The Growing Popularity Of The Private Secondary Market

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LinkedIn Profile Drew Spaventa is the founder and CEO of The Spaventa Group, a leading alternative investment company.

It’s 9:29 a.m. Eastern time, and you’re already on your third cup of coffee. You sit at your workstation—there’s a computer on the desk and a television mounted on the wall. You stare at the television while two news anchors discuss the morning’s news, and you can sense the anticipation filling the air. On the bottom right corner of the TV screen, there’s a countdown clock and a big number “10” displayed in white lettering. You then glance at the computer in front of you and see an unending list of businesses followed by four letter symbols and various numbers. And now your eyes go back to the television and the number on the bottom right keeps ticking down: 3….2…..1…. until the clock finally strikes 9:30 a.m. A familiar “ding ding ding” pierces the air while the numbers on your computer suddenly spark to life, with some turning green, and some turning red.

The public secondary market (aka the stock market) is now in its full weekday swing.

The stock market that the average investor knows—and loves/hates—is a secondary market, which means that it provides a transaction infrastructure through which existing shareholders can sell their shares to willing buyers (with the company itself receiving no money from the transaction). This stands in contrast to the primary market, where investors directly inject their capital into a company and the investor receives a piece of equity (or company ownership) in return.

Broadly speaking, most investors are familiar with the stock market. And just like the stock market, the private secondary market is where existing shareholders can sell private company shares to willing buyers. The private secondary market, however, is far more complex to navigate than the stock market.

The main catalyst for the ascension of the private secondary market is simple: venture capital-backed companies have remained private for longer periods of time. Since the early 2000s, the private secondary market has been dominated by a small handful of large private players, companies like Twitter, Facebook, Spotify, Uber and Airbnb. Recently, the market for private secondaries has exploded, with shareholders at hundreds of large, private companies seeking liquidity. Thousands of early employees at these companies holding hefty stock options as well as the early investors who have significant equity (and the accompanying significant unrealized returns) are all potentially demanding of increased liquidity.

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Today, companies like OpenSea, Stripe, SpaceX, Impossible Foods and Epic Games all command hefty demand in the private market. (Note: My company managed funds with stakes in Epic Games, Impossible foods and SpaceX.) That said, the complex and convoluted nature of the private secondary market has not evolved nearly as much as the increased popularity/demand for this asset class. Unlike the established “easy access” of the public stock market, investors have found that private secondaries investing is neither simple nor instantaneous, you cannot simply open a brokerage account, choose your private investment of interest, and simply click “buy” or “sell.”

First, the buyer or investor needs to identify a specific company in which they would like to invest. Then, the investor must find active sellers of that specific company. Once a seller (or group of sellers) is discovered, the investor must undergo a lengthy investing process, which includes price negotiation, the signing of transfer documentation and the lapse of the right of first refusal (or “ROFR”) period.

At this point, you might be asking yourself: What exactly is a ROFR period? It is crucial to understand that most private companies maintain ROFR rights, which means that the company has the right to purchase any selling shareholders’ shares first before any third parties can purchase those shares. Essentially, the company’s existing shareholders can block the transaction for the outside investor. Once a purchase agreement is executed between the investor and the seller, the company is informed of the upcoming ownership transfer and the ROFR process begins (this can take up to 30-60 days). Once the transaction passes the ROFR period and the company decides not to purchase the shares, then (and only then) the deal can officially close and the private company’s shares are transferred to the buyer.

Investors also need to consider that private companies are not obligated to follow the same strict financial reporting rules and regulations that public companies are subjected to. As such, the due diligence process for considering a private investment is far more nuanced, complex and difficult. Additionally, real-time, concrete pricing information on private company shares can be daunting (even for large financial institutions). So, investing in the private market as an individual is fraught with obstacles and a dearth of good information.

An alternative to acquiring shares is to invest in secondary investment funds, professionally managed funds that identify the most attractive opportunities. Individual investors can leverage this expertise and invest in private companies via these secondary funds. A distinct added advantage to some of the more elite and established funds is that they procure private company shares and get past the ROFR period before they offer fund interests to investors (aka there is no threat of a ROFR occurring).

Private secondary funds have grown significantly in recent years. In 2021, according to one source, PitchBook, approximately $1.17 trillion in private capital was raised through over 2,700 investment funds. Out of that $1.17 trillion, approximately $47 billion was attributed to secondary investment funds (which represents roughly 4%). Although the private secondary market represented a fraction of the total private capital raised last year, the secondary market has been growing rapidly and is poised to continue its high growth trajectory. In fact, private secondary funds raised more private capital in 2021 than all funds of funds combined (which totaled approximately $30 billion).

Investor interest in the private secondary market continues to expand as the number of large, exciting private companies increases. As this interest increases, so too does the need for proper investment analysis and due diligence. While the burgeoning secondary market may still be difficult to navigate alone, finding and establishing a solid relationship with a secondaries-focused firm eliminates many of the disadvantages mentioned above.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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