Secondary liquidity could transform private equity

Increasingly, late-stage large private funding rounds contain elements of both primary capital raising for companies to build their businesses and secondary sales by earlier investors to newcomers to the share register.

“Close to one quarter of the deals we have done in the last two years have included some level of secondary sale by existing shareholders along with primary capital raising,” says Keith Canton, managing director and head of private capital markets at JPMorgan. 

“We have even done all secondary sales as profitable private companies that no longer need to raise growth capital provide monetization events for early backers and bring in high-profile public investors that may anchor an IPO.”

The firm was agent on a $500 million deal for LegalZoom last year, with participation from funds managed by Franklin Templeton Investments and Neuberger Berman Investment Advisers. Earlier investors such as Permira were able to realize some profits by selling a portion of stakes taken up to four years earlier.

Direct listings, in which companies allow their stock to trade on exchanges without raising new capital as in a traditional IPO – paying a couple of banks to arrange this rather than a big syndicate of underwriters – also look set to grow.

“Many banks have been dismissive of direct listings or sought to discourage them, but we have taken the opposite approach with companies and investors,” says one ECM banker. “It’s not yet a pattern. There have only been a few. But for companies that don’t need to raise capital and have a position that will draw coverage from analysts, direct listings could be the right answer.”

He sees other changes coming too: “The next stage in the market’s development may well be new secondary liquidity capability for these private securities.”

Issuers don’t like clandestine sales of private stock held by key management or institutional backers. Boards may withhold consent for transfer of ownership. But the more stock is privately held, the harder this is to enforce. Adam Neumann himself monetized hundreds of millions worth of We Company stock through margin loans.

“We are thinking about the right mechanism to enable private shareholders to sell a portion of their stakes on an as-needed basis,” says Canton. “That would benefit owners but also potentially companies, because investors might then be able to allocate even more capital and write bigger cheques to them.”

A banker at another firm tells Euromoney: “There is growing discussion now of whether we might soon see new platforms for secondary turnover in stock in semi-listed form, even if not on actual stock exchanges. One could see that being restricted to qualified institutional investors of a certain size, perhaps with some allowance for high net-worth investors if they sign suitability and risk awareness documents.”

Banks might face conflict of interest questions here, or at least have to resolve whether their primary client is the issuer of private stock or an investor seeking to sell it.

If a bank has served a company through several private funding rounds that have seen its valuation rise from $5 billion to $7 billion to $10 billion and it then helps an early investor to sell out at $8 billion, that may leave it with a lot of explaining to do to a company hoping to float at $12 billion.

This is already becoming an issue.

“Think of a growth company that stays private for 10 years and goes through multiple private rounds,” says Douglas Adams, global co-head of equity capital markets at Citi. “In the B and C rounds the early investors will likely re-up. But by the time you get to the D, E and F rounds, with new investors chasing the momentum to an IPO, they’re less likely to.

“In the G round, you might need 40 investors, not 10, and you’re now getting smaller hedge funds and family offices. The share register is large and hard to manage. Early investors, each now with only a small percentage, may just want to sell out, not buy. They may not accept lock-ups and they are in any case hard to enforce.”

This is looks set to become a pressing concern. Few investors are desperate to sell when valuations are going up. Everyone wants to sell when they are going down.

And there’s an even bigger issue. If secondary private equity does become much more liquid, then that removes one of the biggest remaining incentives for ever going public.

Banks will need to think hard over contributing to the growth of secondary liquidity in private equity. That really could kill the IPO business, even if it does survive the banks’ recent pricing blunders.