Thao Le and Stephanie Pindyck Costantino discuss the evolving landscape of secondary transactions in the private equity market.
In this episode of PE Pathways, Thao Le and Stephanie Pindyck Costantino discuss the evolving landscape of secondary transactions in the private equity market. They highlight the significant growth in secondary transactions, the nature and impact of secondaries, and the dynamics of LP-led and GP-led secondaries. The conversation covers the complexities and regulatory considerations and emphasizing the importance of third-party valuations and proper documentation. The episode concludes with a reflection on the future of the secondary market which will be driven by institutional players and sophisticated LPs.
PE Pathways — Evolving Landscape of Secondary Transactions in Private Equity
Speakers: Thao Le and Stephanie Pindyck Costantino
Aired: February 25, 2025
Thao Le:
Welcome to our PE Pathways podcast series where experienced dealmakers share their thoughts on current private equity and M&A trends and developments. Today, we are going to discuss secondaries. I'm Thao Le, a partner in our firm's private equity practice. In my practice, I focus on both private equity, M&A transactions, and fund formation matters. We have the good fortune of Stephanie Pindyck Costantino joining us today. She's a dear friend of mine and a fellow partner. Steph, do you want to introduce yourself a little bit?
Stephanie Pindyck Costantino:
Thao, thanks so much for having me join you today. I'm also a partner at Troutman Pepper Locke, and I spend most of my time on private investment fund formation and regulatory matters. I'm really looking forward to spending some time today speaking about secondaries.
Thao Le:
Great. Why are we even talking about secondaries? I think it's good to give the audience a little bit information as to where we are in the private equity industry and what secondaries are. But to start with, I think it's a good fact to take a look at what was happening in 2020 when secondaries only accounted for about $60 billion at its peak in secondary transactions to a height of about $134 billion in 2021.
Today, we're looking at the secondary transactions. We're looking at a lot of money. In the first half of 2023, there was about $48 billion in secondary transactions. That has grown to about 43% when you compare the first half of 2024, which shows what the marketplace is at $68 billion. Now, I've thrown a lot of numbers out of the audience, but what does this really mean, and how does it affect the private equity industry? Steph, why don't we just start with a level set question and describe what is a secondary? What does it really mean?
Stephanie Pindyck Costantino:
Sure. I think, historically, a secondary transaction was really looked at as a sale and purchase of existing interests in what we looked at as an illiquid private investment fund. This was most often done by a private equity or venture capital firm from one investor to another. However, I think the market has really expanded and so has the definition.
Secondaries have evolved to be more complex and a key component of portfolio diversification and allocation for funds and managers as a whole. Secondaries often include now the sale and purchase of an investor's existing interests in portfolio companies. I think investors and managers are looking for opportunities across the board, really agnostic to the industry.
Thao Le:
Yes, Steph. You mentioned a number of things that was quite interesting. You were talking about asset allocation, whether it's a GP-led or an LP-led. But do you think the industry is being driven from the sponsor side or the LP side? Because I know that in our experience and in our practice, we deal a lot with LPs, institutional high-net-worth in LPs, family offices. It seems to me that LPs on an institutional basis are much, much more sophisticated and that secondaries seem to be a tool in their pocket. What do you think about that?
Stephanie Pindyck Costantino:
I think the market really sees both LP-led secondaries and GP-led secondaries. Just so the audience understands and appreciates it, I think an LP-led secondary is a transaction where a limited partner sells their interest in a fund typically to another LP or a secondary firm. I think we're still seeing a number of LPs out in the market for a number of reasons, whether that be COVID or what they refer to as COVID hangover or other types of reasons for illiquidity.
You're seeing LPs really seeking potentially what we would say alternative paths of liquidity. That's why you're seeing, I think, an uptick in the LP-led secondary market, right? You're seeing funds potentially looking for additional extensions as they're finding it potentially difficult to exit portfolio companies or really maximize their return, so they might be looking to extend their terms.
With regards to certain institutional LPs, they may be up against other term limitations or other limitations or need for liquidity that leads them to really seek the LP-led secondary. I think with regards to GP secondaries, I'll let you speak to that a bit. But I think we're seeing an uptick in GP secondaries, whether that be a sale of an LP interest in a portfolio company or a continuation fund. I'll let you speak about that a bit more.
Thao Le:
Yes, certainly. I think that we are seeing in the marketplace a lot of GP-led secondaries, and they become very complex in structure because it's not just a simple, "Do I help my LPs sell a portion of their interest to another LP or to another institutional investor," to being something that's much more sophisticated that talks about a continuation fund, which it is what it sounds like, right? It's a continuation of an existing fund in its portfolio investments but in some other type of structure.
You’re seeing GPs do that because the private equity market as where we are today, when you think about it, is that a number of these funds are at a vintage where they've gone through their investment period. They've gone through their investment or the term of their fund life, and they've gone through the extension. You're seeing LPs demand some form of liquidity or winding up of the fund, but you have a general partner saying, "No, I still believe in this asset. Please give me a little bit more time and allow me to nurture this investment for a bigger return for you.”
What you're seeing then is that you have a GP will then say to negotiate with their LPs, and so we can give you some partial liquidity by raising money in a special purpose vehicle to provide cash to basically fund the purchase of an LP’s interest either in a fund or more commonly seen in a specific portfolio company. I think it's pretty interesting to see the dynamics of that happening when you see the dynamics of the fund arranging this type of SPV continuation transaction to fund a redemption of partial interest in a portfolio company and seeing the dynamics of how that works with the management team that's still at the portfolio company.
Stephanie Pindyck Costantino:
Yes. I think building off of that, I think we're also seeing an increase. I think it's really interesting to see an increase in somewhat of like a niche fund that's an outgrowth of those types of continuation funds, where you're seeing general partners potentially concentrate on a couple of portfolio companies and then build a fund around those, right? They'll seed it with those couple of portfolio companies that they will roll, so to speak, in what we would potentially call a continuation fund, and then build the new fund around a theme. I think the market is really appreciating that. We're seeing institutional LPs, and especially family offices really like that type of vehicle.
Thao Le:
The great thing that we talk about here is the creativity within the private equity market to be able to do continuation funds, SPVs, or what we call special purpose goals and giving partial liquidity. But it always makes me wonder in the back of my head with the SEC's agenda in the past. You don't know what the SEC is going to do now with the new administration. But the SEC has always been critical of the private equity industry, wondering whether or not you're continuing an existing investment just to collect management fees and potential carry.
With that backdrop in mind, Steph, what are you seeing or thinking that we should be advising people to think about when they're thinking about doing a continuation fund or creating some type of partial liquidity with a portfolio company like that?
Stephanie Pindyck Costantino:
I think oftentimes when you're looking at any sort of liquidity option, and especially if the GP is on both sides of the transaction, I think valuation is really important, right? Value is always going to be something that people are keenly aware of and very focused on, whether that be a regulator or a limited partner or otherwise, right? When a general partner is on both sides of a transaction, you're going to really want to understand and appreciate where your value is coming from.
Oftentimes, we would strongly recommend that the third party is involved in understanding and appreciating where the value comes from and striking value. When we look at the third-party valuation recommendations in these types of transactions, we really look for the presence of a third-party value, for example.
Thao Le:
I think that's fair. One of the other reasons why you want the third-party valuation is in situations where this type of transaction might even be viewed as an event that would crystallize the carry, and what do you do when the carry is actually crystallized? As an institutional LP, do you force the GP to say, "Wait a minute. You can't just get out with your carry. You got to reinvest that into this investment as well."
Stephanie Pindyck Costantino:
Right. Like you mentioned, Thao, I think you have to think about that's part of the transaction documents and part of the negotiations is how much you roll and how much you crystallize. I think that we get into some of our favorite discussions, right? I think you're opening up the question about conflicts, right? I think conflicts, I think a topic that is front of mind for everyone, again, whether you be a regulator or otherwise. I think you always have to be mindful of what the conflicts are, whether they’d be inherent in the structure themselves or just the appearance of conflicts.
I mean, I think some of the things we think about always is, is it just the appearance of conflict? How do we have to go about even mitigating that before the conflict actually occurs? I mean, I think I'm looking at that in how we've evolved, how the market has evolved, just understanding and appreciating the backdrop of which the regulation and otherwise.
I mean, when we look at where we were to where we are now, where continuation funds first came out and then now where we are, I think it's really an amazing trajectory. When you think about the secondaries market from where it was to where it is now, what do you think about that?
Thao Le:
I think that it has evolved quite a bit, and it's become, I think now, a part of the permanent arsenal for GPs and LPs in managing their portfolios and ensuring diversification. I think that given how GPs are seeing this as part of their pocket and their tools in their pocket, it makes it very interesting on how do you manage that conflict and how do you make that disclosure. Because I think what we're going to see in the next evolution of fund documents is that you are going to have disclosure about this type of scenario in your PPMs. You may have language in your partnership agreements that give the LPAC authority to go over the potential conflicts and possibly cleanse it.
Now, whether that's sufficient from a cleansing perspective is always going to be viewed at in hindsight and whether or not the SEC is going to think that is sufficient. Again, I mentioned earlier is that we are coming through with a new administration, with a different agenda as to how much government involvement is going to be in businesses and depending on who may become the new SEC chair, whether or not this is still going to be a priority of conflicts and conflict of interest management for the SEC is an open item.
But I do think that managers and GPs should just be proceeding as if the conflict of interest rules continue to be heightened and a source of focus for any type of administrator because it really makes them think about what is in the best interest of their LPs and to exercise their fiduciary duties.
Stephanie Pindyck Costantino:
Yes. No, and I think that's fair enough. But I think the changing of the administration will be, I think, interesting, and we'll see what happens. I think we'll see what ripple effect there is with regards to the regulatory regime. But I think taking a step back and looking at the broader kind of evolution of the secondaries market in general, I think it's amazing to see the trajectory that has happened, right? How it started really as kind of a niche strategy, which was really kind of a liquidity tool. To your point, right now, it's become really, I would say, a permanent part of a manager's – you use the word arsenal, right? So to speak, like a tool they can pull out and think about or at least consider in a conversation, whereas before it was more of, I think, a niche. Just how I think also maybe it was something that was maybe second or third what they thought about. Now, it's become much more legitimate as they really consider about secondaries and how it kind of grows.
Then I think also it's really important to think, even if there is a relatively new regulatory backdrop or if there are substantial changes. I mean, I'm not sure that'll change allocation or the growth of how this occurs. It might change how they occur, but I don't think the growth we're seeing, I don't feel like that that will necessarily slow down right now. What do you think about that?
Thao Le:
Yes. I agree with you. I don't think that there's going to be a slowdown of the growth. I think you're going to have a bit of a supply and demand issue. I think that the supply may be dwindling a little bit. I say that with a very, very big footnote and caveat. I make the observation about a supply and demand issue is because you have very big institutional shops that have created mega funds to be focused on secondaries, that their investment strategy is secondaries.
These mega funds are able to write huge checks to come into the marketplace and be a very active participant in driving what you may see as market terms for secondary transaction. It is going to be a permanent type of strategy that we're going to see in investment objectives and strategies disclosures. With the institutional players that are creating funds focused on secondaries, you have institutional investors who are savvy. Maybe even pension plans, for example, that are state pension plans that have their own investment management team within pension fund, looking at secondaries as a tool.
A big part of our discussion had been about the LPs and the GPs wanting liquidity and getting that secondary type of transaction. But now, it's kind of the tide shifted a little bit that we're now focused a lot more on the institutional players that are creating vehicles, creating special purpose vehicles, that they are the driver of the secondary transaction and coming to the table, per se, to say, “We're here to play. We think that secondary transactions is a very viable and legitimate type of portfolio management investment tool that we want to make it as part of our vehicle.”
I don't think that this industry, the secondary industry, is going to go away. I think it's going to be enhanced. You also see at least one player that I know has a platform to help facilitate secondaries where smaller LPs can put their LP interest on the secondary platform to be sold. Like I said, I don't think it's going to go away.
Stephanie Pindyck Costantino:
If I'm an investor or a general partner or an LP, and it's the beginning of 2025, and I'm trying to think about what are my key takeaways about the secondary market, what are the things I need to think about most, so I would say I need to think about valuation. I need to think about conflicts. I think what are the key ways that you would say to any of those three parties that they need to take away with regards to secondary market.
Thao Le:
Yes. If I'm representing an institutional LP or just an LP that's looking at fund documents that they're about to invest in, I would say we need to take a look at the disclosures and see what the GP is saying as to what they can do with secondary markets. Is anything in this fund that I'm about to invest in a residual portfolio company from a prior fund? I only say that from a perspective of do your diligence LPs and make sure you understand what you're getting into. Do we have a GP that is taking into consideration the balance that they need to do when they're with conflicts of interest and things of that nature when they're talking about secondary transactions? It’s LP be informed on that.
From a GP perspective, I would say, GP, you need to be savvy and understand that your LPs are getting much more sophisticated, and this is something that they're going to be asking for. To be able to have the flexibility to do secondary transactions from a GP perspective, I would need to make sure that I have the appropriate procedures in place that allow me the flexibility to do so with the proper of cleansing any type of conflicts in an efficient manner.
I think it's just making sure that we document, document, document, because it is a hindsight review that's always going to happen if the SEC should come in. Even in a routine exam, as you and I know very well, Steph, routine exams are never routine. But it's one of those things where you want to be able to tell the story to any type of examiner as to your decision making from a GP perspective as to why the secondary transaction was done, what were the factors that were considered in determining and cleansing conflicts, how they got a third party involved to do valuation.
I just think that the key takeaway for me is that this is a niche area of secondaries that is going to be much more normalized, and it's going to be an issue that we all have to plan for from both the perspective of a GP and an LP.
Stephanie Pindyck Costantino:
I definitely agree.
Thao Le:
Any final thoughts, Steph, for our audience before we wrap up?
Stephanie Pindyck Costantino:
No. I would just say that, ultimately, I think secondaries is an incredibly interesting market. I think that it's interesting, and there's a lot of opportunity for whether you'd be a GP, LP, or an investor. It's definitely a market that will continue to see a lot of growth over the course of 2025 and beyond.
Thao Le:
I completely agree. Well, that's a wrap for today's episode of Private Equity Pathways. We'd like to thank our listeners for joining us on this episode. We hope that you can join us on our next episode of PE Pathways, a podcast series where experienced dealmakers share their thoughts on current private equity and M&A trends and developments.
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