Types of Secondary Fund Deals

Secondary funds play a pivotal role in providing liquidity in the private equity (PE) and venture capital (VC) markets by acquiring existing shares in companies. Rather than focusing on new investments, these funds buy stakes from early investors, such as founders, employees, or other venture capitalists, offering them an opportunity to exit and cash out.  

This process benefits both the seller, who can unlock capital tied up in long-term investments, and the buyer, who gains exposure to more established companies with proven track records. With companies staying private longer and IPO markets facing uncertainties, secondary funds present a valuable alternative for investors looking to monetize their holdings while still participating in potential future growth.  

In this article, we discuss the different types of secondary fund transactions and the advantages they offer.  

Types of Secondary Fund Deals

Secondary fund transactions are flexible and can be arranged in various ways to meet the particular requirements of stakeholders. Broadly, these transactions fall into three primary categories:  

1. LP-Led Transactions (Fund Level)  

LP-led transactions occur when existing Limited Partners (LPs) in a private equity or venture capital fund sell their stakes, known as LP interests, to new investors. This allows LPs to exit their investments early, providing liquidity. The buyer assumes all rights and obligations associated with the LP stake, effectively becoming the new LP in the fund. This type of transaction enables the seller to free up capital while allowing the buyer to invest in a more mature, diversified portfolio.  

Benefits:  

• Liquidity for LPs: LP-led transactions provide liquidity to limited partners who want to exit their investment before the fund's maturity, offering flexibility in situations where cash flow or rebalancing is needed.  

• Potential Discount for Buyers: Secondary buyers often acquire LP interests at a discounted price, presenting an opportunity to enter high-quality funds at lower costs than the original price.  

Drawbacks:  

• GP Approval Needed: These transactions often require GP approval, and GPs may charge fees or even block sales if they perceive a conflict of interest.  

• Limited Pricing Power: Sellers may have limited leverage in negotiating the sale price, as transactions typically happen at a discount on the original investment.  

2. GP-Led Transactions (Portfolio Level)  

General Partners (GPs) initiate the sale or restructuring of their fund’s assets in GP-led transactions. The GP may offer existing LPs the choice to either sell their stakes or roll them over into a continuation fund. These transactions often involve the sale of a single asset or a group of assets to extend the life of the fund, maximize returns, and provide liquidity. GP-led deals have become increasingly popular as a means to manage liquidity while keeping promising assets under continued management.  

Benefits:  

• Flexibility for GPs: GP-led transactions offer general partners more control over the timing of exits, allowing them to hold onto top-performing assets while providing liquidity to LPs who wish to exit.  

• Potential for Higher Returns: These transactions are often underwritten to high multiples and offer investors the possibility of attractive returns.  

Drawbacks:  

• Less diversification: P-led transactions often involve fewer assets, leading to less diversification and higher concentration risks compared to traditional LP-led deals.  

• Higher Complexity: These transactions can be more complex and involve restructuring, which can lengthen the negotiation process and increase costs  

3. Direct Secondary Transactions (Asset Level)  

Direct secondary transactions involve investors purchasing stakes directly from existing shareholders of private companies. This approach bypasses the fund structure, allowing buyers to acquire equity in specific companies. Direct secondary deals are typically used when early investors, founders, or employees seek to sell their shares, offering liquidity to these shareholders while allowing new investors to invest in established, growing companies.  

Benefits:  

• Direct Exposure to Assets: Investors gain direct ownership in specific companies or assets, allowing them to target promising individual investments without going through intermediaries.  

• Liquidity for Shareholders: Direct secondaries provide liquidity to founders, employees, and early-stage investors, which is crucial for private companies that are staying private longer  

Drawbacks:  

• Valuation Challenges: Direct secondaries often involve unlisted companies, making valuation more difficult and potentially leading to higher risks.  ‍
• Limited Market Access: Not all investors have access to high-quality direct secondary opportunities, and the transaction volumes are often smaller.  

Conclusion  

As we've explored, LP-led, GP-led, and direct secondary transactions offer unique ways to access liquidity, manage risk, and optimize returns.  

LPs can rebalance portfolios or exit early, while GPs can extend fund life or restructure assets for better value realization. Direct secondaries allow investors to target specific, mature assets. However, success in these markets requires careful consideration of liquidity needs, due diligence, and alignment with investment goals.  

As secondary fund transactions continue to evolve, they provide strategic pathways for investors to engage with the complexities of private equity, offering a balance between flexibility and risk management.