Estimated reading time: 6 minutes

The transaction market for secondary limited partnership (LP) fund interests experienced material growth in recent years, aligning with the overall growth of private capital markets. This market, characterized by its opaque and often illiquid nature, involves buying and selling LP stakes in private equity funds, private credit funds, and various hedge funds, often at material discounts to reported fund net asset values (NAVs) or equity values from an LP perspective. The reporting of specific discounted secondary fund LP transaction values relationship to GP-reported NAVs, theoretically at fair value, has received increased coverage recently. 

Why Does the Secondary Market Exist?

Most private fund structures are closed-end, committed capital, illiquid fund structures whereby limited partners (LPs), or equity investors, commit capital that is drawn down over an investment period of one to two years and agree to receive a return of and return on capital over the contractual life of the fund, often 10+ years. The effective monetization period may be shorter, depending on the GPs ability and desire to monetize equity or debt assets, but it is not guaranteed.

The growth of the secondary market for LP interests is a product of the growing number of private fund LPs’ need for immediate liquidity and, thus, desire to sell their LP investment before the fund’s intended and contractual hold period. However, this liquidity can be costly, with LP sellers often incurring material discounts to the reported net asset value of their LP interest of as much as 10% to 30%. Hence, these markets ultimately provide liquidity to selling investors and simultaneously create attractive potential returns for opportunistic buyers of LP interests.

These discounts are also leading to increased negative press for fund managers and their boards of directors that determine the reported fair value of their investments and for third-party valuation providers that help them determine the appropriate fair values by calling into question the accuracy of such fair value estimates. If interests in such funds are traded at material discounts to fund NAV, then is this indicating that the fair values for the underlying assets are marked too high? We will explain why this is not necessarily or not likely the case.

To understand why secondary transactions are currently gaining press attention, it is essential first to understand what they are and what the underlying issues are when transacted. 

What are Secondary Transactions?

A secondary transaction involves the sale of any security after its original primary market issuance; bonds, public equities, broadly syndicated bank loans, and private equity and debt instruments issued by individual companies are all traded in secondary markets. For this discussion, however, we are focusing solely on transactions where a buyer acquires an LP stake in a fund from one of the current LPs and the resulting value dynamics, which is a significant aspect of these transactions, often resulting in discounts to the Net Asset Value (NAV). Understanding these valuation dynamics is crucial for all stakeholders. 

Typical Scenario: NAV and Fair Value Assessments

Typically, the NAV of a fund is defined as the sum of the fair value (FV) of its assets minus the book value (BV) of its liabilities. Accounting standards such as ASC 820 (U.S. GAAP) and IFRS 13 (international standards) require that Fund GPs determine and report the FV of the assets in audited financial statements, typically at least quarterly. The FV definition in these standards specifies an orderly market scenario where neither buyer nor seller is in distress, and all relevant information is equally available. Publicly traded investments are stated at reported market values; however, private or illiquid investments need to be estimated. Fund managers often use third-party valuation firms to help estimate the FV of their illiquid investments to ensure objectivity and better prepare for regulatory compliance and potential regulatory scrutiny.

For private equity funds, generally, the underlying assets are valued based on an assumption of an orderly exit, such as a sale or IPO, managed by the GPs. This is also true for private credit funds, where investors receive their investment back when funds are wound down in an orderly fashion at the end of their fund lives. Investors, or LPs in debt or equity funds, are expected to hold their fund equity investments until such orderly exits of the fund assets occur. Indeed, LPs that allocate capital to private securities do so with the recognition that their investment is less liquid than public market securities, and they expect a higher return on investment to compensate them for locking up their money. Therefore, the valuations of the underlying fund assets do not typically account for minority or illiquidity discounts, and in turn, the underlying fund NAVs also do not contemplate these discounts.

Discounts in Secondary Market Transactions

Despite the rigorous valuation processes, secondary market transactions often occur at significant discounts to the reported NAV. These discounts can range from 10% to 30% and are influenced by several factors:

1. Cost of Liquidity for LP Investors: The secondary market is more characterized by opportunistic buyers and forced or distressed sellers than by liquid, orderly buyer-seller transactions. Liquidity needs can significantly impact the valuation of LP stakes, especially when sellers face pressure to liquidate quickly.
2. Market Perception and Volatility: The market’s perception of the underlying asset values and the volatility associated with different types of funds (e.g., venture capital = more risky vs. large-cap buyout = less risky) play a crucial role. More volatile or risky assets generally trade at higher discounts.
3. Dividend Yield and Outlook: For credit funds, recurring dividend expectations and their comparison to market comps affect valuations. Equity funds are less influenced by this factor as they typically do not distribute regular dividends.
4. Exit Timeframes and Expectations: The expected timeframe for distributions and exits, particularly in private equity, can impact the secondary market value. Longer expected hold periods can lead to larger discounts.
5. Leverage and Risk Profile: The leverage used by the fund and the associated risk can also influence the discount. Higher leverage might lead to higher perceived risk and, therefore, larger discounts.

Regulatory Oversight and Accurate Valuations

Speculation that the NAV may be overstated is less likely to be the cause of LP stakes trading hands at a discount in the secondary market, thanks to stringent oversight and fair value reporting standards. Auditors and regulators play a crucial role in ensuring the accuracy of these valuations. ASC 820 and IFRS 13 are accounting standards mandating fair value reporting, while regulatory bodies like the SEC oversee most private funds (particularly those with assets under management (AUM) exceeding $150 million, as stipulated by the Dodd-Frank Act.) Although the courts recently overturned the SEC’s attempt to regulate private funds further through the Private Fund Advisers Rule, oversight remains robust through SEC Rule 2a5, which mandates stringent controls over publicly traded funds valuation processes, controls, and documentation. Competitively, many private fund managers have adopted many of the 2a5 mandates as best practices for their respective investors.

Case Studies of Secondary Market Valuations

Some observers have highlighted instances of significant immediate markups in secondary transactions that bring into sharp relief the disparities between secondary LP interest purchase prices and reported NAVs. For example, the Wall Street Journal reported that a leading investment manager’s private assets fund recorded a 39% gain on fund LP investments bought at a substantial discount, marking them up to the GP-provided NAV within a day. Similarly, another private market investment firm reported spectacular gains on LP stakes purchased in the secondary market, marking them up significantly upon acquisition.

Critics argue that the true market value of an asset is what a buyer is willing to pay; thus, secondary market prices might be a more accurate reflection of fair value. However, GPs and valuation firms often defend the higher NAV valuations, citing rigorous valuation processes and the assumptions of orderly market conditions.

Implications for Investors and Valuators

The discrepancies between secondary market prices for LP stakes and fund-reported NAVs underscore the need to consider various factors influencing valuations carefully. Investors in the secondary market should be aware that discounts may reflect not just the liquidity needs of the seller but also differences in market conditions and assumptions about asset exits.

Accordingly, Internal and third-party valuation professionals and auditors must recognize the distinct market contexts and dynamics when assessing reported LP interest values, or NAVs, per GP financial reporting and those reported in the secondary markets. The NAV reported by the GPs under ASC 820 or IFRS 13 for financial reporting assumes orderly market exits for the underlying assets.  Therefore, these GP-determined NAVs reflect the assumption of orderly market transactions underlying LPs’ interests in that fund. However, a fund buying LP interests in the secondary market at steep discounts to GP-reported NAV needs to assess and document if the purchased interest reflected an orderly or distressed trade, i.e. the seller was under duress or highly motivated to sell quickly.  If the trade was deemed distressed, per ASC 820 and IFRS 13 fair value mandates, the fund should not use the lower distressed trade value and should continue using the orderly market NAVs reported by the GP. However, this treatment will often reflect a controversial Day 2 gain by the buying fund, which needs to carefully support and document the differences between GP reported NAV and the lower NAV implied by a secondary market trade for the fund’s board of directors (responsible for final valuations), its auditors, and regulators.

Conclusion

The valuation dynamics of secondary LP transactions are complex and influenced by numerous factors. While NAV provides a theoretical fair value under orderly conditions, secondary market prices often reflect the practical realities of liquidity needs of minority fund investors and market perceptions of these LP interests, which are not necessarily reflective of orderly market trades and, thus, the fair value of the underlying fund assets. We would argue that the secondary LP interest discounts to NAV are more reflective of the minority position and the liquidity needs of the sellers. Understanding these dynamics is essential for both buyers and sellers in the secondary market and those responsible for valuing and auditing these investments.