Secondary funds are gaining traction in Luxembourg’s private equity market. Unlike primary funds, secondary funds invest in assets that have mostly completed their investment periods. Their rising popularity suggests “there is some tension in the market as players search for liquidity or focus,” said Gregory Beltrame (photo), partner in the private equity and real estate practice of Luxembourg law firm Arendt & Medernach.
The standard exit routes for private equity investors are restricted by macro-economic uncertainty, with investors wary about both stock market floatations and buy outs. General partners - the GPs - are keen to protect promising assets in portfolios that might be being weighed down by investments with less potential. Secondary funds offer that possibility.
Health, food and infrastructure
Transferring these assets to a new fund highlights their value and gives existing or external limited partners - the LPs - opportunities to back the most prized growth businesses over a longer timeframe. According to Beltrame, assets making innovations in the health, food, supply chain and infrastructure sectors are seen as having particular promise.
On the LP side, it is often the search for liquidity that is not otherwise achievable which is driving requests for assets to be sold to secondary funds. Even if the asset has to be sold at an apparent undervaluation, some investors need to cash-out. Alternatively, these funds can be used for opportunistic reasons, selling at a price that exceeds investors’ assessments.
In recent months, Beltrame sees about two-thirds of secondary fund transactions being GP led. This is a turn-around from the late 2010s when it was largely an LP driven formula. This change might be due to LPs being less willing to sell during what may be a temporary market dip, while GPs will be keen to ensure their funds are attractive to new investors.
Two types of funds
There are two broad types of secondary fund. Multi-asset funds take over investments in one or several primary PE funds. Alternatively, there are “continuation funds” which will often feature just one or a couple of prized assets that GPs and LPs decide they want to stay committed to. Overall, though, these transactions are becoming more nuanced and sophisticated to suit the needs of different investors and assets.
This is a step towards greater flexibility in the alternatives sector, enabling GPs to become more like active managers. “It is a way for investors or GPs to diversify or to secure a portfolio,” said Beltrame. For example, funds could be made more thematic in terms of sector or geography, depending on the prevailing economic outlook, or, conversely, in a desire for greater diversification. Furthermore, these moves can be made with the benefit of greater knowledge, as working with the underlying companies gives GPs and LPs greater understanding of each asset’s potential.
‘Public markets not in good shape’
Luxembourg is benefitting from this trend. As the main European hub for cross-border PE funds, specialists see no reasons for choosing another jurisdiction for this work. Fund houses have their main funds and teams here, so making the switch to secondaries a relatively easy process that can happen in a couple of weeks.
Yet Beltrame is cautious about the implications of this trend. “Yes, it is good to show that Luxembourg is sufficiently flexible to handle this diversity and generate new option. But it is also a sign that public markets are not in good shape and this has to be a concern for everyone,” he said.
A symptom of this nervousness are the more detailed negotiations that take place before secondary funds are established. “These are taking very much longer: this process used to take a couple of weeks but now takes about a couple of months,” he said.
Fair valuation challenge
Yet even despite this growth, this remains a niche activity. In this interview for the Luxembourg Private Equity Association newsletter, Remco Haaxman of the secondary fund specialist Coller Capital said market volume for these vehicles was around 130 billion dollars in 2021. Although this was double the figure of five years previously, it is a small fraction of the estimated four trillion dollar global PE fund market.
As for potential pitfalls with this strategy, Beltrame cites the related questions of asset valuation and potential conflicts of interest. “The fair valuation of assets is a challenge, but in this business the NAV is not the only reference. A real commercial negotiation takes place between the seller and buyer,” he said. On top of this comes concerns about when assets are moved to a new fund, ensuring that LPs invested in the primary fund are not disadvantaged as regards their access to and investment share of the secondary portfolio.