Trading PE Secondaries?
I'm an undergrad just finishing up IB SA recruiting and I've gotten very interested in PE secondaries over the past few months.
I know there's a buy-side that buys secondary stakes and a sell-side that facilitates the sale of those stakes (like traditional PE, at least to my understanding), but I was wondering if there were funds that focus on trading secondaries?
If not, why so? Isn't there an opportunity in buying a secondary stake at a discount from a seller under pressure, taking your time for a few months to find an interested buyer, and selling it to them for a price closer to its actual value?
In the realm of Private Equity (PE) secondaries, the concept of "trading" secondaries, akin to the frequent buying and selling observed in public markets, is less common. This is primarily due to the nature of secondary transactions and the market itself. Here's a breakdown based on the insights from the WSO content:
Nature of Secondary Transactions: Secondary transactions in PE involve the sale of existing interests in funds or direct investments from one investor to another. These transactions are typically complex, requiring thorough due diligence, valuation assessments, and negotiations. The process is inherently less liquid and more time-consuming than trading stocks or bonds, making rapid trading less feasible.
Market Dynamics: The PE secondary market is characterized by bespoke transactions tailored to the specific needs of the sellers and buyers. Sellers might be motivated by a need for liquidity, portfolio management reasons, or regulatory considerations. Buyers, on the other hand, are often looking for access to mature assets, diversification, and potentially discounted investments. The alignment of these motivations, along with the due diligence process, means transactions are more deliberate and less frequent than in public markets.
Investment Horizon: Secondary buyers typically have a longer-term investment horizon. They are looking to capitalize on the underlying value of the assets or funds over time, rather than seeking short-term trading gains. This approach aligns with the general investment philosophy of PE, which is focused on value creation over several years.
Regulatory and Structural Considerations: The regulatory environment and the structural complexity of secondary transactions can also pose challenges to a trading model. Each transaction can involve negotiations with fund managers (GPs), consent processes, and potentially the transfer of commitments and unfunded liabilities. These factors add layers of complexity that are not conducive to a high-frequency trading approach.
While the idea of buying secondary stakes at a discount and selling them at a higher value is appealing, the practical execution within the PE secondary market is constrained by these factors. However, there are specialized funds and firms that focus on secondary transactions, employing strategies to identify opportunities, negotiate purchases at attractive valuations, and ultimately realize value through strategic exits over time, rather than through short-term trading.
Sources: Q&A: PE Secondaries Principal, Q&A: PE Secondaries Principal, Secondary PE Modeling, Is there any part of the financial industry that is growing?, Learning recs for secondaries
For starters, it is technically against securities law to be buying a private company (or fund) for the purposes of quickly reselling it - in reality, people do this, but it is usually for no where near the gain you contemplate. The reality is that even if a seller is in distress, provided they don't own junk, there is an efficient market to get them a fair price. Assuming you can flip the position quickly you'll probably only gain 100-300 bps. Now if you buy junk for 20 cents on the dollar, don't expect to flip it for 70 cents - junk trades for junk pricing.
Forgot what the term/law is but isn’t there a literal annual limit on how many transfers a fund can have before it loses certain tax exemptions?
Yes, that is called "PTP Restrictions". Funds have a limit on the amount of secondaries that can occur in a single calendar year. If you look at some older NEA funds there are several year long queues to exit.
I didn't know that it was against securities law, makes sense.
It might be an issue with how I'm thinking of secondaries (my reading/research on the topic is very limited), but I thought that secondaries were usually sold at a discount as a way of providing quick liquidity to the seller who might have found a better opportunity (not necessarily because they're distressed or own junk). In which case, I don't see why a well-connected middleman can't just jump on any good buying opportunities (say at 70% of fair value) and resell them at a substantial profit (say 90% of fair value) by taking their time to find the ideal buyer.
Curious how these are related to securities - are privately owned stakes always categorized as such?
If a buyer becomes known in the market for flipping interests, GPs will just block the transfer, its annoying for them.
You don't know shit about secondaries and it shows
Who said I knew anything lol? that's why I'm asking you guys, just seemed intuitive to me
Interesting thought, but you’re missing a key point here. Few things to think about:
How does the second buyer in your analogy make a return? Why wouldn’t they just step-in and take advantage of the transaction dynamic?
I'm probably wrong, but what if the middleman is just more efficient and able to find these kinds of opportunities because that's all they focus on?
I guess it probably has to do with the way I'm picturing secondaries; from my understanding, a seller who is under some kind of pressure (like maybe they found a better investment opportunity and they need the cash asap) sells their investment at a discount to a willing buyer. My thinking is, wouldn't some kind of middleman (with no time pressure and always on the lookout for good buying opportunities) be able to snap up the deal and take some time to find the ideal second buyer, since they're not under the same kind of pressure?
A buyer that is able to offer certainty of closing and able to do it quickly is a tactic used. The same buyer may have bought a portfolio of assets but only wants to keep some, will then off-load the unwanted parts to another buyer (this happens but it’s not frequent).
Why is it not frequent? Legal restrictions or difficulty finding buyers?
Could probably list a couple (outside legal and regulatory restrictions mentioned above on being classified as a PTP transaction). The transactions dynamics at play:
- Valuations for assets are marked quarter to quarter (with a quarterly roll-forward cash flow adjustment). Short hold is means a buyer is probably buying off the same record date as the first buyer
- Transactions like the one above happen when a sale is not intermediated or the right buyers were not brought to the table to offer the distressed seller a “mosiac offering” aka buyers pick and choose pieces as opposed to one buyer buying one portfolio. If advisors do their job, there would be no second buyer to go resell to. The second buyer would already be bidding for the asset in the first round
- Discounts on record date do not model out to a “PE return”. These funds are raised on pitching LPs a risk-adjusted PE return. Is there a market for shorter holds, higher IRR investments? Yes, but simply flipping is not a reliable long-term strategy.
Don't secondaries investment firms do essentially what you're describing, but just hold the stakes for longer than your idea of a few months
Yes, basically
PE -> HF
Secondaries PE -> what OP is describing
Similar difference
Sorry, so is what I'm describing more of a HF thing?
new to all this so sorry if it's a stupid question
Not sure tbh, I didn't even know this industry existed up until a few months ago. From what I've read or heard (limited, so someone please correct me if I'm wrong), secondaries usually hold on to the investment and exit as normal (the only thing that's different is that they get in at a later stage, so it's less risky but also less rewarding).
What I'm wondering is why there aren't funds that behave more like traders and focus on being an intermediary instead of taking the reins from the primary PE investor (a few other commenters brought up legal restrictions and PE firms' investment strategies as reasons, so I guess that's why not).
But if secondaries investors buy stakes in year 5 for example of a 7 year hold period, it still holds the stake over a relatively shorter term
I work in direct secondaries PE. This is what my fund does but the reality is you can’t exit positions that quickly. Not realistic to hold for only a few months unless the company is already in flight to be acquired. At that point shareholders are okay sticking around unless they really have a bad liquidity need. And once a company gets to a certain scale you can’t get in at a good valuation. So what you’re describing is a secondaries fund with perfect execution coming in right before the exit every time. Show me a fund with that track record and I’d love to be an LP haha.
To your point though, the trading platforms (Hiive, NPM, EquityZen etc.) would love the market to be more liquid, greater volume, higher velocity, etc. A ton of brokers and sell-side advisors are spending all their time making it easier to buy and sell private shares. It’s just going to take a while and will likely never be as liquid as the public markets without extensive lobbying.
Makes sense, I hadn't thought of the difficulty of pulling it off.
Out of curiosity, what are some of the big names in the direct secondaries space? Are they pretty much the same names from the SI50?
W Capital
SecondAlpha
Lead Edge
Seligman
Savano
Industry Ventures, Top Tier, and Greenspring (Stepstone) do some but as part of a broader VC platform
One Prime
Akkadian
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