Within the private markets space, an area that’s grown in recent years is “secondaries” – buying and selling pre-existing stakes in private equity, credit, real estate, and infrastructure. Such markets encourage price discovery, and the promise of more liquidity makes investors feel more comfortable.

The following article comes from Steven Brod, the senior partner, CEO and chief investment officer at Crystal Capital Partners, a firm based in Miami, Florida. 

The article draws a parallel between the ancient Silk Road and modern private equity markets, particularly focusing on the roles of secondaries and continuation funds. In particular, Brod’s article highlights how secondaries offer early exits for liquidity, while continuation funds allow the extension of high-potential investments.

He argues that financial advisors must understand these markets if they are to guide clients properly through changing market conditions. 

This article speaks to the continued trend of wealth management interest in private market (equity, credit, infrastructure, other) areas, a field that has boomed on the back of cheap money post-2008, and a structural shift of corporates away from listing on the public markets. 

The editors are pleased to share these ideas; the usual editorial disclaimers apply to views of outside contributors. To respond, email tom.burroughes@wealthbriefing.com

From the second century BCE to the 14th century CE, traders traveling the lengthy and perilous path from Asia to Europe, known as the Silk Road, innovated by establishing trading posts and intermediate markets along the route. They served not only as rest and resupply stops, but also facilitated the exchange of goods, allowing traders to cash out or continue on their journey with new lucrative inventory. In the world of private equity, secondaries and continuation funds serve a similar purpose: secondaries funds offer early exits for investors who require liquidity, much like the Silk Road’s trading posts, and continuation funds provide a way to extend the journey of high-potential investments without locking up capital indefinitely.

As the Silk Road witnessed an increasing number of travelers, so too has the private equity market experienced increased interest in these types of funds. It is therefore important that financial advisors, when serving as fiduciaries, understand these offerings so that they can provide the best advice to their clients.

First, advisors must consider the private equity market more broadly. Exit volumes have shrunk considerably, while managers contend with record levels of dry powder and unrealized value. Last year, global private equity exit value totaled only $575.8 billion, its lowest level since at least 2019, according to Preqin (1), while global private capital has grown to approximately $12 trillion in assets under management, nearly double its 2019 amount, as reported by PwC (2). Against this backdrop, private equity managers are considering ways to optimize high-potential assets by extending their investment horizons, and investors are seeking liquidity, exit strategies and a quicker turnaround on invested capital.

The secondaries market has evolved into a sophisticated arena for portfolio management, with the market increasing 7 per cent to $60 billion in 2023, according to Jefferies Financial Group (3). But how should advisors analyze the aforementioned dynamics with respect to advising their clients? Secondaries funds, which typically consist of more mature assets with potentially lower risk profiles, may provide more predictable and stable return streams. These assets often come with established performance histories and the initial dip in return an investment experiences (a function of the J-curve effect) is typically less pronounced. As these investments are more mature, they can offer nearer-term liquidity compared with traditional private equity funds, which can be attractive for clients looking to realize investments sooner.

Continuation funds, used by managers to roll over assets from one fund to another within the same firm, are seeing a similar rise in popularity. This is partly due to robust performance. 

These funds have earned a median of 1.4x multiple on invested capital, on par with secondaries funds and higher than the median 1.2x from buyout funds, according to Morgan Stanley (4). There are several potential benefits for advisors’ clients. There is the opportunity to invest in well-vetted companies that GPs have strong confidence in, given their willingness to extend the holding period. Continuation funds may therefore also provide access to high-potential assets that have a clearer path to liquidity and more defined exit strategies.

Forward thinking advisors should always be cognizant of how the private equity market is evolving. As the sector matures, the volume of older funds will expand opportunities in the secondary market, and newer asset classes and innovative investment vehicles will likely enter the space. 

Over time, firms and funds will become increasingly institutionalized, adopting more formalized processes and standardized practices. Additionally, technology integration, especially in data analysis and transaction processing, will enhance efficiency and transparency, while encouraging more players to enter the space. Similar parallels can be seen in the maturation of the Silk Road, where advancements in the medium of exhange lead to the invention of paper money, making trading more efficient, and ultimately facilitating greater commerce.

However, before allocating to a secondaries fund, advisors should be aware that secondaries transactions are not usually general partners’ first choice. They are often undertaken when managers cannot execute on other exit strategies, such as initial public offerings or strategic acquisition. This could be due to several factors. First, it can be challenging to find buyers at desired prices. Second, there is significant counterparty risk, as transactions depend on the reliability and creditworthiness of counterparties. Third, it can be hard to determine the fair value of assets as there is less transparency and less frequent pricing in secondary markets, as compared with primary ones. 

For continuation funds, investors must similarly be wary of accurate asset valuation, as the value of the assets being transferred can be subjective and not reflect true market value. On top of this, market or sector conditions may change unfavorably during the extended holding period, impacting portfolio companies’ performance. 

Continuation funds also face operational risks, and the success of the funds heavily depends on the skill and track record of the funds’ general partners.

These risks highlight the importance of careful due diligence. Advisors would be well served by engaging third-party specialists who can help them research the top managers offering secondaries and continuation funds, as this expertise is not often found within financial advisory firms.

Advisors looking to navigate the complexities of private equity investments should be aware of the way the industry has matured in recent years and how it will continue to do so in the future. For discerning investors, secondaries and continuation funds may provide potential benefits with regards to diversification, high-quality assets and liquidity/exit strategies. However, understanding the specific associated risks of each strategy is crucial for making informed investment decisions.

[1] S&P Global, Apr. 2024, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/private-equity-exit-value-sinks-to-3-year-low-in-q1-81247928

[2] PwC, Jan. 2024, https://www.pwc.com/gx/en/services/deals/trends/2024/private-capital.html#:~:text=Private%20capital%20has%20approximately%20US,these%20investments%20to%20be%20exited.

[3] Global Secondary Market Review, Jan. 2024, www.jefferies.com/wp-content/uploads/sites/4/2024/01/Jefferies-Global-Secondary-Market-Review-January-2024

[4] Kokalitcheva, Kia. Riding the Continuation Fund Trend in Venture Capital. Axios, May 2024, www.axios.com/2024/05/07/venture-capital-continuation-funds.