What is the Secondary Market and How Does it Work?

What is the secondary market and why is it important? 

The secondary market plays a crucial role in global economic and financial markets, acting as the hub of investment activity after the initial launch of an illiquid fund on the primary market. Unlike primary investments, where investment managers raise capital for an illiquid fund ahead of deploying capital, secondary markets facilitate the ongoing trade of existing fund interests between investors. Illiquid funds span a range of asset classes, including Private Equity, Private Credit, Infrastructure and Real Estate. 

The market has seen significant growth in the last five years, as investors have sought liquidity in the high-interest rate environment. 

While this dynamic and fast-growing marketplace provides routes to liquidity for existing investors, and an alternative investment route for new ones, there are nuances to this market. In this blog, we explore what the secondary market is, how it operates, and why it is an important tool for investors. 
 

What do we mean by the secondary market? 

The secondary market we are referring to is where existing assets, such as stocks, bonds, property and investment funds are sold and bought between investors. For the most part, our clients (pension schemes, insurers and charities) invest into illiquid assets through pooled investment vehicles, rather than direct investments into individual assets. When we talk about trading assets on the secondary market, we are referring to the purchase and sale of existing interests in these pooled funds. Trades that take place on the secondary market do not normally involve the fund provider.  

From the perspective of those taking part in the secondary market, if you purchase an asset on these markets, you buy the share from the current owner and not from the fund provider itself - the money is transferred from the purchaser to the seller, not the fund provider.  Similarly, if you are a seller, you do not redeem directly with the fund provider.  The fund provider reflects the change in ownership for the interest in the fund but the negotiations for the transaction take place between the purchase and seller, often through an intermediary such as a broker. 
 

How does the secondary market work? 

As mentioned above, transactions on the secondary market are where existing interests are bought and sold by other investors. The amount that securities sell for goes directly to the investor selling them, while the original issuer receives nothing from the trade. This is why the markets are referred to as ‘secondary’, as the issuing investment manager would have had to first sell the underlying securities in the primary market to return the investment to the investor if the secondary market was not used. 
 

What is the difference between primary and secondary markets? 

The difference between primary and secondary markets is quite simple. When an investment manager launches a fund to invest into illiquid assets for the first time, it will do this with a primary fundraising. In most instances, this takes the form of the manager launching a particular vintage of their investment strategy, and investors then commit capital to this vintage. Once a sufficient amount of capital has been committed, the investment manager will then begin searching for suitable assets, and will call upon this committed capital from investors when they have been found. This period of investing into new assets can typically take c.2 - 3 years. Once capital has been deployed, it is expected that the fund will start to generate returns and begin to distribute income to investors (depicted by the Harvesting Period in the above graphic).

Most illiquid asset funds are closed ended meaning that, once capital has been called from investors, it is invested and the investor receives liquidity from the investment manager when the underlying assets are sold or mature, and the proceeds are returned. For some asset classes, it may take 30 years+ until the assets mature and the full investment is returned. The expected lifespan of the fund is an important consideration when investing in illiquid assets. 

When an investor sells an existing fund investment on the secondary market, they are receiving liquidity sooner than the underlying assets mature. This can be very valuable if the investor wants to make changes to their investment strategy. Investors who purchase through the secondary market can achieve full exposure to an illiquid asset fund on the day of purchase, rather than waiting for c.2 - 3 years to achieve this for an investment made on the primary market. 

What is the importance of the secondary market? 

The secondary market is becoming increasingly important as it can provide many benefits to investors, both sellers and purchasers. Some of these are highlighted below: 

• Liquidity for investors: Secondary markets allow investors to buy and sell securities, providing liquidity to investments by allowing them to be bought and sold for cash. 
• Risk management: Investors can exit their positions and sell securities when needed, helping them to manage investment risks. 
• Encouraging investment: The ability to easily trade investments increases confidence in investing, benefiting investment managers, companies and economies. 
• Economic growth: Secondary markets can contribute to economic development through improving capital allocation. Additionally, they can be used as a crude measure for growth by indicating if an economy is in a boom or recession period based on the rise or fall of purchase price relative to NAV. 
• Diversity of investment opportunities: Secondary markets offer a wide range of investment funds, such as Private Equity, Private Credit, Infrastructure and Real Estate, catering to various risk approaches and financial goals. 

Are there any disadvantages to the secondary market? 

As with any form of investing, there are some considerations to be aware of. These are not necessarily disadvantages, but rather factors to consider to mitigate risk and achieve your investment goals. These include the following: 

• Volatility: Prices in secondary markets can fluctuate due to market sentiment, supply and demand, company news or economic events. This natural volatility leaves investors open to risk of losses. 
• Off-market pricing: As it is a private transaction, there can be no reliance that the price paid for a fund is a fair market price. This means considerable risk is borne by both the buyer and seller that the price is appropriate.  
• Market manipulation: Despite regulation, secondary markets are vulnerable to practices like insider trading and price manipulation. 
• Legal considerations: Trading illiquid assets between parties transfers the right and liabilities of the investment between them, creating the risk that not all rights and liabilities are transferred appropriately if the correct legal considerations are not made. Legal advice is therefore a must when trading illiquid assets. 
• Tax considerations: As part of transferring the rights and liabilities, any relevant tax rules need to be followed and associated documentation completed. If traded incorrectly, a large tax liability may be created when not expected.  Tax advice should be considered as part of any trade on the secondary market. 
• Costs and fees: Trading in secondary markets often incurs fees and other expenses such as commissions, transaction costs, and taxes. 
• Economic sensitivity: Secondary markets are highly sensitive to economic conditions, such as interest rate changes, inflation, or geopolitical events, which can lead to instability. 

How XPS can help

If you’re unsure on how to access the secondary market to sell or purchase an illiquid fund, or you’re not sure which approach is best for your specific assets and financial goals, our team can offer tailored advice to help clients, including pension schemes, insurers and charities. Visit XPS Xchange to learn more about our services and how we can help or contact us for more information.