Secondaries Primer Part 1: A Quick History of the Secondary Market
While secondary transactions have occurred for decades, their popularity has skyrocketed in recent years. Unfortunately, the secondary market is still rather opaque, so I thought I would try to shed some light on the industry in a series of posts. This first post will cover the basics including what a secondary transaction is, why it exists, and the history of the secondary market.
What are Secondaries?
The private equity secondary market (often simply called “secondaries”) refers to buying and selling pre-existing shares of a company or existing LP positions in a venture capital portfolio. Secondaries are different than typical VC investments, otherwise known as primaries.
The headlines you read in TechCrunch about so and so VC investing millions of dollars into some new high-flying startup at a huge valuation, that’s a primary investment. In these transactions, the company issues new stock (typically preferred) to the investor in exchange for capital. That capital goes onto the company’s balance sheet and is used to support operations and fuel growth.
In a direct secondary investment, no new shares are created. Rather, existing shares are purchased, and the capital used to purchase those shares goes directly to the seller of the shares (typically either an early investor or long-time employee), not to the company. In other words, a secondary transaction is not a financing event for a company, rather, it is a liquidity event for select shareholders.
There are other secondary investments that consist of buying out existing LP positions in a fund rather than purchasing shares in a single company. In these transactions, the buyer purchases either part of or the entire position from the investors who originally invested in a particular venture fund (otherwise known as LPs). This way they now become LPs in that fund that owns positions across a number of different companies.
Why does the secondary market exist?
Investments in startups or venture funds are very illiquid with long time horizons, often 10+ years. There are a number of legitimate reasons why a VC or LP would want to sell their position (I will cover these reasons in more detail in Part 2) before this long commitment has run its course. However, unlike in public markets, there is no easy way to exit these positions. As a result, the secondary market developed to provide liquidity to private equity investors.
History of the secondary market
The very first secondary fund was raised by VCFA back in 1982. Whereas today, a number of secondary firms have raised multi-billion dollar funds, VCFA’s original fund was only $6 million. By the late 1980s, a handful of secondary funds existed, all less than $50m in size. Another early pioneer of secondaries was Jeremy Coller who founded UK based Coller Capital in the early 1990s.
As PE and venture capital grew in the 1990s, secondaries remained a small, niche market. Secondary funds, in aggregate, raised a total of $10.4 billion over a ten-year period from 1991–2000. To put that in perspective, today some of the largest firms in the market, Ardian and Lexington for example, have single funds dedicated to secondaries that are roughly that size.
It wasn’t until after the dot com crash that the secondary market really began to become more prominent. In the early 2000s, many investors began searching for an early exit from their existing commitments to the private equity asset class, particularly venture capital. As a result, the nascent secondary market became an increasingly active sector. Secondary transaction volume increased from historical levels of 2–3% of private equity commitments to a little over 5% of the addressable market. By 2006, annual secondaries transactions exceed $10 billion, equal to the total market activity from 1990 to 2000 (1).
Before 2000, private markets were still characterized by limited liquidity with secondary transactions trading at significant discounts to fair value. The demand for liquidity and attractive pricing following the dot com crash prompted new entrants to the market. By the mid 2000s, the secondary market had transformed into a much more developed industry and for the first time, assets traded at or above their estimated fair values and liquidity increased dramatically. This maturation of the secondary market coincided with the evolution of the broader private equity industry as an increasing number of investors begun to pursue secondary sales to rebalance their portfolios.
However, it wasn’t until after the financial crisis of 2008 that the secondary market began to develop into what it is today. Prior to 2008, companies would typically IPO before many of their employees had fully vested their options or the early investors needed to sell their stakes and wind down their funds. After the 2008 financial crisis, tech IPO’s became increasingly rare due to new regulation and an influx of capital at the later stages which has allowed tech companies to remain private for much longer.
This trend has increased the demand for liquidity from early employees and investors. As a result, the secondary market has nearly quadrupled since the financial crisis of 2008.
As it has grown and matured over the past two decades, the secondary market has evolved from a niche market characterized by distressed sellers and significant discounts to a functional and active marketplace with increasingly sophisticated participants. The secondary market is not only a necessary release valve for the private markets, but its growth is inevitable so long as companies continue to postpone entering the public markets until they are much more mature.
(1) Source: https://www.collercapital.com/about-secondaries/history-secondaries
