The landscape of private investment funds has seen a notable evolution with the rising trend of transfers of interests in private funds on the secondary markets, particularly with respect to closed-end funds or funds that have a lock-up or infrequent redemption windows.¹ This shift is driven by a confluence of factors including the desire for liquidity among current investors and the appeal of attractive terms and entry points for new investors. Secondaries offer a unique opportunity to have a “free look” at a portfolio without the initial “blind-pool” investment risk, providing a compelling proposition for buyers, and a welcome avenue of liquidity for sellers.

Growth of Secondary Transactions

The secondary market for interests in private investment funds has been active for decades and has grown significantly in recent years. During the aftermath of the financial crisis, there was considerable secondary activity as allocators sought to realign their portfolios in response to turbulent markets. Although macroeconomic conditions are vastly different today, the fundamental reasons for engaging in these secondary transactions persist.  For example, many portfolios constructed during market highs are anticipated to require considerable additional incubation before delivering the expected returns. Consequently, some investors are willing to endure short-term losses and/or forgo potential greater growth to reallocate their assets to more immediate and attractive opportunities.  And where investors are invested in illiquid products, secondary transactions provide an excellent solution.

Drivers of Secondary Transactions

The following is an overview of some of the primary reasons that buyers and sellers engage in secondaries:

1. Liquidity for Current Investors: One of the primary motivations for secondary transactions is the liquidity they offer. Investors who need to free up capital for other ventures or who want to reduce exposure to less-liquid asset classes find secondaries an effective solution.
2. Attractive Terms for New Investors: For new investors, secondaries present an opportunity to enter established funds at potentially discounted rates. This entry point is often more favorable than committing capital to new vintages, which carry higher risks and longer wait times for returns.
3. Free Look at a Portfolio: Secondaries provide buyers with a “free look” at a portfolio’s performance and composition. This transparency allows investors to make more informed decisions compared to the blind pool nature of traditional fund commitments.

Key Considerations in Secondary Transactions

Executing a secondary transfer involves navigating several critical factors:

1. Transferability Rights: The core transferability rights under fund documentation are pivotal.  Does the transfer require the consent of the investment manager or general partner of the fund and/or other investors in the fund?  It is further essential to identify whether any rights of first refusal or other transfer restrictions exist, as adhering to these mechanics can delay the closing of the transaction and introduce risk for the buyer that the transaction may not ultimately be completed.
2. Accrued Carry: Accounting for any accrued carried interest is crucial. This often requires detailed negotiations to ensure appropriate adjustments to the purchase price to fairly account for any accrued carry.
3. Fair Value Determination: Determining the fair value of an illiquid portfolio is challenging. The approaches may vary based on the subject fund’s portfolio’s life cycle – for example, a cost basis approach may be appropriate if the portfolio is early in its development, while a more mature portfolio likely would require a more robust portfolio valuation exercise.
4. Discount Negotiation: Once the fair value of the portfolio is determined, the negotiation of any discount to the fair value is a typical aspect of any secondary transaction. Buyers typically seek discounts to account for the risks and potential future performance uncertainties, as well as expecting sellers to “pay” some amount for the liquidity that the buyer is providing.
5. Remaining Capital Commitments: Any remaining capital commitments must be accounted for. Both parties need to agree on the post-transfer handling of these obligations, most often with the buyer assuming the obligation to fund all future calls (with adjustments to the purchase price if any capital calls are made during any pre-closing period).
6. Contingent Obligations/Benefits: The allocation of the economic consequences of contingent obligations (e.g., indemnification by fund investors) and benefits (e.g., limited partner clawbacks), is important to protect both parties’ interests and often impacts the purchase price where the contingency is seen more likely to be implicated.
7. Unintended Crystallizations or Resets: It’s important to confirm that the transfer does not trigger synthetic realizations of the GP’s carried interest or reset time-based liquidity restrictions (e.g., lock-up periods), particularly in less-liquid open-end products that often have these features.
8. Transfer Costs, Taxes and Expenses: The allocation of transfer costs, taxes and expenses – including any reimbursement owed to the fund for approving the transfer – should be clearly defined.

Synthetic Transfers

In scenarios where the fund’s investment manager or general partner is unwilling to facilitate a transfer, or where penalties for transferring exist, certain participants have opted to use synthetic transfers. These transfers are structured to approximate the economic consequences of a direct transfer, and these can take a variety of structures – often informed by the transfer restrictions in the underlying fund documents. Naturally, synthetic transfers come with their own set of tax, economic, and legal considerations – including often violating the terms (or at least the spirit) of the applicable fund documents – which must be carefully evaluated.

Reasons for GPs to be Open to Secondaries

For existing GPs who may not be thrilled that their limited partners are seeking an exit, it should be kept in mind that these transactions not only provide a solution for otherwise having to attend to investors looking for liquidity, but also come with the benefit of introducing new limited partners interested in their investment approach and track record. This can foster more dynamic and resilient relationships with limited partners over the longer term, and also remove a degree of hesitancy of limited partners to make an initial commitment during the original fund-raising process.  While concerns exist that a transfer might unfavorably impact the perception of the portfolio’s valuation, the general awareness of the multitude of idiosyncratic reasons that drive a limited partner to seek liquidity should mitigate these concerns. Moreover, standard confidentiality provisions typically suffice to prevent the disclosure of sensitive information.

Future Outlook

Based upon historical observations and the modern landscape, it can be expected that secondary transactions will become an increasingly important aspect of investing in private equity, private credit, venture capital, and other illiquid products. Investors’ desire for liquidity and flexibility to rebalance portfolios across market cycles will also continue to drive this trend. Additionally, the growing number of private equity funds dedicated to investing in secondary fund interests underscores the market’s recognition of their value.

Secondary transfers in private investment funds represent a significant and growing segment of the market. They offer vital liquidity options for investors and attractive entry points for new participants, contributing to a more flexible and responsive investment ecosystem.