by initial gains as managers take advantage of acquiring assets at discounts to reported net asset values.”

Take Hamilton Lane Private Assets Fund, a $2 billion fund launched in 2021 that has almost half of its assets in secondaries. That fund has a 17 percent IRR, according to Preqin. Such a sizeable gain was accomplished, in part, by writing up the LP interests it purchased at a hefty discount.

In general, some 30 percent of the gain in secondaries’ funds is due to the “pop” that the accounting treatment allows, according to an individual close to Hamilton Lane.

For example, on June 30, 2023, Hamilton Lane closed on deals to buy several LP interests. That same day, it wrote those assets up significantly from their purchase price, according to an investor document Institutional Investor has obtained.

The fund notched a $5.5 million gain on interests in Advent International, buying them at 81 percent of NAV. It paid $23,884,382 for that LP stake and wrote it up to $29,419,229. Hamilton Lane was also able to buy LP interests in Arrowhead Capital at 83 percent of NAV. It paid $3,671,396 for those interests, writing them up to $4,419,876 for a $748,480 paper profit.

A third gain was taken in the interests of GoldPoint Mezzanine, bought at 79 percent of NAV. Hamilton Lane paid $4,086,907 for those LP interests and marked them up to $5,201,583 for a $1,114,676 paper profit.

On secondary interests the fund owned three months or less, Hamilton Lane made a total of $12.8 million by marking up the interests to NAV.

A Hamilton Lane spokesman said that the markups were not done immediately. “In the case of the funds highlighted, this record date was several quarters before the ‘closing’ date where this acquisition was funded. During this period, there is the potential for the funds to generate additional gains or losses on the assets,” he said.

The fund carried a loss on only two investments, and those were owned over a longer period. The biggest loss was on LP interests in TorQuest, purchased in September of 2022. By the end of June 2023, Hamilton Lane had marked those assets down, for a $2.9 million loss.

According to Hamilton Lane’s website, the firm has invested $17.4 billion in secondaries. It is currently planning to close its sixth stand-alone secondaries fund, Hamilton Lane Secondary Fund VI, which is currently sized at $5 billion.

“Secondary transactions continue to be a valuable portfolio management tool — for both secondary buyers and secondary sellers — regarding the management of portfolio liquidity, duration, and characteristics of risks,” the Hamilton Lane spokesman added.

The surge of interest in secondaries has happened at a time when investors are strapped for cash as they are receiving more capital calls from private equity firms than they are getting back in distributions from funds, according to a Preqin analysis reported by the Financial Times. It has also been spurred by the growth of evergreen funds, which have no finite end date and provide only limited distributions.

The Hamilton Lane Private Assets Fund is an evergreen fund. It remains open to take in new investments and allows investors to redeem 5 percent of the fund’s assets each quarter. Currently that percentage amounts to $100 million, which would be spread across all investors who might want out of the fund.

The main problem of this accounting treatment for secondaries, according to critics, is that the gains aren’t real. “If it was worth a hundred cents on the dollar, you wouldn’t be paying 85 cents for it, would you?” asked Hooke, who worked in private equity before going to academia.

He argued that the general partner of the fund should mark down the fund’s NAV if someone is selling interests in that fund for less than 100 cents on the dollar. “If someone buys it for 85 percent of NAV, that’s really what everybody else should mark it to because that’s the open verified auction type purchase price. Clearly the LP interest has been shopped around and the top bidder was 85 cents on the dollar,” he said.

These secondaries are different from the general partner-led secondaries, also called continuation funds, that are a smaller but growing part of the overall secondaries market. The GP-led secondaries had come under scrutiny in the new private assets rule of the Securities and Exchange Commission, which is concerned that the assets were purchased at a discount from an earlier fund and immediately marked up in the new one. But the new rule — which was just overturned by a federal appeals court — does not address LP-led secondaries.