Why the second-hand private equity market is thriving

AT MIDNIGHT ON August 31, 1602, the public offering of shares in a new type of company was closed. The charter for the company, the Dutch East India Company, granted it a monopoly on trade with Asia until 1623, after which it was believed the company would be liquidated. Twenty-one years is a long wait for capital return. Smaller maritime enterprises were generally liquidated and the spoils divided after three or four years, when (and if) the ships returned. Shareholders were therefore given an option to pay out after ten years. It hardly mattered. A faster exit route soon became available.

The merchants who gathered daily around Amsterdam’s Nieuwe Brug to trade spices and grains appeared willing to buy and sell shares. These developments are told in The Worlds First Stock Exchange, by Lodewijk Petram, a historian. One of the many lessons from the books is that wherever there is a primary market for a new type of asset, there will soon be a secondary market.

There is a contemporary analogy in the treatment of interests in private equity funds. The limited partners in such ventures, the pension plans and the state funds that provide capital are basically tied for the life of the fund, which is usually ten years or more. The reality is different. A booming secondary equity market has emerged, negotiated sale of limited partner shares, while private equity has matured. Today’s private equity investors are no more tied to their obligations than the Amsterdam citizens of four centuries ago.

Secondary markets are initially driven by wealth owners who really need the money. The earliest sales on the Amsterdam stock exchange were usually by merchants who could not afford the promised subscription. In private equity, the early secondary transactions were typically emergency sales. They often received huge discounts of 25% or more on the appraised value of the assets in the fund.

Over time, the stigma of selling out has dissipated: In 2019, approximately $85 billion in bets changed hands. The reason for selling an interest is often strategic these days. It may be to rebalance portfolios on a geographic, sector or vintage basis, for example for risk management reasons, or to reduce the number of relationships with the general partners of private equity firms. Many limited partners simply want to manage their private assets as actively as their listed ones. Often, funds will sell for more than the appraised value of the companies in the portfolio.

Over the past decade, there has been a trend towards secondary transactions led by general partners, says Andrew Sealey of Campbell Lutyens, a consulting firm. It may be that a ten-year fund is about to expire whose general partners are not willing to sell the portfolio of companies because the time is not favorable for a good exit price. However, some of the limited partners will need their money back.

The solution is a follow-up fund. One example was Nordic Capital VII, a fund founded in 2008, which transferred its nine portfolio companies in 2018 to a 2.5 billion ($3 billion) continuation fund. Investors had the choice of selling their shares at a premium to its appraised value or staying in it for another five years. Most chose to stay indoors.

The nascent trading of secondary funds was supported by the rapid growth of specialized funds. Twenty years ago there were only a handful; now there are dozens of them. Five of the top ten private capital pools raised last year were dedicated to specialized secondary funds.

The secondary market attracts large fund managers who want to offer their clients the full range of assets, including private ones. For starters, it looks a lot less busy than the primary business. Anyone can set up a buyout fund, says a fund manager. Funds often compete to buy the same companies. In contrast, a secondary fund is more likely to benefit from expertise. It requires expert analysts and good information gathering to assess an interest in a portfolio of companies when it is put up for sale. The general partners have the right of approval over buyers of second-hand shares. These are high barriers for potential rivals to remove.

Paradoxically, the boom in the shorter-term secondary market has allowed the formal time horizon of private equity funds to stretch almost ad infinitum. In this, as in other ways, private equity follows 17th-century Amsterdam. The Dutch East India Company would have a limited lifespan in the beginning. Nearly two centuries later, it was still going.

This article appeared in the Finance & Economics section of the print edition under the heading “Going Dutch”