Secondary funds, in the context of private equity (PE) and venture capital (VC), refer to investment funds that focus on purchasing existing shares in companies rather than making primary investments. These funds acquire stakes in companies from existing investors, such as early employees, founders, or other venture capitalists or private equity firms. The goal is to provide liquidity to those investors and allow them to exit their positions, while also giving the secondary fund an opportunity to potentially profit from the future growth of the companies in which they invest. In this article, we delve deeper into Secondary Funds.
Typical funds last between eight to twelve years (VC Fund life cycle is typically shorter than a private equity (PE) fund life cycle). In the initial stages of the fund, managers or the General Partners (GPs) of the Fund source deals and invest into companies by using the Limited Partner's (LPs) paid-in capital. The GP deploys most of the LP’s capital within 3-6 years of raising the fund, post which the GP starts selling the stakes to generate profits to be distributed to investors (LPs). This asset class is illiquid in nature for lengthy periods of time. As companies are tending to stay private longer, even the VC investment holding period has also lengthened over the last decade. The primary exit strategy for GPs has traditionally been IPOs (Initial Public Offerings), but with the current market conditions, IPO activity has taken a beating and is expected to be lukewarm. Secondary funds could potentially solve this problem and help investors sell their stakes and realize liquidity sooner, thereby increasing the efficiency of capital allocation. Secondary funds reduce their risks of being early investors by investing money in companies that are reasonably mature. This means that the secondary funds have the advantage of analyzing past performance of companies and hence being in a better state to calculate future value potential of the underlying companies.
VC secondary funds specifically focus on buying existing stakes in venture-backed companies. They provide an avenue for early investors and employees of start-ups to sell their shares before the companies go public or get acquired. VC secondary funds can also purchase shares from other VC funds that are looking to exit their investments to return capital to their limited partners (the investors in their funds).
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PE secondary funds, on the other hand, focus on acquiring stakes in private equity-backed companies. These funds buy interests in companies that have already received initial investments from private equity funds and are at a more mature stage compared to early-stage startups targeted by VC secondary funds.
Secondary transactions can be structured in numerous ways and can vary based on the specific circumstances and the stakeholders involved. However, broadly we can categorize them into three types.
A LP secondary transaction, also known as an LP interest transfer or LP stake sale, is a type of secondary transaction in the private equity and alternative investment space. In this transaction, an existing limited partner in a private equity fund sells some or all their ownership interest (also known as LP interest) in the fund to a new investor. The buyer of the LP interest becomes the new limited partner and assumes the rights and obligations associated with that ownership stake.
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GP-Led transactions refer to secondary transactions in the private equity space where the existing fund's GP initiates and drives the sale or restructuring process. In these transactions, the GP plays an active role in finding a new investor or facilitating the sale of the fund's assets to provide liquidity to LPs or to extend the fund's life to maximize value for investors. Existing LPs have the option to either ‘roll-over’ or cash out the interest to a secondary buyer. GP-led transactions can take various forms, such as single-asset sales, continuation funds, or other restructuring arrangements, and they have become increasingly popular in the secondary market as a way to address liquidity needs and optimize investment outcomes.
In direct secondary transactions, investors purchase direct stakes in private companies or assets from existing shareholders, rather than buying interests in funds. Direct secondary transactions allow investors to gain exposure to specific companies or assets without going through the traditional primary fundraising process. It provides liquidity to existing shareholders and offers incoming investors access to private assets outside of the primary market.
