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The rising prominence of secondary private equity deals has become a significant concern. Institutional investors with private capital investments in their portfolios are actively seeking ways to reduce them. These so-called “limited partners” are utilizing the increasingly expansive secondary market to sell their stakes in buyout funds or portfolio companies. This trend is expected to exert pressure on the substantial fees charged by private equity firms.
Private capital has been under strain for some time. Challenging market conditions have made it more difficult to secure profitable exits. The traditional fee structure known as “two and twenty,” which refers to annual management and performance fees, is no longer widespread. A Financial Times report indicates that private equity fundraisers are now offering discounts to attract large investors.
Up until July, private equity fundraising has declined by over a third compared to the previous year. Preqin reports that fund management fees, excluding expenses, were a mere 1.4% last year.
The combination of rising interest rates and weak performance in the public equity market during the past year has prompted institutional investors to exercise caution when considering additional private holdings. Speculative bets on the abilities of portfolio managers in illiquid markets are losing their appeal.
Interestingly, funds specializing in secondary transactions are not facing difficulties in raising capital. In fact, secondaries’ fundraising has already surpassed $47 billion this year, outperforming the entire year of 2022. This amount represents more than a tenth of the total private equity funds raised. There is a possibility that this year’s total could surpass the 2020 record of $79 billion in secondaries.
Although this may sound peculiar, it reveals that new money has entered the secondary market in search of attractive deals at the same time motivated sellers emerge. However, differing expectations among parties involved often lead to challenging negotiations and deal closures, according to experts.
The opaque nature of private capital may partially account for this. The general partners, i.e., the buyout executives themselves, have little incentive to lower the prices of portfolio companies to reflect higher risk-free rates of return and decreased equity market values. Conversely, potential buyers of secondaries have strong reasons to reassess their value significantly.
This puts limited partners in a difficult position, as they are eager to exit investments but hesitant to accept substantial discounts.
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