Separating Bargains from Busts: Five Steps to Evaluate Private Equity Secondaries

By Madison Murphy, Associate, FS Investments 
& Daniel Wilk, CAIA, Executive Director and Client Portfolio Manager, FS Investments

Investors have flocked to private equity secondaries over the last three years, largely driven by the allure of acquiring stakes in private equity funds at deep discounts to NAV. Structural perks like J-curve mitigation and the elimination of blind pool risk, highlighted in our whitepaper “Secondaries in First Place,” further add to the appeal. But much like a knock-off Rolex that can’t keep the time, not all bargains are worth the buy. This same logic holds true with secondaries. Smart shoppers know to look beyond the price tag before buying from the discount rack.

So, what should investors look out for when assessing secondaries? We outline the considerations with an emphasis on analyzing the quality of the sponsor and underlying portfolio.

1. Evaluate technical and fundamental drivers for pricing discounts.

Pricing discounts in the secondary market reflect various factors, namely the cost of liquidity and the quality and age of the underlying portfolio companies. For investors, these discounts offer an immediate performance boost, as assets are marked up from their traded price-to-book value, enhancing returns and providing a cushion against potential market downturns. However, like any asset class, pricing in the secondary market is cyclical and buying on price alone is not always the best strategy. 

Discounts widened precipitously in 2022, as the Fed’s aggressive rate hike cycle drove up the cost of financing, significantly curtailing M&A activity and exits for private equity managers. As exits slowed and public equity markets drew down (18% in 2022), many LPs found themselves overweight their private equity targets (aka “the denominator effect”).[1] The market rebound in 2023 helped alleviate the impact of the denominator effect, yet many LPs still face allocation challenges. The slower exit environment persists, which has reduced the level of distributions to LPs and, in turn, liquidity to fund future capital commitments. In fact, capital calls outpaced distributions by 20%–30% in 2022 and 2023—the largest gap since 2008, as shown in Figure 1.

As rates rose in 2022, secondary supply outpaced demand, driving average prices of global buyout transactions down to 87%, as seen in Figure 2. Stronger demand has since emerged, balancing increased supply and leading to a recovery in discounts. These dynamics resulted in record first-half volume for 2024 of $68 billion, up 58% from the same period in 2023, with volume projected to reach $140 billion by year-end.[2] While the supply/demand imbalance persists today, dedicated secondary funds hold approximately $189 billion in dry powder.[3] Growing demand has helped push the average price for global buyout transactions to 94%—slightly above the average since 2015.² 

While deeper discounts remain in certain segments, such as venture or transactions where the underlying GP sets purchasing restrictions, tighter overall pricing requires investors to carefully weigh the allure of discounts with the long-term return potential of secondary portfolios.

2. Seek managers with a track record of generating returns through appreciation—not simply relying on discounts 

Value creation in private equity is driven through multiple expansion, leverage, and organic growth. We believe the latter—which relies on improving earnings and expanding margins—is critical in today’s high interest rate environment, which has raised borrowing costs and tempered valuations. 

Over time, middle market managers have derived a greater percentage of value creation from organic growth compared to large cap peers. According to a Morgan Stanley study, middle market managers grew revenues and EBITDA of portfolio companies by nearly 3x more than large cap peers over the course of their holding period.[4] 

Deep discounts can easily overshadow an investment’s potential—or lack thereof—to improve earnings and expand margins. While buying an LP interest at 50% of NAV may seem like a bargain, investors need to weigh the short-term write-up pop against the forward return potential of the portfolio. 

To illustrate this point, we consider two funds investing in different secondary portfolios at varying discounts and assumed forward annualized returns: Fund A, priced at 90% of NAV with a 12% annualized return, and Fund B, priced at 75% of NAV with a 4% return. Fund B’s steep discount could reflect a weaker outlook, influenced by factors like age or a lack of clear exit paths.

Despite the strong head start for Fund B, driven by the steeper discount, Fund A significantly outperformed, delivering a 1.96x multiple over the following five years due to stronger underlying performance of the portfolio post-acquisition. 

This simple exercise highlights why relying on discounts alone may not be a winning approach when investing in secondaries. While discount realization offers a short-term IRR “sugar high,” driving long-term growth through appreciation can provide higher overall returns. Why do some funds trade closer (or at a premium) to their NAV? Because investors will pay for a portfolio’s long-term growth potential.

3. Consider the importance of a portfolio’s age to its forward return potential 
The slow exit environment has resulted in PE managers holding onto portfolio companies longer. Over the last 10 years, portfolio companies owned by private equity funds for 7–12 years averaged 21% of all company inventory. That figure rose to 28% as of June 30, 2024, the highest level since 2014.  

This matters because portfolio company growth and exits typically occur in years three to seven of a fund's life cycle. Historically, top quartile U.S. buyout funds have driven most of their total value creation approximately six to eight years into the fund's life cycle, topping out at IRRs around 21%.[5] Said differently, late-stage portfolios may present limited future growth for investors. While experienced sponsors can certainly still drive value in a fund’s later years, investors should seek a sound understanding of the sponsor’s ability to drive value creation through fundamental performance. As holding periods extend, secondary investors should consider the average age of investments by reviewing a secondary portfolio’s vintage year diversification.

4. Assess the manager’s ability to source unique deal flow 

By definition, the private equity market is…private. Relationships, experience, and reputation are often the critical, intangible difference between being invited to the deal party—or not. These dynamics are especially pronounced in middle market transactions in the secondary market, where we see the greatest opportunities for relative value.

In secondary transactions, GPs have the right to approve or deny the transfer of LP interests in their funds. Middle market GPs tend to be highly selective and rely on a “preapproved” network of trusted LPs when their funds trade in the secondary market. These relationships are typically built over many years and start with an LP investing in the GP’s primary funds. Pre-existing relationships not only provide LPs with a seat at the table for deal flow, but reduced competition can also provide LPs with a greater ability to negotiate pricing. In addition, strong GP relationships may provide LPs with an information edge to underwrite secondary opportunities when a known GP’s fund comes to market.

Conversely, large/mega-cap GPs are motivated to promote a wider net of LPs to create secondary market liquidity and keep capital flowing efficiently through the system. This helps these GPs secure continued commitments to their often-massive primary funds—with recent examples topping $20 billion in fund size. As a result, secondary transactions for large/mega cap transactions tend to be highly competitive, with many bidders sharing a similar level of information, resulting in more efficient pricing and smaller discounts to NAV.

Accessing top performing GPs in the middle market has rewarded investors over time. Top quartile middle market buyout funds have outperformed top quartile large/mega-cap by 540bps on average, driven by several factors, including lower pricing, more paths for value creation, and greater exit optionality.[6] 

5. Find the right vehicle to meet your liquidity needs, investment time horizon and return expectations

The type of investment vehicle used to access secondary investments can help meet varying portfolio allocation goals with differing return profiles. 
Historically, private equity has been accessed through drawdown funds, whereby an investor’s capital is committed at a certain point in time and invested, or drawn down, over several years, requiring a long-term investment horizon (10+ years). More recently, perpetual offerings—or evergreen funds—have gained popularity, as they allow investors to purchase or redeem shares on a periodic basis. Evergreen funds offer greater liquidity and lower investment minimums, providing access to a broader swath of investors. 

Given the structural differences between closed-end funds and evergreen funds, investors should consider how these differences impact the client experience, as noted in Figure 6. The ability to deploy capital—important, regardless of fund structure—is particularly pressing for evergreen funds. Evergreen fund managers face increased pressure to deploy capital quickly to avoid the "cash drag" of idle cash sitting on the balance sheet not generating returns. Therefore, it is crucial that evergreen fund managers have a broad investment platform and access to strong deal flow to ensure efficient and diversified capital deployment.

Additionally, for early-stage, secondaries-focused evergreen funds, discount markups can generate outsized short-term returns compared to long-term performance. As these funds scale and diversify or market pricing increases, sustaining returns that rely on discount realization may prove more difficult. Since evergreen fund investors buy in at current NAV, where prior discounts have already been realized, it is crucial to assess how much of return has been driven from discounts versus underlying appreciation to determine go-forward return expectations.

Summary

While the private equity secondary market presents attractive opportunities for investors, it is important to recognize that not all secondaries are created equal. The allure of discounted pricing and immediate capital deployment can be tempting, but careful consideration of the underlying assets, the quality of the fund, and the manager’s ability to access high-quality deal flow are critical to achieving long-term value.

About the Contributors

Daniel Wilk is an Executive Director and Client Portfolio Manager at FS Investments, where he is responsible for supporting investor diligence regarding Portfolio Advisors’ middle market private equity initiatives. He serves as a key resource for private equity across transaction types, including primaries and secondaries (both LP-led and GP-led), and direct equity co-investments. He also leverages expertise in digital assets, real estate, alternative credit and liquid alternatives. He received his BA in Political Science from the University of Pennsylvania and is a CAIA charter holder.

Madison Murphy is an Associate on the Investment Research team at FS Investments where she focuses on private equity markets and multi-strategy hedge fund investing. She also assists in messaging efforts across the firm’s suite of alternative investment products, developing targeted communications and educational resources. Ms. Murphy holds a BBA in Finance from George Washington University and has prior experience with structuring and pricing municipal bond issues.

Learn more about the CAIA Association and how to become part of a professional network that is shaping the future of investing, by visiting https://caia.org/