The diversification and distribution attributes of the once niche asset class may make it ideal for a core private markets holding in a workplace pension scheme
Many UK defined contribution (DC) pension schemes have been held back from allocating to private markets due concerns around illiquidity, but the attributes of the growing asset class of private equity secondaries may provide a solution to the issue.
DC funds would otherwise have a liquidity mismatch, as members can theoretically withdraw their money from individual funds at any time while private markets investments can take a long period to unravel. However, the growth in the private equity secondaries market may be rapid enough to offer a viable source of private markets exposure while alleviating the liquidity concern.
Data compiled by Lexington Partners found that transaction volumes in secondaries had a record year in 2024, which it estimated to be in excess of $150 billion globally compared to $113 billion in 2023.
Philip Smelt, managing director, Lexington Partners, said investing in a LP-led secondaries fund, where a secondaries house buys stakes in ongoing private equity funds from existing LP investors, provides the benefit of huge diversification as well as potentially superior performance and distribution.
“The beauty of investing as a secondary buyer is that you get all the information on the existing funds,” he said. “You get information on the companies and the funds, so you can compare their performance and look at their history.”
He said his firm builds valuation models based on previous experience and spends considerable time discussing investments with the GP. “It pays to really understand the outlook for every single company that we’re buying into,” he said.
“We are in a far better position coming in late than the LP that went into the original fund. We’ve got a nice advantage. We bring all the information together and reset the valuations of assets, building that into the price we pay.”
These discounts mean the secondaries fund can offset some of the primary fees, allowing investors to gain exposure to private equity performance a potentially lower cost.
The diversification within LP-led secondaries funds is typically far better than in primary funds as they are composed of a wide variety of LP stakes in funds, which in turn are also diversified.
Gareth Doyle, Principal Consultant, Barnett Waddingham, said: “If you believe private markets can outperform public markets over the long term, and see private equity and subsequently secondaries as being a primary growth driver, you want members to have high exposure from a young age… As long as we make sure the platform is capable of addressing the liquidity issue.”
Liquidity is improved because secondary investments are made often several years into the life of the primary fund, well into the investment phase and perhaps close it starting to return capital. Secondaries funds are also likely to be made up several different vintages, with underlying funds maturing at different times.
Jake Williams, head of international product strategy, Franklin Templeton, said: “There’s certainly a role for secondaries to play throughout the glidepath. Secondaries demonstrate liquidity and [improved] dispersion of returns. Dispersion materially drops in private equity, compared to listed equity, but when you move into secondaries there’s definitely an improvement to dispersion.”
The benefit of the secondary approach is that the secondaries manager not only understands the underlying portfolio but also has a relationship the primary manager, according to William Martinez, a senior vice president and investment advisor at Apex Group. “It’s important to note that not all secondaries are created equal. It’s very important to have the ability to discriminate between very high-quality deals and those that are less so,” he said.
Martinez cautions that it is also important to diversify geographically to achieve sectoral diversification. “If you were to focus purely on the UK you would end up being underweight in healthcare and overweight in fintech. So reducing the opportunity set to focus purely on the UK might not be desirable.”
Added Smelt: “The beauty of secondaries is that groups like ours have been doing this for many, many years and we know the industry inside out. We know all about the finances and have the commitment, relationships and expertise to offset a lot of potential issues.”