December 15, 2020
In the 14th century, traders and merchants from all over Europe would gather in the square opposite the Ter Buerse Inn in Bruges to exchange promissory notes, government issues, and other securities as they sought to raise liquidity, lay off unwanted risk, or both. Since the advent of these exchanges, or bourses, global capital markets have grown larger and more complex. Today, trillions of dollars in equities, bonds, derivatives, and commodities are traded on these exchanges daily. The flexibility and price transparency inherent in liquid markets have historically eluded investors in private equity, venture capital, and real estate, who accepted the prospect of outsize and uncorrelated returns as adequate compensation for the illiquidity and opacity of private market holdings.
However, as private markets have gone from alternative to mainstream over the past several decades, an ecosystem of investors and advisers has developed that offer ready liquidity to limited partners (LPs) and general partners alike. From its earliest incarnation on the streets of Bruges, the so-called secondaries market eventually reached private markets. They first appeared in private equity and venture capital. Now, secondaries have come of age for the largest and oldest asset class, private real estate.
Secondaries provide several potential benefits to real estate investors including, alpha generation and risk mitigation through discounted entry pricing, portfolio management efficiencies and enhanced diversification. Although this paper emphasizes traditional private equity real estate (PERE) secondaries, there are several alternative ways for investors to access this compelling opportunity.
Traditional PERE fund secondaries are purchased from LPs seeking liquidity prior to the natural liquidation of a fund’s assets. Because the fund has often been substantially invested, buyers have greater insight into the underlying assets in the fund’s portfolio. Often, they are able to secure some level of discount to the net asset value (NAV). Active secondaries investors can build portfolios that offer a compelling set of attributes, including J-curve mitigation (due to buying at discounts to reported NAV) and an exceptionally high degree of diversification, gaining exposure to many individual assets, property types, markets, and managers. Because secondaries investments are typically made later in the life cycle of a fund when assets are often closer to liquidation, their duration is significantly shorter than that of a primary fund investment. Owing to discounts, returns can be higher than those achieved on comparable assets acquired directly.
The PERE secondaries market has expanded significantly over the past decade, becoming a widely used tool for institutional investors seeking to actively manage their portfolios. The secondaries market provides a means for investors to sell down what would otherwise be illiquid holdings in a relatively straightforward manner. Recessions and corresponding real estate downcycles have historically triggered a wave of secondaries sales as investors seek to generate liquidity and rebalance their portfolios. This white paper describes the evolution of the traditional secondaries market, the structures available, the market factors that give rise to them, and how we would expect those opportunities to manifest in a post-Covid market.
The Emergence of the Real Estate Secondaries Market
The availability of PERE secondaries opportunities will naturally reflect the size of the underlying primary fund universe. The comparatively low volume of real estate secondaries trading activity in the early 2000s was attributable to the relative newness of PERE funds as an institutional asset class. This was especially true of funds with either a Value Add or an Opportunistic risk profile, which only really started to grow after 2004. The PERE secondaries market emerged during the pre-GFC market upcycle and matured during the bull market that preceded the onset of the Covid-19 pandemic.
