A co-investment fund invests directly in a portfolio company, usually alongside a private equity fund's general partner (GP). The arrangements are often collaborative, allowing investors to pool their resources and skills to make joint investments. The GP is the active manager, and the co-investor is generally passive, meaning there is no direct involvement in the companies. The co-investor does not invest directly in the fund but does receive preferential fees and terms with the fund’s GP. Unlike a secondaries fund, the co-investor is not buying from, nor providing liquidity to, the fund’s limited partner (LP) investors.
- A co-investment fund is generally more narrowly focused, purchasing individual portfolio companies and deciding which deals to join. A secondary fund has the flexibility to choose any GP fund, focusing on thematic, sector, or geographic exposures.
- The co-investor and GP must establish a relationship and agree to deal terms. The secondary fund generally accepts the existing fund and terms as initially structured.
- Both benefit from the GP's knowledge, network, and skills.
- Both benefit from the underlying growth in the private equity market as the opportunity set has increased significantly with an estimated $8T in AUM managed by PE firms.
- While both can customize exposures and diversify across sectors and geographies, generally, secondaries do so at a sector level, and co-investments do so at an idiosyncratic level.
Secondaries Market Provides Liquidity to Primary Market
Private investments across real estate, credit, equity, or infrastructure are typically locked-in, illiquid investments with time horizons of 7 to 10 years. The secondaries marketplace provides investors with an exit option allowing the sale of a fund prior to the end of its holding period. Over the past several years, the secondary market has evolved significantly, providing LP investors with opportunities to actively rebalance portfolios across sectors, investment horizons, GP, liquidity, or capital call schedules.
Primary Market (Key Characteristics)
A Primary fund generally deploys capital across one strategy or one sector, usually across 10 to 20 portfolio companies
Lock-up usually seven years or longer
Illiquid by nature
J-curve results in negative returns from fees and expenses in early life of fund and requires investors to retain liquidity to fund subsequent capital calls
Blind pool risk results in investors committing capital without knowing the exact companies a GP will invest in
Cashflow unpredictability – investors face uncertain timing and sizing of distribution
Secondaries Market (Key Characteristics)
A Secondaries fund invests across multiple GP funds across strategies or sectors, often gaining exposure to dozens of portfolio companies
Fund purchases interest from existing LP investor, allowing initial LP to exit, creating liquidity for an illiquid investment
Transaction price between fund and existing LP often occurs at a discount to NAV, providing immediate IRR gain and downside protection for fund
Shortens payback period, with exposure to more mature portfolio companies
Mitigates blind pool risk, minimizes J-curve exposure
Assume the obligation to provide funding for future capital calls but also gain the right to receive future distributions
Size Of Primary Market Versus Secondaries Market
Since 2014, private equity funds have raised nearly $5T in assets, and secondary funds have raised almost $500B. This size mismatch favors buyers over sellers, often benefiting secondary investors that provide liquidity or active portfolio management options to investors seeking an early exit.
Pension funds and financial institutions are the most active participants in the secondary markets, followed by family offices and endowments. While liquidity requirements are the primary driver, many investors pursue deals for portfolio management reasons.
* 2023 data is preliminary.
Source: Pitchbook: Global Secondaries, December 2023.
GP Led Secondary Transactions
GP initiates the deal – aiming to provide liquidity to existing LP investors and/or extend the duration of the investment
GP’s aim to retain exposure to strong firms and, most importantly, avoid being forced to sell a ‘trophy’ asset with potentially significant upside
LP is generally given a choice to either exit and receive pro-rate share or roll investment into a new fund (continuation) or sometimes a combination of both
GP-led transactions have increased in the last few years, nearing 50% of deal activity from 20%-25% during the 2014-2017 period
LP Led Secondary Transactions
LP initiates the deal –providing liquidity to existing LP investors looking to exit
Existing LP investor can rebalance a portfolio, deploy capital elsewhere, or take advantage of other market opportunities
Transfer facilitates true price discovery as buyer and sellers meet and negotiate a price, similar to a transaction on a public stock exchange
Under certain circ*mstances, the GP or other LPs in the fund may need to approve the transfer of ownership to a new LP
Source: Lazard Private Capital Advisory, Jan 2022
Enhancements and Benefits to Portfolio Construction
Secondaries and co-investments allow investors to actively manage their private market portfolios. In addition to providing liquidity to the marketplace, both strategies offer investors an opportunity to better manage their capital call schedule, timing and pricing of assets, responsiveness to market opportunities, and risk exposures by actively rebalancing across sectors, geography, or size. Both strategies seek to enhance returns by capturing inefficiencies within private markets, primarily driven by illiquidity.
Co-Investments
Create customized portfolios for LP investors by focusing on individual assets
Accept higher levels of idiosyncratic risk but have full control in selecting portfolio exposures
Require a heavy lift from a research and due diligence perspective – but gain significant opportunities to collaborate with skilled GP investors
Demand deep understanding of value creation within asset, industry, and, importantly, the managing GP’s team
Improve fee efficiency by reducing fees, increasing potential return
Can be dedicated strategy or tactical, can be opportunistic during periods of market dislocation
Superior diversifier given exposure to concentrated set of companies
Secondaries
Create opportunities for more active management – more responsive to changes in market opportunity and trends –increases ability for tactical positioning
Offer significant diversification potential as investors can gain direct access to niche strategies, specific regions, or strong GP teams
Provide greater ability to manage the duration or investment horizon of private market investments
Allow investors to ladder vintages - similar to bond laddering – improving risk and liquidity management
Capture potentially significant upside in returns given the dramatic increase in dispersion across GP returns over the past several years (see Figure 2)
One of the best diversifiers within private markets given lower correlation
Source: Pitchbook, Custom Benchmark, Secondaries, Vintage 2000-2023, returns by IRR, 2023 Q2
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