Secondary Funds Signal: Companies' Troubles Are Investors' Opportunity

Cold water has been poured on the global economy. A confluence of events and shifts in the macroeconomic environment — chief among them a sharp and sustained rise in interest rates in response to an inflationary surge — has created a reality that is the reverse of what the business sector had grown accustomed to for over a decade. For as long as interest rates hovered near zero, companies, executives, and investors enjoyed easy access to capital, primarily through banks and traditional financing bodies that generously distributed funds and contributed to a near-unlimited supply of cheap, available capital.

But when interest rates rose, the reality reversed — and quickly. Money became more expensive, more limited, and far less accessible; liquidity sources dried up accordingly. Investment and financing bodies tightened their belts, debt costs rose significantly, the flow of investment into companies slowed, fundraising volumes shrank, and cash flow difficulties began emerging even among those who had long enjoyed well-cushioned capital reserves.

This combination of factors, and the vacuum it created in the market, led to the convergence of two parallel processes: while companies and asset owners faced an immediate and sharpened need to diversify and access alternative liquidity sources, shifts were also registered in the PE market. Strategies previously considered marginal expanded their operating zones and reshaped the balance of power in the market.

Secondary Funds Claimed the Top Spot

Against the backdrop of market conditions and the acute liquidity crunch, secondary transactions gained enormous momentum, emerging as the leading investment strategy in the Private Equity world in 2023 in terms of fundraising volumes ($91.2 billion) — a trend that also characterizes 2024, which is shaping up, so far, to potentially become another record year for the industry.

But before diving into numbers and data, a brief explanation of the secondary market. The secondary market allows managers and investors to step into the shoes of holders of stakes in private assets and companies. In practice, the secondary market creates a liquidity solution for the non-traded world: unlike the public market, where shares are traded continuously and transactions occur at any given moment — making it easy for shareholders to liquidate their holdings — in the non-traded market, asset holders face a problem, as they cannot sell their assets on a continuous basis. This is where the secondary market was born: a kind of enormous “second-hand” market spanning many sectors, one where the volume of such transactions expands significantly in a challenging economic environment that amplifies the need to generate liquidity through asset sales, both traded and non-traded.

Evidence of this comes from the private equity sector, where last September saw a record for assets under management (AUM) that approached the $6 trillion threshold. Of this sum, the secondary market accounted for approximately 6.5%, reflecting an increase of half a percentage point compared to the previous year. The reason for the growth, as noted, lies in the answer secondary funds provide to holders of non-traded assets — one that becomes increasingly necessary during periods of liquidity stress.

A Window of Opportunity

At StepStone, one of the world’s largest asset management firms, analysts explain that the macroeconomic climate has affected pricing dynamics in the market, which were characterized by a certain narrowing of discount rates in secondary transactions throughout the first half (H1) of the year. The primary reason lies in the abundant supply of liquid capital competing for investment opportunities in high-quality underlying assets, alongside a sustained bull run in the public markets that also feeds into pushing valuations and pricing among private companies (PE).

However, StepStone also presents the other side of the coin, clarifying that while the discount is modest relative to previous years, it is clear that the deal flow currently being examined features potential investment assets of very high quality — assets that embody a significant opportunity for value realization, one that will allow patient investors to reap the rewards further down the road.

In fact — and this is the crucial point — the macroeconomic shifts have sharpened the immediate need of asset owners, managers, and companies, however mature and established they may be, to locate alternative liquidity sources. Their ability to clear the hurdles and keep the wheels of business turning during an economically uncertain period depends greatly on access to liquid capital. This means that those sellers are not necessarily selling their holdings out of desire, but rather out of an immediate need to reduce leverage and generate liquidity — which also explains the discount embedded in the price at which the asset is sold.

In Summary

In the current era, we are witnessing an investment market that is different from the one we knew in the past. The interest rate environment has stabilized, but remains elevated and is expected to decline gradually over the coming years. At the same time, the stock market has seen exceptional years in terms of performance, which has created a natural fear of a sharp correction that could be coming. The collection of changes and trends amplifies the importance of secondary transactions in the private market, which is expected to develop wherever liquidity solutions are needed — and it is therefore likely to extend beyond the PE world into debt markets and real assets in the years ahead. All of this together reflects the fact that while the economic environment piles difficulties on one side, for others it creates exceptional business opportunities — and at the doorstep of sophisticated investors now stands the chance to translate that trend into an investment.

The author, Inbar Steiner, is a Managing Partner at the strategic advisory firm Value Global, part of the Value Advanced Investments group. This article does not constitute investment advice.