The second-mover advantage

The most basic trade-off in private investments is between higher returns and lower liquidity. Stronger performance in the private markets must be balanced against the operational constraints of highly illiquid private fund structures. We see this trade-off in the current market environment as investors grapple with the ubiquitous “denominator effect”: Higher returns from private strategies in 2022, relative to publicly traded investments, have left portfolios overweight illiquid private funds.

Allocators have limited ability to rebalance back to their strategic targets. To some extent, this dilemma arises from a self-imposed constraint: specifically, concerns about using secondary markets to sell stakes in private funds. Such concerns may be outdated, reflecting prior periods in which investors faced a daunting mix of information asymmetries, opaque pricing and counterparties focused on extracting punitive terms.

Those days are gone.

The secondary market has grown up since the 2008-09 global financial crisis (GFC). Today, secondary transactions offer more stable, transparent and effective tools for managing the timing of capital inflows and outflows from private asset portfolios. The value of this solution is clear. The private equity secondary market has grown significantly since the GFC and has become a standard component of diversified investment programs. It is quite likely that the private credit market, which has emerged more recently as a strategic asset class, is likely to follow the same path.

The secondary market has grown – and grown up

Secondary transaction volume has been increasing in recent years (Exhibit 1). We expect this trend to continue as private markets grow – and participants’ need for liquidity grows along with them.

There appears to be a visible connection between the growth of primary markets and corresponding secondary transaction volume. Investors should consider secondaries as a distinct asset class within the private markets, with a somewhat differentiated risk and return profile. Fundamentally, a secondary strategy’s potential returns are not limited to those of its individual private fund stakes. It also includes an ability to earn a spread, in exchange for providing liquidity to other investors when it purchases secondary assets. Secondary strategies can generate return streams independent of the broader market’s direction and the performance of the underlying funds.

The secondary market has also evolved since the GFC and offers a number of transaction types that can suit investors’ different needs across time and changing market conditions. Exhibit 2 shows five key types of secondary deals, from the more traditional sales of seasoned assets to deals targeting earlier-stage investments.

Expanding the use cases for secondaries

The focus of many private market investors has always been on bottom-up manager selection and top-down vintage-year diversification. And for good reason: Selecting top-tier managers is essential to driving high returns, while inefficiently recycling capital across vintages can impose a significant drag on performance. Secondary market transactions have a valuable role in both of these cases.

The secondary market can offer exposure to managers or general partners (GPs) that may be difficult to access in the primary market. In some cases, willingness to provide liquidity to current limited partners (LPs) may offer a path to accessing primary commitments later.

Using secondaries can also help manage the pacing of flows in and out of a diversified pool of private investments, increasing investors’ flexibility in several ways.

  • Investors looking to deploy funds quickly can immediately access fully invested funds, limiting the J-curve effect and absorbing excess capital during periods of higher distributions1.
  • Allocators looking to move capital between private investments have the opportunity to realize gains on mature funds and recycle the capital into new primary commitments when they are being called.
  • At the portfolio level, allocators can rebalance more fluidly across public and private investment categories, preserving strategic allocation parameters during periods of volatility.

Private credit’s secondary market evolution should mirror that of private equity

Private equity offers the best example of the positive feedback loop between the growth of the primary investment channel and the evolution of a robust secondary market that has made the primary market more flexible and transparent. The benefits to investors have been material. The private credit market is still in the early stages of this process and we think it will likely follow a similar path.

Private credit today is a smaller market than private equity, but it has grown substantially over the past decade and signs point to further growth going forward (Exhibits 3A & 3B). We anticipate that the market for private credit secondary transactions will deepen as well, following the model of the private equity market.

The rapid growth of private credit in recent years means that the supply of mature private credit portfolios that would be well suited to secondary market transactions is limited. But the supply is growing and the scope of activity will likely expand, moving beyond sales that are driven by liquidity needs, and eventually evolving to include transactions that can optimize portfolios and fine-tune investment and distribution patterns.

The private credit secondary market currently has a capital gap, in which the number of providers of liquidity to the market has not kept pace with the supply of deal opportunities. This creates an attractive entry point for investing directly in funds focused on private credit secondaries, where investors face favorable conditions: growing supply and the ability to be highly selective across the opportunity set.

In addition to the consistently high yields that characterize primary investments in private credit, secondary market strategies offer a number of additional benefits:

  • Shorter durations: Assets are acquired well into their lifecycle and have significantly shorter expected lives than other types of alternative credit. Allocators can rapidly deploy capital into cash flow positive vehicles with greater visibility into the timing of distributions.
  • Increased visibility and transparency: Whereas primary commitments are made based on manager track records and reputations, secondary transactions provide greater visibility into the underlying credit assets.
  • Improved diversification: Unlike private equity secondaries, which may be a single asset, secondary credit transactions typically consist of portfolios with more than 20 loans. Investing in private credit secondaries can improve diversification within portfolios, across managers, geographies, industries, vintage years and individual borrowers.
  • Risk management: Secondary investors have the advantage before purchase of reviewing seasoned private credit portfolios against the latest macroeconomic conditions, rather than relying exclusively on GPs who may be incentivized to put capital to work during their investment window, regardless of prevailing conditions.
  • Attractive valuations: The private credit secondary market exhibits some inefficiencies and may offer buyers meaningful discounts to net asset value (NAV). In the second half of 2022, credit secondary transactions priced in at an average of 75% of NAV, providing downside protection and attractive yields.

Skilled secondary managers with a deep knowledge of the private credit market will have an advantage accessing attractive secondary opportunities. Specialized skills in underwriting and pricing loan portfolios are also critical, as every opportunity should be independently valued at the underlying asset level – not simply the discount to NAV.

Experienced managers with capital to put to work should enjoy multiple sources of deal flow from current limited partners, general partners and banks and brokers that are originating transactions. A more robust pipeline and favorable pricing dynamics could offer investors the potential to achieve higher returns.

A powerful solution to a real-world problem

The widespread embrace of private investments has been followed by a broad recognition that the lack of liquidity is a genuine challenge. Relying exclusively on vintage year diversification to manage liquidity can be ineffective, given the uncertainty around the timing of initial capital calls and eventual distributions. Against a backdrop of volatile public markets, the stickiness of private allocations can make the strategic allocation process difficult.

Private market secondaries offer an effective solution. Embracing the role of secondaries in private market investing can offer investors more than a safety valve in periods of volatility. Secondary funds can help manage risk and fine-tune exposures across time, while adding differentiated return streams that are not available elsewhere.


1 The J-curve effect, common in private investment, describes negative performance in the first few years before it turns positive as value is created.