A secondary fund transaction is a deal in which an investor buys an existing interest in a private investment fund, or a portfolio of a fund's holdings, from a current owner. It contrasts with a primary commitment, in which an investor agrees to put money into a new fund as it is being raised. Because private funds are closed-ended and typically run for ten years or more with no right to redeem, a secondary sale is the main way for an investor to leave early and for a buyer to gain exposure to a portfolio that is already largely invested.
The market grew up around private equity buyout funds and now also covers venture capital, private credit, infrastructure and real estate funds. Sellers are usually institutions such as pension funds, endowments, banks and insurers; buyers are mostly dedicated secondaries funds, along with a fund-of-funds or large institution buying directly.
Main types
Transactions fall into two broad groups:
- LP-led transactions. A limited partner sells its interest in one or more funds. The buyer takes over the seller's capital account and its remaining limited partner commitment, including the duty to meet any future capital call. The fund and its manager carry on unchanged.
- GP-led transactions. The fund manager arranges for one or more assets to be sold from an existing fund to a new vehicle that it also manages, financed by secondary buyers. Existing investors are offered a choice between taking cash and rolling their interest into the new vehicle, known as a continuation vehicle.
Other forms include tender offers, in which a buyer offers to purchase interests from all investors in a fund at a set price, strip sales of a share of a portfolio, and preferred equity financings that provide liquidity without an outright sale.
Pricing
Prices are quoted as a percentage of the fund's reported net asset value at a reference date, usually a recent quarter end. A price below 100 per cent is a discount and one above is a premium. Buyers form their own view by valuing the underlying companies, forecasting the timing of future distributions and deducting the manager's fees and carried interest. Discounts tend to widen when public markets fall or when many investors want to sell at once, and to narrow for high-quality, recently valued portfolios.
The purchase price is adjusted for cash flows between the reference date and closing: capital contributed by the seller in that period is added, and distributions it received are deducted. Payment of part of the price may be deferred.
Process and administration
An interest in a private fund cannot be transferred freely. The fund's partnership agreement normally requires the consent of the general partner, and may give other investors a right of first refusal. The buyer must pass the fund's investor checks, including anti-money laundering and tax documentation. Larger sales are run as auctions by specialist advisers.
On completion, the parties and the manager sign a transfer agreement, and the fund administrator records the change in the investor register, reassigns the capital account and directs later notices to the buyer. This work is part of private equity fund administration. Transfers are commonly timed for a quarter end to simplify the accounting. Distributions continue to follow the fund's distribution waterfall, with the buyer standing in the seller's place, and any clawback provision affecting past distributions is allocated between buyer and seller in the sale contract.
Why investors use secondaries
Sellers use the market to raise cash, to rebalance when private assets have grown too large a share of the portfolio, to reduce the number of manager relationships, or to meet regulatory changes. Buyers are attracted by shorter holding periods, since the funds are already several years old, by the ability to see the actual assets before investing, and by the possibility of buying at a discount. Because distributions arrive sooner, secondaries can soften the early period of negative returns that new fund commitments usually show.
Conflicts and regulation
GP-led deals raise a conflict of interest, because the manager sits on both sides: it sells the asset on behalf of the old fund and buys it on behalf of the new vehicle, from which it will earn fresh fees. Industry bodies such as the Institutional Limited Partners Association have issued guidance calling for a competitive price-setting process, adequate time for investors to decide, and review by the fund's advisory committee. An independent fairness or valuation opinion is commonly obtained. Securities regulators, including the US Securities and Exchange Commission, have examined these transactions as part of their oversight of private fund advisers.
Other criticisms concern valuation. A buyer that purchases at a discount may mark the interest up to the fund's reported value soon after closing, producing an immediate accounting gain that does not reflect any cash received.