Secondary fundraising stays strong despite pandemic

Secondary funds raised $40.06bn in 2020 through 22 June, already surpassing the $21bn raised in all of 2019, according to data from Preqin. However, two massive funds accounted for a large portion of that amount. Ardian closed a record $19bn across its eighth secondary fund and related co-investment allocations, while Lexington Partners raised $14bn for its Lexington Capital Partners IX LP and related vehicles.

Leading up to the pandemic, secondary firms raised funds fairly quickly and easily and continued to amass larger amounts of capital, according to the results of our Guide to the Secondary Market Buyer Survey – “State of the Secondary Market” 2020 Edition. Among firms surveyed, 54% raised their most recent fund in one year or less, down from 63% in a similar survey in 2019, but still more than half of all respondents. Nearly 68% of this year’s survey respondents characterized their most recent fundraising process as either “fairly easy” or “very easy” with only 32% saying the fundraising process was “somewhat difficult”.

Appetite for secondary funds has increased in the last few years from investors who viewed them as a “risk-adjusted way to invest” in private equity, according to Eric Zoller, founder and partner at intermediary Sixpoint Partners. That’s helped swell fund sizes for many managers. Among respondents to this year’s secondary survey, 80% said their most recent funds were at least 5% larger than their prior funds, including 27% of firms that raised a fund that was more than 50% larger than its predecessor.

Ardian’s latest secondary pool, for example, is around 36% larger than the $14bn the firm amassed for its prior offering in 2016. Meanwhile, Whitehorse Liquidity Partners, which specializes in issuing preferred equity securities backed by private-equity assets or fund portfolios, is seeking $3bn for its newest fund, a roughly 50% increase over the nearly $2bn the firm collected for the fund’s predecessor.

The likelihood of additional dislocations in both public and private markets in the next four years could change the nature of investor appetite for secondary funds, moving from “a quiet, evergreen interest to a cycle-changing cyclical or opportunistic interest”, said Sean Gill, partner at investment consulting firm NEPC and member of its alternative asset investment committee. “There’s probably a little more interest in that sort of end-of-cycle quasi-opportunity right now.”

Investors looking for secondary funds to back have plenty of choices. Around 65 secondary funds were in the market seeking $61.2bn in capital from investors as of 22 June, Preqin data shows. Firms that raise capital now stand to profit from a more favorable buying environment, according to Solomon Owayda, founding partner of secondary adviser Mozaic Capital Advisors.

“Valuations have come down and if somebody raises money right now, they have the capacity to invest over the next two to five years or two to four years.”

However, even if discounts on secondary deals remain modest in a post-Covid-19 world, as long as the underlying portfolios generate a private equity rate of return, deals would still produce “a pretty strong secondary return. This marketplace does not need deep discounts to thrive and survive, just continued transactions and flow”, Gill said.

Stronger projected returns by secondary funds in the last few years are also inviting more investor interest, Zoller said. He added that historically, secondary funds were underwriting returns of anywhere between 1.4 times to 1.8 times their invested capital. But some secondary funds, focused on higher return strategies like structured equity and sub-strategies like single-asset recaps, are now able to target returns close to 1.8 times to 2 times.

“The increased returns profile of some hybrid secondary funds almost competes on the low end where some buyout funds are,” Zoller said.

However, some industry observers say that as the pandemic slows exit activity and hits underlying private equity portfolio performance, some secondary funds also stand to suffer. As valuation markdowns filter through to secondary portfolios, they promise to lead to a greater disparity in fund returns, secondary firms say.

For example, some firms’ funds may be heavily concentrated in a small number of deals or industries, resulting in an outsized impact on returns if those assets are negatively affected by the pandemic. Other firms that relied heavily on debt to boost their fund performance may find it more challenging to do so as the cost of debt increases.

“A very interesting question that has come up is, as there has been more variability in returns, are we going to see LPs pay more attention to how returns are being generated in the secondary market?” said Jeffrey Akers, partner and head of secondary investments at Adams Street Partners.