Investment Strategies

Secondary markets have been a favourite of PE firms in recent years as the equity markets have been booming since the 2020 slump. Exiting the investment through an initial public offering (IPO) is a widely used strategy by global private equity firms. By taking a company public, privately held companies can obtain funds while private investors can realise their invested capital. With the IPO route, PE firms earned decent returns as the stock prices weren’t heavily affected in the secondary market as the demand exceeded the supply.

This chapter explores the secondary market where opportunities are ripe, risks are calculated and every transaction adds a new chapter to your financial journey.

Secondary markets are a financial marketplace where investors can trade securities among themselves. These securities include stocks, bonds, derivatives, mutual funds, etc. It is a secondary market because the securities are already listed on the exchange and available to the public, unlike primary markets where securities are only available to private investors.

Importance of Secondary Market

• The secondary market provides a platform for investors to buy and sell securities, and this leads to creating liquidity in the market.
• It facilitates the determination of prices of the securities based on the demand and supply of the securities among investors.
• It gives businesses a platform to expand their value based on market sentiment and also encourages corporate governance among listed companies as they abide by the rules and regulations of the market regulator and offer more transparency.
• The secondary market helps investors mobilise their savings and investments efficiently. This capital flows from investors to companies, enhancing economic growth and development.
• It also provides the investors with a diverse range of securities thus, offering more stability and minimising the overall risk that the investors would otherwise face.

Secondary investments refer to the purchase of already existing private equity assets. These transactions typically involve buying shares from current investors and then selling them to privately held companies.

Private equity investments are primarily intended for long-term investors, they are inherently illiquid. By investing in secondary transactions, institutional investors can access private equity investments from earlier periods.

It is common for institutional investors to acquire private equity fund interests through secondary transactions, which are usually facilitated by third-party fund vehicles structured like funds of funds. These transactions allow private equity fund investors to sell their remaining unfunded commitments and the investments they have made in the fund.

In the last few months, several PE firms have successfully exited their investments in Indian companies.

Another remarkable exit was made by Barring Private Equity Asia sold a 26.6% stake in Coforge while Everstone Capital sold a 25.4% stake in Restaurant Brand Asia (formerly Burgerking India).

Secondary markets have been on a roll lately! In fact, they’ve experienced tremendous growth in recent years. Even in the first half of 2020, when the pandemic caused chaos in the markets, secondary markets bounced back and set new records for transaction volumes.

This growth isn’t just good news for investors – it’s also thanks to the market’s diversification. In the past, secondary markets were mostly dominated by buyouts. But now, there are many other strategies to choose from, including real estate, private credit, natural resources funds, infrastructure, and more. This means that there are more opportunities for a wider range of investors to participate in the market.

Annual Secondary PE market Transaction volumes in $Bn

Source: JP Morgan

Investing in secondaries can be an excellent way to access established companies and market winners. These companies have already gone through the early stages of their lifecycle and have established market positions, which can offer investors a more stable investment opportunity.

One of the key advantages of secondary transactions is that they often involve buying investments at a discount to their net asset value or the latest post-money valuation. This means investors can acquire assets at more favorable valuations compared to primary investments, which can be a great opportunity for capital appreciation.

By investing in mature companies, investors may benefit from shorter investment holding periods compared to primary investments. This can result in faster returns on capital, as the underlying investments may have already gone through initial growth phases.

One of the most significant benefits of investing in secondary shares is that it allows investors to avoid some of the risks associated with early-stage companies, such as product development, market validation, and initial revenue generation. This means they enter the investment at a later stage when the business has potentially achieved vital milestones and reduced some uncertainties.

Investing in secondaries of individual companies allows investors to target specific industries, market segments, or geographies. This targeted approach can provide exposure to companies that align with the investor’s investment thesis or expertise. This diversification can help spread risk and potentially enhance returns.

Lastly, some secondary direct investments may offer opportunities for investors to have a more active role in the company’s direction. Depending on the terms of the transaction, investors may be able to participate in board meetings, provide strategic guidance, or have influence in certain decisions. So, investing in secondaries can be a great way to access specific opportunities and potentially have a more active role in the investment

The secondary market allows investors to sell their ownership interest in a private equity fund or a portfolio of interests in several funds. This provides liquidity for the funded investments and releases the investors from their obligations to the fund.

There are two types of Secondary Transactions:

Sales of Fund Interests

Structured agreements are often used to complete these sales in addition to conventional cash sales such as:

Structured joint ventures involve exchanges that have been negotiated between the buyer and seller, which are catered to their individual needs. These arrangements are usually more complicated than the ones that involve the transfer of full ownership of the fund interest.

The private equity firm may raise new capital investments for a fund by selling an investment in an existing fund to a secondary buyer, it is known as a stapled secondary transaction. These transactions are typically initiated by private equity firms during the fundraising phase.

If a seller requires partial liquidity for the seller, a new vehicle called a collateralised fund-obligation (CFO) vehicle is created to issue notes. Through fund interests, the investor contributes money to the CFO vehicle, and sometimes, the investor will sell a portion of the leveraged vehicle’s stock to fund it.

Sale of Direct Interests

There are different types of secondary transactions in private equity.

• One type is the selling of remaining assets in a fund that is coming close to its expiry, which is known as tail-end.
• Another type is the selling of portfolios of direct investments in running companies, which can be further divided into two subgroups.
  • The first subgroup is secondary direct, which involves a second buyer owning the entire investment by buying out a portfolio of direct investments from the first buyer.
  • The second subgroup is synthetic secondary or spinout, which involves creating a new LP to buy a stake in a portfolio of direct investments

There are two types of private equity secondary transactions: GP-led and LP-led.

In a GP-led single-asset continuation transaction, typically involving general partners, a portfolio company or asset is moved from one entity to another. By opting for this type of transaction, one can potentially secure additional capital and gain more time to implement a value-creation strategy.

In a transaction led by limited partners, the commitment of a limited partner in a fund is sold to a secondary buyer who assumes the rights and responsibilities of the limited partner in the fund that already exists,

Private equity secondaries are transactions where the main investors of the PE funds buy a stake or asset from limited partners. These deals offer flexibility for limited partners who may want to sell some of their investments to rebalance their portfolios and are becoming more popular in the private equity market.

Buyers of secondaries benefit from a shorter investment duration, faster returns, discounted access to assets, and more information about the underlying portfolio.