The New Silk Road: The Rise of Secondaries and Continuation Funds

From the second century BCE to the 14th century CE, traders traveling the lengthy and perilous path from Asia to Europe, known as the ‘Silk Road’, innovated by establishing trading posts and intermediate markets along the route. They served not only as rest and resupply stops, but also facilitated the exchange of goods, allowing traders to cash out or continue on their journey with new lucrative inventory. In the world of private equity, secondaries and continuation funds serve a similar purpose: secondaries funds offer early exits for investors who require liquidity, much like the Silk Road’s trading posts, and continuation funds provide a way to extend the journey of high-potential investments without locking up capital indefinitely. As the Silk Road witnessed an increasing number of travelers, so too has the private equity market experienced increased interest in these types of funds. It is therefore important that financial advisors, when serving as fiduciaries, understand these offerings so as to best advise their clients.

First, advisors must consider the private equity market more broadly. Exit volumes have shrunk considerably, while managers contend with record levels of dry powder and unrealized value. Last year, global private equity exit value totaled only $575.8 billion, its lowest level since at least 2019, according to Preqin¹, while private capital has grown to approximately $12 trillion in assets under management, nearly double its 2019 amount, as reported by PwC². Against this backdrop, private equity managers are considering ways to optimize high-potential assets by extending their investment horizons, and investors are seeking liquidity, exit strategies and a quicker turn around on invested capital.

The secondaries market has evolved into a sophisticated arena for portfolio management and value creation, with the market increasing 7% to $60 billion in 2023, according to Jefferies Financial Group³. But how should advisors analyze the aforementioned dynamics with respect to advising their clients? Secondaries funds, which typically consist of more mature assets with potentially lower risk profiles, may provide more predictable and stable return streams, especially given that these assets often come with established performance histories and the initial dip in returns an investment experiences (a function of the J-curve effect) is typically less pronounced. As these investments are more mature, they can offer nearer-term liquidity compared to traditional private equity funds, which can be attractive for clients looking to realize their investments sooner.

Continuation funds, used by managers to roll over assets from one fund to another within the same firm, are seeing a similar rise in popularity. This is partly due to robust performance. These funds have earned a median of 1.4x multiple on invested capital, on par with secondaries funds and higher than the median 1.2x from buyout funds, according to Morgan Stanley.⁴ There are several potential benefits for advisors’ clients. There is the opportunity to invest in well-vetted companies that GPs have strong confidence in, given their willingness to extend the holding period. Continuation funds may therefore also provide access to high-potential assets that have a clearer path to liquidity and more defined exit strategies.

Forward thinking advisors should always be cognizant of how the private equity market is evolving. As the sector matures, the volume of older funds will expand opportunities in the secondary market, and newer asset classes and innovative investment vehicles will likely enter the space. Over time, firms and funds will become increasingly institutionalized, adopting more formalized processes and standardized practices. Additionally, technology integration, especially in data analysis and transaction processing, will enhance efficiency and transparency and encourage more players to enter the space. Similar parallels can be seen in the maturation of the Silk Road, where advancements like the invention of paper money made trading more efficient and facilitated greater commerce.

These funds do not come without risks, however. Asset valuation, or determining the fair value of secondary market assets, can be challenging due to less transparent and less frequent pricing compared with primary markets. There are also operational risks, and the success of continuation funds heavily depends on the skill and track record of the funds’ general partners. This highlights the importance of careful due diligence; advisors would be well served by engaging third party specialists who can help them research the top managers as this expertise is not often found within financial advisory firms.

Advisors looking to navigate the complexities of private equity investments should be aware of the way the industry has matured in recent years and how it will continue to do so in the future. For discerning investors, secondaries and continuation funds may provide potential benefits with regards to diversification, high-quality assets, and liquidity/exit strategies.

Sources:

1. S&P Global, Apr. 2024
2. PwC, Jan. 2024
3. Global Secondary Market Review, Jan. 2024
4. Kokalitcheva, Kia. Riding the Continuation Fund Trend in Venture Capital. Axios, May. 2024