When investors look at public markets today, many see high current valuations, low expected returns, and a likelihood of increased volatility. Against this backdrop, it’s little surprise that more than a few are increasing their focus on private markets, and on private equity (PE) specifically. Their interest is amplified by a shift in the public-private balance of company ownership. With more companies going private or staying private for longer, allocators who want to be invested in growth over the next decade have even more reason to consider private equity.
There are several ways for institutional investors to access private equity today: the traditional route of GP/LP structures; co-investments alongside those structures; secondary markets; and direct, flexible-hold strategies.
This II interview with Konnin Tam, Managing Director and Co-Head of Secondaries and Liquidity Solutions at BlackRock Private Equity Partners, is one of a three-part series on creating persistent alpha in private equity and is focused on private equity secondaries, which involve the sale and purchase of investors’ existing interests in PE funds and portfolios.
A lot of people are concerned that we’re late in the economic cycle. How does this affect the market for secondaries?
I think you need to consider the effects on both the supply and the demand side. On the supply side, we think the belief that we’re late in the cycle is prompting PE investors to consider repositioning their portfolios in advance of the next downturn. So, we’re seeing an increasing number of sellers that are motivated by either a desire to lock in what they view as attractive underlying fund valuations or by a desire to generate some liquidity to reinvest into other opportunities in PE or in different asset classes.
On the demand side, we think that buyers are more consciously factoring late-cycle dynamics into their asset selection, underwriting and structuring. So, we’re seeing greater interest in less-levered and higher-growth assets, as well as in assets that have more flexible debt packages or that offer greater secondary-market discounts.
When you consider the environment from the perspective of both buyers and sellers, it makes sense that this is shaping up to be a record year in terms of secondary-market volume. If you believe that we’re late in the cycle, then it may be prudent to pare back or reposition your portfolio. At the same time, if you are an informed buyer and can properly navigate the environment, there are opportunities to take advantage of the supply that is coming to market to acquire assets with counter-cyclical properties.
We’ve seen tremendous growth in sponsor-led secondaries in recent years. What are the biggest challenges and opportunities in investing in these deals?
In a sponsor-led secondary — which can be defined as one in which the PE manager is partnering with a secondary buyer to offer liquidity for some part of an existing PE portfolio — there are several unique challenges. I think the biggest ones revolve around transparency and alignment of interests among stakeholders. The rationale for the manager doing a sponsor-led deal needs to stand up for their investors to be supportive of the deal. There also needs to be a true status-quo option for existing investors, meaning that they’re not forced to sell if they don’t want to. Ultimately, successful sponsor-led secondaries need to benefit the sellers, the buyers, and the PE manager, and that makes these transactions quite complex, but it can also create interesting opportunities for buyers and for PE firms that can craft an aligned solution.
Because of that increased transactional complexity, we believe the market is underwriting such sponsor-led secondaries at a higher level than traditional secondaries. In addition to that “complexity premium,” sponsor-led secondaries often carry a unique opportunity from a portfolio-construction perspective. Sponsor-led deals, by their nature, tend to be more concentrated than highly diversified portfolio deals, so buyers may be able to fill in gaps in certain areas of a PE portfolio, such as strategy, industry, or geography.
What is the role of secondaries in investors’ portfolios and how has that changed in recent years?
It used to be that secondaries were primarily used by investors that were new to private equity, as a means to get invested quickly in a risk-mitigated and diversified way. By purchasing a shorter-duration, highly diversified portfolio in the secondary market, it’s possible to get immediate vintage-year diversification, with exposure to a number of managers across different strategies, geographies, and industries.
While these new entrants to private equity continue to play a role in driving capital into the market, we now also see seasoned PE investors maintaining, or in some cases increasing, their allocations to secondaries. I’ve talked about secondaries as a counter-cyclical and opportunistic strategy. I think seasoned investors are maintaining an allocation partly because of those characteristics. We also think that an allocation to secondaries adds resilience to private equity and private markets portfolios, due to the benefits of additional diversification and the ability to price in more factors in a partly funded portfolio, among other factors.
Because of these potential benefits, we do think more and more private equity investors consider secondaries to be an integral and consistent part of their PE portfolios. The way the secondary market has evolved over the years is analogous to the way the broad PE market has evolved. Private equity used to be seen as an alternative investment, now it’s a core one for many institutional investors. And secondaries used to be considered a niche part of the PE market, but now they are a core holding for many PE investors as the sheer size of the market expands and secondaries become a regularly accepted portfolio management tool on both the buy side and the sell side.
How do you see the secondaries market evolving in the future?
In a little over a decade, we’ve seen the market evolve from just single- or multi-fund portfolio transfers to encompass dozens of different kinds of transactions, including sponsor-led deals, team and portfolio spinouts and carveouts, real asset secondaries, private credit portfolios, preferred equity, and synthetic secondaries, which replicate the economic outcome of a secondary transaction without actually transferring the underlying fund portfolios. So, there’s been a great deal of innovation in the market in a relatively short amount of time, really in response to the dynamic and complex asset class that is global private equity. We expect that to continue, and we believe that market participants will continue to develop new transaction types to address new needs and opportunities.
We also think market transparency and the speed of execution will continue to evolve and improve, but inefficiencies will persist as well. I think one area where we’ll see a good deal of innovation is in the quality of the analytics. We think of the secondaries market as data-rich, but analytics-poor, so we believe it’s ripe for future advancements in analytics that will allow investors to leverage more of that data.
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