By Glen Anderson, CEO & Co-Founder, Rainmaker Securities
The Less Sophisticated and Less Efficient Private Equity Secondary Market Presents an Interesting Opportunity for Equity Traders
If history is an indicator, the best investments are made in the periods of market lows and economic pressure. This is particularly true with equities, where buying shares in high-value companies when valuations are lowest provides opportunity for maximum potential returns.
Take for instance the financial crisis of 2008. At the bottom of the market, the investors who took large equity stakes in quality public companies at low entry points achieved outsized returns when the market recovered.
Now, as we stare down the barrel of reminiscent conditions, including a looming recession and an unfavorable interest rate environment, the private equity secondary market offers a relatively new market segment with characteristics that provide a potentially similar value proposition.
The Dawn of the Private Equity Secondary Market
It’s first useful to understand the evolution of this nascent private equity secondary market – a market that simply was not a widely accessible for investors in 2008.
Prior to the financial crisis, private companies had limited access to capital and, as a result, were going public sooner to access liquidity. In turn, early employees and venture capital firms with equity in those private companies similarly did not have to wait an extended period for liquidity.
The birth of the secondary marketplace for shares of late-stage private companies can be mapped back to the phenom that was Facebook. Facebook was the first company of its size to demonstrate the ability to stay private while providing liquidity to shareholders. The success of Facebook and others caused a deluge of venture funding into private tech companies, making access to capital a non-issue. Consequently, companies began to stay private longer. However, that created a problem that needed to be addressed – an extended period where shareholders have no liquidity. Enter the private equity secondary market which has since boomed from a cottage industry focused on a handful of large private companies, to a booming marketplace where thousands of private company’s are traded regularly.
Separating the Wheat from the Chaff
After private companies experienced a venture funding boom in 2020 and 2021, the public equity market correction over the past year has acted as a leveler which has slashed private company valuations and begun to separate the high-quality private companies from those buoyed by an overinflated market.
Companies that are well-managed and primed for profitability will emerge successful and remain so in the long-term as they grow into their lofty projections, while many of the high-growth companies that focused on growth at all costs with no financial discipline are facing either severe down-rounds or even insolvency. As the dust settles, the companies well-positioned to withstand this downturn will remain valuable long term. This has created an opportunity for buyers. Discounted valuations have created highly compelling entry points for these high-quality companies – at discounts of as much as 70% from a year ago.
As a relatively new market, the private equity secondary market doesn’t have a long history, making it difficult to draw a direct parallel to a trajectory of returns found in public equities. However, we can examine interesting nuances and divergences between the two markets, understanding that value is often uncovered in less charted and established corners of the markets.
Public Equities Markets vs. Private Equity Secondary Markets: A Study in Asymmetry
As it has evolved over the past decade, the private equity secondary market has developed with a unique set of unique features, not seen in public equity markets.
For one, bid-offer spreads in the private equity markets are highly exaggerated compared to those in public equity markets. Unlike public equities, there is no singular price or value ascribed to a company and agreed by market participants. Instead, a company’s valuation is based on the limited research available and is therefore highly speculative. With more subjectivity and less consistency around valuations, there are often large spreads between the midpoint of where buyers and sellers are willing to trade. These wide spreads ultimately can lead to better pricing for the buyer.
Unlike public markets, which include players of varying degrees of sophistication on both the buy and sell sides, private equity secondary markets are made up of two distinct groups: sophisticated buyers and primarily unsophisticated sellers. The buy-side is comprised of asset managers, hedge funds, family offices, and other highly advanced investors who combine experience with private companies and unparalleled access to as much information as is publicly available, enabling them to establish frameworks to assess company valuations. Whereas the sell-side is comprised largely (though not always) of employees of tech companies, who don’t have the same level of sophistication and ability to accurately assess the value of their shares.
In addition, sellers have motivations beyond achieving alpha. Sellers often have more pressing liquidity needs, as many have their net worth tied up in primarily in equity shares of their employer and tend to get more motivated to trade as their equity options are set to expire, limiting their alternatives and increasing their likelihood of accepting trades lower than initial expectations.
Finally, the uneven buy- and sell-side volumes creates a trading environment which can be highly advantageous for buyers. Fewer and more sophisticated buyers with a singular goal of returns, trading with a higher volume of unsophisticated sellers with mounting liquidity needs is a mismatch that benefits buyers.
Challenges and Opportunities ahead
In terms of historical track record, private equity secondary markets haven’t been battle-tested in the same way that public equity markets have. The lack of information and opacity around company performance also present a significant challenge – and is priced in as a potential risk. But, for equity traders, those inefficiencies make for an interesting alternative market to look at to generate outsized returns.
To summarize, efficient and mature markets often mean compressed returns. By contrast, the current market conditions and unique dynamics of the private equity secondary market – especially the asymmetry between buyers and sellers – creates a significant opportunity for investors.
