As an intrepid business journalist with a passion for demystifying complex topics, I often get asked by readers to explain secondary shares in private equity and venture capital. “What are they?” “How do they work?” “What’s their value proposition?” Valid questions indeed!

Secondary shares allow investors to sell their ownership stakes in private equity and venture capital funds before the prescribed exit window. However, navigating this opaque corner of the private markets requires an expert guide. Luckily, I’ve got you covered!

In this post, we’ll explore what secondary shares are, why they matter, who the major players are, and how to think about valuation and risks. Clear explanations mixed with practical examples – my favorite recipe for understanding complex subjects.

Let’s get started!

What are Secondary Shares?

Private equity and venture capital funds have traditionally come with long lock-up periods, typically 10 years or more. General partners raise capital from limited partners (LPs) and draw down this capital to invest in private companies over a 5-year investment period. Following this, GPs focus on helping portfolio companies operate and grow with the goal of exiting at a profit. The lifespan of a typical private equity or venture fund can range from 10-13 years.

As a result, LPs have their capital locked up for prolonged periods. If an LP wants to exit early for whatever reason (rebalancing, change in strategy, need for liquidity), secondary shares provide a potential avenue.

In a secondary share transaction, an LP sells their unfunded commitments or existing investments in a private market fund to another investor, prior to the prescribed exit window. The buyer of the secondary shares continues with the remaining commitment/investment until the fund reaches maturity.

Simply put, secondary shares provide liquidity and early exits for LPs in illiquid, long-duration private market assets.

Let’s break this down further:

• Unfunded commitments – When LPs make capital commitments to new funds being raised by GPs, a portion remains unfunded until capital calls are made. An LP can sell these unfunded commitments.
• Existing investments – After a fund starts investing, LPs own proportional stakes in the underlying portfolio companies. These stakes can also be sold before exit.
• Buyers of secondary shares – The buyers are often other LPs looking to gain exposure to attractive funds or take advantage of perceived value discrepancies. There are also dedicated secondary market firms.
• Early exit – Sellers get liquidity ahead of the typical 10+ year lock-up by passing the remaining exposure to buyers.

So in essence, secondary sales allow LPs to unwind ownership in a private market fund earlier than would be possible normally. The long duration and illiquidity of these investments can make secondaries an appealing option under certain circumstances.

Why are Secondary Shares Useful?

Secondary share transactions in private equity and venture capital serve several important purposes:

1. Early Liquidity for LPs

The multi-year fund life cycles create portfolio drag for LPs. Capital remains locked up for 10+ years. If an LP needs liquidity for any reason earlier, secondaries offer a way out. Common seller motivations include:

• Exit underperforming funds – Cut losses on struggling funds that are unlikely to meet return objectives.
• Strategy pivots – If an LP decides to change investment strategy, selling existing private market assets can free up capital for new opportunities better aligned with updated strategic goals.
• Portfolio rebalancing – LPs may want to rebalance their private market exposure if concentrations build up beyond targets in particular funds or sectors.
• Meet liquidity needs – LPs facing funding requirements like pension payouts can create liquidity via secondaries if more attractive options are unavailable.
• Regulatory reasons – In some cases, regulations may incentivize LPs to reduce exposure to certain categories of funds. Secondaries provide a pathway to accomplish this.

The motivation often comes down to exiting unfavorable exposures or generating liquidity for other needs. LPs faced with these scenarios can utilize the secondary market for private equity and venture funds as a release valve of sorts.

2. Exposure for New Investors

On the flip side, secondaries also offer new investors access and exposure to private market funds that are typically difficult to access:

• Mature funds – For newer LPs, secondaries allow accelerated exposure to seasoned funds with established portfolios compared to investing in newly launched blind pool vehicles.
• Top-tier funds – Strong past performance can make well-regarded funds oversubscribed. Secondaries give new LPs a way to gain access.
• Co-investments – Buyers may be able to access co-investment rights attached to certain secondary stakes. These co-investment stakes are often in mature companies nearing an exit.
• Strategic positioning – If a new LP wants portfolio exposure to a particular sector, geography, or vintage year, secondaries can help tactically build these exposures.

New LPs participate in secondaries to gain strategic exposure to seasoned assets and access coveted funds. This allows them to accelerate their private market programs and selectively build desired exposures.

3. Pricing Efficiency

The secondary market also serves an important role in improving pricing transparency and efficiency:

• Fund metric discovery – Unlike the public markets, there are no live tickers for private market valuations. Secondary transactions create valuation reference points, improving visibility into fund health and performance.
• Portfolio company valuations – As secondary share sales incorporate portfolio company valuations, they provide market-based valuation data points for private businesses.
• LP transparency – LPs selling secondary stakes reveal their desire for liquidity or readiness to crystallize gains/losses. This LP activity offers useful behavioral signals.
• Corrective mechanism – Premium secondary pricing can indicate high-performing funds worthy of more capital, while discounts could suggest poor managers that LPs should avoid. This differentiation incentivizes capital shifts toward better performing funds.

Through flow and the discovery of pricing levels, secondary transactions increase transparency for the overall private markets. This ultimately strengthens efficiency and capital allocation.

Who are the Major Players in the Secondary Market?

Over the last decade, the secondary market has evolved from a niche corner of finance into a sophisticated industry with over $100 billion in annual transaction volume. Here are some of the main participant groups:

Secondary Funds

Dedicated secondary firms raise capital in their own secondary funds to actively acquire secondaries across private equity, venture capital, real estate, infrastructure, and other adjacent categories. These specialized secondary investors account for the majority of secondary market activity. Well-known names include:

• Lexington Partners – The largest secondary firm with over $56 billion in acquired assets historically. An active, opportunistic buyer across all sectors.
• HarbourVest – A global player with strengths in Asia-Pacific and emerging markets. Manages over $17 billion dedicated to secondaries.
• Ardian – This French firm focuses primarily on funds and co-investments in Europe and North America. Manages $24 billion in dedicated secondary capital.
• Goldman Sachs – The investment banking giant has a thriving secondary business as part of its asset management division.
• Coller Capital – A pioneer of the secondaries market with nearly $30 billion deployed into over 650 discrete secondary transactions since 1990.

Increasing competition has compressed secondary pricing and returns, but the addressable market remains massive at over $4 trillion in locked-up LP capital according to Preqin data.

Pension Funds

Large pension funds have become active direct secondary buyers looking to proactively manage their portfolios. Notable examples include:

• Teacher Retirement System of Texas – This massive public pension has invested over $8 billion in secondaries and sees it as a “source of market opportunity.”
• Canada Pension Plan Investment Board – The C$500 billion Canadian pension deploys billions into secondaries annually to provide liquidity and rebalance its private equity portfolio.
• Washington State Investment Board – This public pension views secondaries as an avenue to generate liquidity and exit underperforming funds. It has historically targeted $2-3 billion secondary exposure for new investors allocations.

Pensions use secondaries tactically within their broader private market programs. Direct access allows them to save on intermediary fees charged by secondary funds.

Endowments & Foundations

Prominent endowments like Harvard, Yale, Stanford, and MIT have multi-billion dollar secondaries allocations. Other active direct buyers include the Ford Foundation, the William and Flora Hewlett Foundation, and the Rockefeller Foundation.

Large endowments adopt secondary programs primarily for portfolio management purposes like rebalancing, liquidity generation, and exiting undesirable funds. As sophisticated investors, they also opportunistically target valuations and specialty situations.

Family Offices & HNW Investors

Many family offices and high-net-worth individuals are involved with private equity and venture capital funds directly as LPs. When liquidity needs arise, they may sell secondary stakes using platforms like Forge Global which provides access to accredited investors.

Secondaries offer wealthy individual investors the chance to carefully manage their private market exposures. They also present the potential for boosted returns through opportunistic purchases at favorable discounts.

Fund Managers (GPs)

Even private equity and venture capital firms get involved with secondaries on both sides of the table:

• As sellers, GPs may look to sell or restructure older funds to raise capital for new offerings.
• As buyers, leading GPs have raised dedicated secondary funds to invest across the market much like traditional secondary firms.

Examples include Blackstone, Carlyle, Apollo Global, and TPG Capital. Top-tier GPs active in secondaries demonstrate the maturation of the asset class.

How are Secondary Shares Valued?

The value of private market fund stakes is not as simple to determine as listed stocks or bonds. Here are some key considerations for GP stakes:

1. Net Asset Value Based on Portfolio Holdings

Like mutual funds, private equity and venture capital funds provide periodic net asset value (NAV) updates based on the value of underlying portfolio company holdings. Secondary sellers refer to fund NAVs in pricing discussions.

However, these NAV numbers are just a starting point since they incorporate GP-reported figures and may not fully reflect market realities.

2. Comparable Public Company Multiples

Public market comps offer useful valuation reference points:

• Trading multiples for public companies in the same sector as an underlying private portfolio business provide valuation ranges, adjusted for size and growth differences.
• Average sector trading multiples can also benchmark private company valuations.
• For venture-backed businesses, factors like revenue growth rates strongly inform value relative to public SaaS or internet comps.

Public companies set the valuation ceiling since private market investors expect an illiquidity discount.

3. Precedent Transactions

Previous secondary transactions for the same fund or asset serve as direct value markers. Several factors determine appropriate premiums/discounts relative to past trades:

• Timing – Later transactions command higher pricing as underlying holdings mature and near exit, reducing risk.
• Market conditions – Periods of market exuberance allow higher pricing compared to periods of volatility where discounts prevail.
• Seller motivation – Distressed sellers accept steeper discounts compared to motivated but patient sellers.
• Deal structure – Sellers may accept discounts in exchange for downside protection or earnouts tied to fund performance.

Historical transactions provide a key starting point, which gets adjusted based on the above factors.

4. Portfolio Company Performance

Detailed due diligence provides a bottom-up understanding of portfolio company health to determine fair valuations:

• Operational and financial metrics reveal trajectory and exit readiness.
• Qualitative assessment examines leadership, product/market fit, competitive dynamics, and growth outlook.
• Major business milestones also dictate value adjustments.

Primary diligence validates valuations and may lead to further discounts or premiums versus top-down benchmarks.

5. Qualitative Factors

Several qualitative factors impact pricing negotiations:

• GP reputation and track record – Stakes in funds managed by top-quartile GPs trade at premiums.
• Expected return prospects – Better growth outlooks warrant higher valuations.
• Strategy relevance – Fund stakes aligned with attractive sectors or geographies garner higher pricing.
• Ease of exit – Fund portfolios with near-term liquidity potential command higher valuations.

Both quantitative models and qualitative judgments come together to reach agreed pricing. Absolute valuation matters, but relative value versus alternatives ultimately determines if a deal strikes the right balance to get done.

What are the Key Risks for Secondary Buyers?

While secondaries offer advantages, they also come with downside risks that buyers must consider:

1. Adverse Selection

Since sellers aim to offload unattractive exposures, the most appealing assets rarely come to market. Bottom-performing funds are overrepresented. Without proper diligence, adverse selection can saddle buyers with duds.

2. Information Asymmetry

Sellers inherently know more about underlying assets than potential buyers. This information asymmetry favors the sell side. Without access to fund data or the ability to conduct due diligence, buyers may overpay for assets whose issues are obscured.

3. Pricing Risk

As secondary deals remain private transactions, pricing efficiencies are inferior to public markets. Errors in comparative valuation analysis or qualitative judgments can lead to overpayment. And illiquidity makes exit difficult if assets underperform.

4. Timing Risk

Secondary purchases early in a fund lifecycle require the buyer to stay invested until maturity with no control over exit timing. The interim period brings performance uncertainty and exposure to macro volatility.

5. GP Cooperation Risk

Lack of cooperation from existing GPs who prefer to select their own LPs creates headaches. At a minimum, tense relationships can impede diligence and communication. At worst, GPs may try to block or force buybacks of secondary stakes.

Appropriate mitigants exist for each risk, but regardless, secondary buyers must incorporate prudent risk management practices within their investment processes.

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Key Takeaways

And with that, we’ve covered the key facets of the sophisticated secondary market for private equity and venture capital assets. Here are the key takeaways:

• Secondary sales enable private market LPs to exit stakes in funds prior to the end of long contractual terms by selling to new LPs. This provides liquidity and flexibility.
• Buyers utilize secondaries to gain access to mature, high-quality funds and assets often unavailable in the primary market. Acquisitions can also be made at favorable discounts.
• A dynamic marketplace has developed with over $100 billion in annual transaction volume. Participants include dedicated secondary funds, pensions, endowments, sovereign wealth funds, family offices, and GPs.
• Complex valuation methodologies incorporate quantitative models based on portfolio company fundamentals as well as qualitative judgments of asset quality.
• Risks include adverse selection, information asymmetry, pricing errors, timing uncertainty, and GP cooperation issues.
• Overall, the secondary market strengthens the private equity and venture ecosystem by improving liquidity, pricing transparency, and capital mobility across top-performing funds and assets.

Private equity secondaries remain an exclusive arena, but hopefully, this explanation has shed some light on this fascinating corner of finance. Understanding how others profit can often lead us to opportunities of our own!