The private equity secondaries space is a very innovative market. Over the past 20 years, many new types of transactions and structures have appeared such as direct secondaries, GP-led transactions, and preferred equity.
PE secondaries funds are often made off a combination of different products, ranging from diversified portfolios of LP interests to single-asset GP-led deals. Bundling these transactions together within a flagship fund offers some advantages to the GP.
First, the diversification brought by the LP positions allows to maximize the use of leverage, especially through non-recourse nav-based facilities. Additionally, the cash-flow profile of diversified transactions also enables the GP to recycle distributions into new investments.
Second, the higher complexity of some transactions such as GP-leds allows to justify higher fees and carried interest paid by the investors on the overall commitment.
This type of fund offers a combined exposure to many different areas of the secondaries market and is sensible for smaller institutions and retail investors who can only make a limited number of commitments. Nonetheless, larger institutions can construct their portfolio actively by choosing which strategy they wish to invest in.
Should PE secondaries split their flagship funds into specialized strategies?
The sponsor-led market has grown very quickly over the past 18 months with single-asset GP-led transactions becoming a popular strategy for GPs to hold on to their champions for longer. Despite this rapid growth, this side of the market seems to remain slightly under-capitalized (low ratio of available capital per unit of deal flow), with only a handful of institutions providing secondaries capital.
Therefore, a handful of managers such as TPG and Blackstone have decided to launch funds targeting GP-led secondaries deals. These funds provide a better-defined investment outline and represent an interesting opportunity for LPs to get a ‘cleaner’ exposure to this part of the secondaries market.
Large institutions can choose where to invest and are likely to be attracted by the modularity of separated strategies. Therefore, it is likely to see more secondaries firms launching pure-play GP-led funds to attract institutional capital and defend their position against new entrants (e.g., buyout managers like KKR, CVC, or EQT). It is likely to observe the same phenomenon with credit and preferred equity where a few firms such as 17 Capital or Whitehorse Liquidity Partners have specialized.
Marketing and managing a flagship secondaries fund made off many different sub-strategies will become increasingly difficult as investors need clarity and well-defined products to construct their program. Moreover, having a pure-play fund investing in one strategy (e.g. GP-leds) and a flagship fund competing on the same deals raises important conflicts of interests, e.g., how to split the deals between the flagship fund and the other funds?
Therefore, it is likely that secondaries funds will become more specialized and fragmented into sub-strategies in the future. This will allow LPs to choose from a larger spectrum of well-defined products depending on their needs. It also means that pure-play LP-led funds with lower fees might appear.
The LP-led secondaries market is very competitive and probably over-capitalized (high ratio of available capital per unit of deal flow). Fees have remained stable over the past few years partially because of the lack of segmentation between complex deals and diversified transactions. If the trend toward more specialized funds happens, we might witness more pressure on fees between secondaries firms where the main differentiators are speed and cost of capital.
These two advantages can be gained by relying more on technology and data-driven approaches. A smart algorithm provides a cost-effective systematic and fast alternative to price diversified portfolios of LP interests. The incumbent players might not directly decrease their margins on this part of their business, but we might see a few disruptive low-cost players appear on this segment of the market in the future (see this article for more https://www.secondariesinvestor.com/how-machine-learning-could-lower-secondaries-fees/).
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