- Greetings, Azat! Can you tell us about the key characteristics of Real Estate Secondary strategy?

- Good afternoon, sure. Let me start by outlining the basic features. In a Real Estate Secondary transaction, a Limited Partner or “seller” seeks to sell its interest in a real estate comingled fund to another investor or “buyer”, who will have to accept all rights and obligations relating to fund interest being sold, including the obligation to cover remaining unfunded commitments according to the fund interest. Limited Partners may have a variety of reasons to consider a sale of fund interests on the Secondary market; however, need for liquidity is perhaps the most common. In most cases, a General Partner of a fund retains the ownership and management responsibility over underlying assets and/or properties. While those are the most common features, there are a few sub-strategies within the Real Estate Secondary market that I will describe later.

- What are the main advantages of investing in Real Estate Secondaries from the portfolio management perspective?

- There are several benefits of Real Estate Secondary investments. The first one is “J-curve” mitigation. “J-curve” phenomenon refers to the trajectory of Primary investments when investor returns are initially negative due to fund expenses and fees before they turn positive as fund capital is deployed and investments grow in value over time. Secondary market provides opportunity to purchase interests in more mature Real Estate funds at a discount to Net Asset Values. According to historical data provided by Jefferies Group and Greenhill, the pricing for Real Estate fund positions has generally been more favorable for Secondary buyers relative to Private Equity Buyout and aggregate pricing, i.e. Discounts to NAV on Real Estate fund positions were larger. Discount to NAV may often serve as a source of downside protection in an adverse scenario. This results in returns of Secondary investments exhibiting “n-curve” trajectory when initial returns are quite high due to write-ups of new investments and tend downward over time. High interim returns also create an opportunity for early capital distributions to investors.

- Great. What other factors should be considered with secondary investments?

- One more advantage of Secondary investments is risk reduction. It can be attributed to two related factors. First, Secondary investments are made at a point when underlying assets or properties are either near stabilization or near realization. As a result, Secondary investments have reduced blind pool risk as Secondary buyers are able to identify and evaluate underlying assets with relative ease. Also, stabilized assets that are purchased through Secondary investments have stable and predictable cash flows along with shorter holding period which are added benefits for investors.

- What can you say about diversification?

- It is rare for investors to sell their Primary fund interests one at a time. Instead, a portfolio containing many interests in various funds which represent hundreds if not thousands underlying Real Estate assets is usually sold on the Secondary market. The clear benefit of purchasing such a portfolio is instantly available diversification across fund managers, vintage years, geographies, investment strategies and property types. The implication of this deep diversification is lower standard deviation of Secondary investment returns implying lower risk. Historically, Secondary funds have exhibited lower standard deviation of returns around the median values relative to Primary funds.

- Could you please describe the various kinds of Real Estate Secondary transactions?

- Two of the most common types of Real Estate Secondaries today are LP-led Secondaries and GP-led Secondaries. LP-led Secondaries, also known as Traditional Secondaries, are transactions involving a purchase of an individual interest or a portfolio from a Limited Partner in a real estate fund at a discount to NAV. Such transactions are commonly initiated by a Limited Partner in a fund seeking liquidity, hence the name LP-led Secondary. Extensive diversification, short duration, potential for high returns, reduced risk and ease of execution are its appealing features for Secondary investors.

- We also hear more about GP-led secondaries these days. Is that the opposite?

- GP-led Secondaries, as the name suggests, are initiated by a General Partner with a goal of transferring a prized high-quality asset or a small portfolio of assets from a primary fund to a new special purpose vehicle. Primary fund Limited Partners are given a choice between selling their interest or rolling it into a new SPV. Secondary investor or Secondary fund manager acts as a buyer and provides liquidity to Limited Partners that elect to sell their interest in the primary fund. As a result, General Partner has the opportunity to keep ownership of certain assets that it believes have potential for further growth while not being pressured to exit due to certain fund provisions and providing optionality to Limited Partners. By their nature, GP-led Secondaries are more concentrated investments and do not provide the same diversification benefits as the LP-led Secondaries. Furthermore, the duration of such investments can vary and therefore may not be as short as with LP-led Secondaries. GP-led Secondaries require significant resources and expertise on behalf of General Partner and Secondary buyer due to the associated complexity. An added benefit for investors in GP-led Secondaries is access to high-quality General Partners and Secondary fund managers that can efficiently execute such transactions.

- Any other types of secondary investments?

- Other types of what are considered niche Real Estate Secondary sub-strategies include Direct Secondaries, GP Permanent Solutions, Preferred Equity and Mezzanine Secondaries. Direct Secondaries involve purchase of minority equity in privately owned company or property. GP Permanent Solutions refer to purchasing equity in firms that manage real estate comingled funds and are not universally considered to be Secondary investments. Preferred Equity and Mezzanine Secondaries are highly customized and specialized transactions that comprise the smallest portion of the overall Real Estate Secondary market.

- What was the evolution of different types?

- About 10 years ago, LP-led Secondaries have comprised the largest share of Real Estate Secondary deal volume; however, that share was decreasing substantially in the recent years. That is due to the sizable growth in GP-led Secondary transaction volume. Today Continuation Vehicles and Recapitalizations are the most common types of GP-led Secondaries currently comprising the largest share of the Real Estate Secondary market. Since COVID-19 pandemic, there were several large high profile GP-led Secondary transactions in robust sectors such as Industrial/Logistics, Multifamily Residential and Life Science properties.

- What are some of the trends that you observe in the market?

- Growing capital flows into the Primary Real Estate funds over the last 10-15 years led to substantial growth in the Real Estate Secondary transaction volume. One of the earlier catalysts was the Global Financial Crisis in 2008. The latest catalyst events were COVID-19 pandemic in 2019 and rising interest rates in 2022. According to data from Ares Secondaries Group and Burgiss, average Real Estate Secondary transaction volume grew from 5.5 billion US dollars in 2013-2017 to 8.8 billion US dollars in 2018-2022, a 60% increase. Notably, 2022 total transaction volume amounted to a record 12.4 billion US dollars, largest year on record for Real Estate Secondaries.

- Who are the key players in the market?

- Real Estate Secondary fund manager market remains dominated by a handful of GP’s. The large names such as Ares Secondaries Group, Blackstone Strategic Partners, StepStone Real Estate, Partners Group have been synonymous with the market itself. Nevertheless, the growing global opportunity set resulted in few other large investment managers to enter the market with similar product offerings. For example, Vintage Partners owned by Goldman Sachs and Brookfield.

Overall, Real Estate Secondary market is poised to further growth supported by the continued growth and momentum in Real Estate Primary market. GP-led Secondaries were the main driving force behind Real Estate Secondary market for some time now and will continue garnering interest from Limited Partners and General Partners alike. That said, the inflationary environment, rising rates, and tightening liquidity constraints have pushed many institutional LP’s to consider rebalancing their portfolios thus causing the rebound in Traditional Real Estate Secondaries that was observed in the second half of 2022.

Azat, thank you for sharing your views on the market. We wish you and your team best of luck in your work!