One number—$3.2 trillion—goes a long way toward explaining why secondary funds raised 92% more capital in 2023 than they did in 2022 (albeit from a very small base).

That’s the unrealized value represented by the 28,000 unsold companies weighing down buyout portfolios globally, more than 40% of which are four years old or older.

This backlog is massive by historical standards—four times by value what it was during the global financial crisis—and a flash point in the liquidity crunch plaguing private capital markets broadly. With exit markets dormant across the alternatives industry, funds of all kinds are badly in need of ways to get cash back to investors and keep the private capital flywheel spinning.

Enter secondaries, a catchall term for funds that help general partners (GPs) and limited partners (LPs) sell or restructure private capital holdings to generate liquidity. While the asset class is small, it is growing rapidly. At the moment, secondary transactions provide only about $120 billion in liquidity annually for an industry with over $20 trillion in assets under management globally (this vs. US public equity markets, which turn over more than $200 billion in assets daily). But given the rapidly expanding need for liquidity solutions in private capital, the potential for continued growth is exponential. The challenge: devising the innovative structures needed to capture the opportunity at scale.

Secondary funds have been around since before the global financial crisis. They started as pools of capital formed to let LPs sell GP positions when they needed cash faster than GPs could provide it. In those early days, growth was limited by the stigma attached: Abandoning a GP was akin to acknowledging you’d somehow made a mistake.

But as the industry has exploded and the need for liquidity solutions has grown, rapid innovation has produced a wide variety of tools that both LPs and GPs can use to manage the increasingly complex needs of their stakeholders.

LPs have embraced secondaries to rebalance portfolio exposure across strategies, geographies, vintages, and funds. They can now securitize positions via structured portfolios traded on the bond market. GPs are using direct secondaries, continuation funds, and “strips” of portfolios to generate liquidity when exit markets sputter (as they’re doing today). Tools are also available to raise cash for firm-level objectives like succession management or expansion.

Utility, however, isn’t the only thing fueling the growth of secondaries. Because the fund and company positions at the heart of these products are initially sold at a discount to market value, they also deliver strong, consistent returns for investors with less volatility. Indeed, secondaries are the only alternative asset class in which even the fourth quartile of funds ekes out a positive return (see Figure 1).

Figure 1

GP-led secondaries generally contain solid assets backed by high-quality managers and are expected to deliver strong performance. They also have a shorter payback period (or J curve) than typical private capital investments because the assets are already approaching maturity. And buying exposure to private capital through secondaries offers a quicker path to a diversified portfolio for investors who are new to private markets.

While the liquidity crunch behind the secondaries growth spurt will eventually subside as exit markets slowly recover, there are plenty of reasons to believe demand for these products will continue.

One potential driver: a shift in the sponsor-to-sponsor channel, which currently accounts for nearly 30% of all buyout-backed exit activity. These deals are fine, but GPs increasingly question why they should sell their best assets to a peer, just to watch the buyer capture future returns. A secondary fund presents an alternative by stepping in with a continuation vehicle that allows a sponsor to sell off part of a company but maintain control and continue to realize the upside. This way, the GP can offer liquidity to LPs who want to get out at a price set by an independent third party, while the secondary sponsor finds a consortium of new LPs or GPs who want a chance to get into the company (or companies) at a new price.

Today’s secondary funds typically lack the scale to underwrite sizable transactions on their own, so they tend to recruit other, similar funds to participate in big deals. But that’s changing as buyout funds seek to close the funding gap. A recent example is Accel-KKR’s investment in LEA Partners’ continuation vehicle, which extended LEA’s ownership of two portfolio companies, Zvoove and OneQrew. Variations on this theme of a buyout firm backing a peer’s continuation vehicle have the potential to dramatically transform the sponsor-to-sponsor exit channel.

Another stimulus for secondaries demand is private capital’s ambition to court wealthy individuals—specifically, sophisticated investors who are increasingly hungry for diversification and stronger returns than public markets can deliver. Right now, individuals account for only around $4 trillion in alternatives assets under management, but the industry is poised to expand that to $12 trillion over the next decade.

One major hurdle to this growth is liquidity, but secondary firms are already stepping up to address the problem. Lexington Partners, for instance, teamed with Moonfare, a digital platform that offers individual investors access to private markets. Lexington participates in Moonfare’s secondary market, enabling its clients to periodically cash out of their private capital investments. 

The critical thing in any of these scenarios is the presence of an honest broker. All sides of a transaction need to know that a trusted third party is determining value and structuring deals fairly. As happens too often today, a GP will set up a continuation fund to restructure a portfolio company, recapitalize the balance sheet with a swath of new equity, and essentially cram down the existing LPs, giving them the choice of getting out at a big discount or staying in on the bet that a hoped-for return will eventually materialize. Such stories have often left a bad taste in the marketplace, something new structures will have to solve for with independent valuations based on rigorous due diligence.

It will also be critical to rapidly increase the amount of capital flowing into secondaries and build out the infrastructure underpinning scale. In a world where most other strategies draw concerns for having too much dry powder, the secondaries space is undercapitalized. Currently, the asset class has about $200 billion of dry powder, or enough to fund only about 20 months’ worth of transaction volume.

Given private capital’s propensity to fill a vacuum profitably, however, this state of affairs is unlikely to last long. For large investors like sovereign wealth funds, the returns and flexibility offered by secondaries will become more and more attractive. The same could be said for the giant investment houses managing trillions in wealth for individuals eager to access alternatives.

Already, we are seeing major private fund managers positioning themselves to grow in the space. Deals like CVC’s acquisition of secondary player Glendower Capital, TPG’s acquisition of NewQuest, and Oaktree’s investment in 17Capital are reshaping the marketplace.

The landscape tomorrow will look very different from the one we see today. But it’s a safe bet that smart people will find a way to match the market’s massive need for liquidity solutions with the equally massive pool of capital available to fund them at scale.