For all the uncertainty in the wake of the autumn 2022 mini-budget, one thing that quickly became apparent was that the fallout would engender both pressures and opportunities stretching far beyond the initial market turmoil.
One area that encapsulates both for investors is the secondary market. The secondary market is where investors buy and sell investments that already exist. The transactions are called ‘secondary’ because they’re one step removed from the transaction that originally created the exposure. In our case, we’re referring to investments in private markets, such as private equity, private credit, real estate and infrastructure, rather than listed securities on exchanges.
As a trusted investment adviser to a wide range of clients – including DB and DC pension schemes, LGPS, endowments, foundations, wealth managers and more – with strong relationships with asset managers and brokers through our dedicated Manager Research team, Redington has a unique perspective on how the market landscape has evolved post liquidity crisis and the importance it could play in the months ahead.
So, here’s a snapshot of where the secondary market stands today, with some key considerations for both buyers and sellers looking to engage.
Even as recently as three years ago, the secondary market was primarily the domain of private equity, and this does remain the largest and most mature secondary market today. However, the volume and transparency of secondary activity in infrastructure, private credit and real estate is expanding swiftly, in line with the growth of the relevant primary market (see Chart 1).
During the second half of 2022, secondary volumes overall declined versus expectations and were about 23% lower over 2022 than the record 2021 volumes. This was driven by a material disconnect between seller and buyer pricing expectations, with bid-offer spreads typically ranging between five and 20 percentage points depending on the asset class, the vintages, and even the managers. It felt like a waiting game.
Moving into 2023, however, we’re already seeing valuations in underlying property assets reset, and there are expectations that as Q4 and Q1 valuations progress – and once Limited Partners (‘LPs’*) have determined how they plan to manage the illiquid assets in their portfolios – bidders and sellers will move closer to one other and secondary transaction volumes will increase.
As many of you reading this will vividly recall, the plunge in UK government bond prices following Kwasi Kwarteng’s mini-budget forced many DB pension trustees to act incredibly swiftly – especially those in pooled liability-driven investment (‘LDI’) funds.
It wasn’t the first time in 2022 that LDI customers had to meet collateral calls in response to rising gilt yields – many successfully did so earlier in the year – but the size and rate of this second round of calls was on another scale, with yields spiking 120 basis points over just three days. This increased the weighting of portfolios towards illiquid assets, accelerating a trend already taking shape due to the underperformance of public assets throughout last year.
The mini-budget further exacerbated the overweight in illiquid assets at a time when many DB pension scheme plans are trying to increase liquidity in their portfolios, effectively catalysing the need to move from illiquid to more liquid asset portfolios.
For funds in this position, the secondary market could now prove a valuable solution, enabling LPs with excess illiquid assets to ‘exit early’ and rebalance their portfolios relatively quickly.
As the secondary market has developed, brokers and managers have become increasingly sophisticated in evaluating portfolios and matching sellers with buyers to try to maximise value. This may include decomposing portfolios into asset classes to attract strategic bidders, pooling exposures to create scale, or using deferral mechanisms that reduce the cost of capital for bidders, leading to improved pricing for sellers.
A lesser-mentioned but more positive outcome of last year’s gilt market movements was that some DB pension schemes emerged from the experience in a much stronger funding position.
By the time the initial shock had been absorbed post mini-budget, the addition of spiking gilt yields to the existing high-rate macro backdrop had reduced many schemes’ liabilities by more than it had diminished their assets, ultimately leaving them closer to their endgame.
Those schemes that have suddenly found themselves in a better-funded position may now be looking for ways to dispose of illiquid assets. The secondary market could likewise prove an invaluable outlet for liquidating assets.
While it was General Partner (‘GP’**)-led transactions that represented the majority of secondary transactions in 2020 and 2021 – as many looked for ways to retain prize assets or release capital for subsequent fundraises – LP-led deals returned to lead the charge in 2022, driven by the scenarios outlined above, accounting for 54% of transactions.¹
Whichever the motivation, it’s clear there are more LPs looking to sell in 2023 (see Chart 2), and the number of portfolios in the market is already rising in Q1.
A buyer’s market
While evaluating potential sales on the secondary market may be a necessity when rebalancing portfolios or revising illiquidity budgets in preparation for buyout, a competitive landscape also creates potential opportunities for anyone considering investing in secondary funds.
Because the above scenarios represent technical selling pressure on illiquid assets, not a loss of confidence in the underlying investments, the result is a market increasingly saturated with good, stable assets potentially available at large discounts. This, combined with a finite amount of dry powder in the secondary market to acquire assets – the typical supply-demand imbalance – supports the construction of high-quality portfolios sourced from a $7trn primary market, with over $1.2trn raised over each of the past five years (see Chart 3).
One of the major benefits of investment in secondaries is typically the transparency through to the underlying portfolio of assets, thereby reducing not only the ‘blind pool’ risk witnessed in primaries, but also mitigating the J-curve versus a typical primary fund allocation. This helps to reduce the perennial issue for closed-ended fund investors of managing committed but uncalled capital.
Furthermore, secondaries may offer a lower dispersion of returns, helping to reduce the uncertainty of outcomes for clients managing their funding positions.
Is the secondary market right for you?
Needless to say, engagement with secondaries also brings its own set of risks and challenges, and market dynamics are (as we’ve seen) highly dependent on the changing macro climate.
Nevertheless, the secondary market is set to be vibrant in 2023, with a potentially vital role to play for both buyers and sellers. To discuss how secondaries could fit within your own scheme’s objectives, please don’t hesitate to get in touch.
*LPs are investors in closed-ended fund vehicles i.e. pension funds and insurers.
**GPs are the investment managers who run the fund strategies.
Unless indicated, these are the views of the author and may differ from those of the firm.