Secondaries Investments: Buying Existing Shares, Interests, and Stakes

ALTERNATIVE ASSETS FOR PRIVATE INVESTORS—AN ASSURE ANALYTICS SERIES

Alternative Assets for Private Investors — Secondaries Investments: Buying Existing Shares, Interests, and Stakes

This content is for informational purposes only and is not intended to be investing advice. 

Imagine it’s early 2018, and as an investor you’re wondering how you might access some of the exciting late-stage privately held startups before they IPO. Perhaps it's DocuSign (NASDAQ 2018), or Airbnb (NASDAQ 2020), or the fast-growing social media platform TikTok (ByteDance, still private as of publication). Historically, without the right connections and sufficiently deep pockets to participate directly in $100 million-plus late-stage financings, this was virtually impossible. Most investors – who weren’t angels in or employees of those startups – were locked out of these deals until a company went public. But thanks to secondaries, each of these companies were accessible to accredited investors at certain points and prices.

Investors seek out secondary investments for many reasons, including shorter hold periods, less early stage risk / mediation of the J curve, and pre-IPO access. With many startup companies staying private longer, alpha is increasingly generated in the private markets. Companies that go public today tend to do so at much higher valuations than was seen 20 or 30 years ago, meaning that more value is captured by private market investors. As a result, more investors are looking to secondaries as an avenue to capitalize on such deals before they go public.

This article is the second in our Assure Analytics series that examines various types of alternative assets, providing insights both to new investors and seasoned professionals. Our clients at Assure utilize our back office services to paper and administer investments across all kinds of assets in the private markets, including secondaries. 

IPOvsPrivateGrowth

Secondaries: Facilitating Liquidity

The secondaries market, at its core, is the buying and selling of existing private investments between investors. Secondary transactions occur across a wide range of asset classes – from startup equity, to wholly owned private companies, to General Partner (‘GP’) stakes and pro rata rights, to private credit, real estate, infrastructure and beyond. Secondaries can occur in specific assets or companies, or via fund structures. 

It’s a complex landscape with a wide range of performance expectations, opportunities, and risks. For the purposes of this article, we’re going to focus specifically on private equity transactions. 

Secondary transactions occur for a multitude of reasons, but generally they’re built around demands for liquidity and access. The private markets, by their nature, have longer hold times and less liquidity than public equities. Existing shareholders or investors in a deal may be looking to exit their positions, while other investors are looking to gain access to (or add to their existing positions in) that same deal. If these two parties can find each other, they may be able to agree on a price and execute a secondary transaction. 

Measuring the secondaries market is tricky, because it spans so many asset classes and investment structures. By some estimates, it’s grown from around a $2 billion annual market 20 years ago to $130 billion-plus in 2021 with projections of it reaching $250 billion in the next five years. These numbers focus on ‘GP-led’ and ‘LP-led’ (Limited Partner) secondaries largely within venture capital and private equity funds. The actual market size is even larger, with smaller funds, individual startup secondary transactions, and other asset types escaping measurement. 

The rise in secondary activity is a relatively recent innovation in access and alternative investment opportunities. “Secondary sales of private securities were culturally unacceptable five to ten years ago, but are accepted and common today. Acceptance has been driven by necessity, as companies have stayed private longer,” per Alliance Bernstein’s 2021 report on the market. At Assure, we have seen similar growth in secondary SPVs, with nearly 2000 SPVs created in the last few years.

Secondaries-SPVGrowth

Part of this growth is driven by the emergence of online secondary investment platforms such as Forge (2014), InvestX (2014), EquityZen (2013), and MarketX (2015) which focus on facilitating shareholder liquidity in late-stage startups. (Others, like EquityBee, don’t process secondaries but instead facilitate financing for employee options, targeting similar upside potential for investors.) These platforms have helped employees and others sell their shares to accredited investors in companies such as Airbnb, Robinhood, and hundreds of other businesses in advance of anticipated IPOs. The online platforms tend to focus on startups that are near or beyond $1 billion valuations. Today, there are over 1,000 startup companies valued at over $1 billion each, for a collective $3.5 trillion in private market value. ByteDance, Neuralink, The Boring Company, Fanatics, Cruise, Open AI. The list is extensive, with each company difficult to access for accredited investors if not for secondaries.

Key Players

Every asset class has people and entities that have notable influence in and around the asset. In the case of Secondaries, key players to bear in mind include:

 

  • Sellers: To make a secondary investment, you must have someone who wants to sell their existing position. These people and entities can vary widely, depending on the specific secondary approach. Sellers can include:

    • Company Founders – Being a multi-millionaire on paper yet unable to buy a house is not an uncommon phenomenon for entrepreneurs. As startups and private companies grow, the founders may want to unlock some of the value they’ve created. This is often to enable quality of life increases (such as purchasing a home) or taking some ‘risk off the table.’ While some investors dislike founders selling some of their shares in secondary transactions, it’s increasingly common as companies enter the growth stage of their lifecycle. A common perspective is that a partial sale of founder equity enables the founders to focus on hitting a home run for the company, whereas they may make different decisions if they’re worried about their personal net worth being entirely locked up with their company. Note that the existing investors usually have some say in whether, when, and how much equity a founder might sell. They’ll almost always want to see founders retaining meaningful stakes in the company. 

    • Company Employees – Similar to founders, employees of private companies are another large source of secondary selling. The reasons are typically in-line with those of founders (quality of life improvements, sending kids to college, etc) – but the framing is usually around employee retention and morale. With startups staying private longer, the interest in unlocking liquidity from employee stock options has grown commensurately. Early employees may have spent a decade with a startup, and they have life goals as well. Entrepreneurs and investors are recognizing this, and facilitating partial sales of employee equity to keep their talent happy and fulfilled. 

    • Fund GPs – The managers of venture and private equity funds can also be secondary sellers. There are some different aspects to what they may transact: Continuations, GP stakes and pro rata rights. 
      • With Continuation Vehicles, the GP is essentially rolling over a specific deal (or multiple deals) into a new SPV or fund – usually because the deals are still privately held and the existing fund’s legal structure is set to wind down. 
      • In the case of GP stakes, the managers are generally selling rights to anticipated future profits from their existing fund or funds. Managers may sell the stakes to a specific deal, a specific fund, or they may sell partial ownership in the entire venture firm (all current and future funds). Depending on the negotiated terms, GP stakes may be for future carry, or it may also include rights to future management fees. (Note: there’s an entire category of GP Stake specialist investors that we may discuss in a future article.) 
      • Lastly, selling pro rata rights is generally due to VC or PE firms having insufficient dry capital to take advantage of these rights as the underlying deals scale and raise hundreds of millions or billions of dollars. The ‘right to maintain’ ownership has value – and secondary investors may want to buy access to this right – as late-stage growth companies are generally considered less risky. 
    • Fund LPs – The investors in private funds may also want to access liquidity, rebalance, or reduce their number of managers in their portfolios. Being an LP generally requires significant patience and a long time horizon, with hold periods in venture capital funds commonly taking 10+ years. As with other sellers, life circumstances can change for LPs, which can shift their risk appetites and time horizons. Note that the ability of an LP to sell some or all of their position in a fund usually requires the approval of the GPs, with specifics defined in the fund’s Limited Partner Agreement. 
  • Buyers: Of course, a buyer must be on the other side of the transaction, and vary just as much in their motivations and strategies as the sellers. Most often, secondary buyers like that a deal is more mature, more de-risked, and should have a shorter timespan to liquidity than if they had been primary investors. They also may have been unable to access a specific startup in its earlier funding rounds. Some examples of secondary buyers include: 
    • Secondary Funds and Firms – Beyond funds that might sell their positions, there are also funds that specialize in buying secondaries. Some of these go deal-by-deal and use SPVs to bundle their own investors into a specific transaction. Others raise traditional blind-pool fund structures. They may target employee shares, GP stakes, LP stakes, Pro Rata rights, entire companies, or any other tactic or asset type in the secondaries market. Regardless, they’re led by professional investors who seek out promising secondary opportunities. 
    • Accredited Individuals – High-net-worth individuals are increasingly investing in secondaries. Some may choose to invest with a specialized secondary fund (see above), but many are choosing to use online investment platforms focused on secondary deals (see below). In some cases, individuals may also buy a specific position from another investor in a VC fund or an SPV. 
    • Institutions, Hedge Funds, and Family Offices – investors with particularly deep pockets such as pensions, endowments, and hedge funds may also be secondary buyers. 
  • Facilitators and Market Makers: It can be difficult for buyers and sellers to find each other on their own. Multiple marketplaces or ‘exchanges’ have emerged to facilitate these connections, with other financial services providers supporting as well. 
    • Online Investment Platforms – Numerous platforms have launched over the last several years to facilitate the buying and selling of secondaries. Each platform is a bit different, some focusing on certain kinds of sellers or buyers, others focusing on specific assets or data. Most platforms allow investors to choose secondary investments on a deal-by-deal basis. Some have also launched their own diversified secondaries funds, which spread investor capital across multiple secondary opportunities. 
    • Merchant Banks, Broker Dealers and RIAs – professional money managers may also look to facilitate secondary trades for their clients. Examples include Manhattan Venture Partners and Rainmaker Securities. 
  • Back Office: Someone needs to paper these transactions. While law firms and other fund administrators can help form a secondaries fund or special purpose vehicle, Assure has a particular strength in supporting secondary transactions. We provide end-to-end formation and administration for some of the largest secondary investment platforms, and also have dozens of non-platform clients who focus on secondaries.

Key Attributes of Secondary Investments

 

Returns / Performance

Varies, see below

Liquidity

Moderately Illiquid

Exits

IPOs, Acquisitions, other Secondary Sales 

Time Horizon

Months to a few years

Risk

Comparable to late-stage private equity* 

Correlation

Somewhat uncorrelated (with public equities, etc) 

Yield

Usually none

Taxes

Varies 

Minimums

$10K to $100M+ (depending on block size, investment mechanism, target deal(s), etc)

 

Returns / Performance: Performance assessments are challenging, in part because it ranges so broadly and there are so many kinds of secondary investments. Even within private equity, there is substantial difference between a platform-facilitated startup transaction that IPOs in a year, a boutique SPV network that buys GP stakes from small funds, and a large private equity continuation vehicle. That said, Hamilton Lane finds that secondary deals within large private equity funds have historically realized an average 3.2X MOIC (money-on-invested-capital).  April data from Forge showed that pre-IPO secondary investors over the prior 6 months had an average return of +36.4%, versus –38.2% for anyone who invested in the same deals at the IPO. (May data showed that, while at this point returns for trailing 6 months pre- and post-IPO investors had both moved negative, the performance spread was still massive, with pre-IPO secondary investors doing comparatively much better:  -1.7% for pre-IPO versus -61% for post-IPO.) And past data from EquityZen stated that its investors have seen returns ranging from 100% loss to a 2,831% gain, across a broader time period.

Liquidity: Because a secondary deal has already transacted once, there’s already an established market for resale of the asset, and thus a possibility that it could transact again. (Some startup companies even have multiple secondary offerings.) That said, it’s more likely that the asset will sit until it has a formal exit. And in the cases of fund secondaries, full portfolios and GP stakes are much more illiquid. 

Exits: Many private equity secondaries target exits via some form of public listing: IPOs, Direct Listings, or SPACs. (Online secondary platforms generally target ‘pre-IPO’ startups). Investors would receive publicly traded shares, and following any lockup period, they would be free to sell at their own pace. In some cases, a deal may liquidate via a large acquisition, with the underlying investors receiving either cash (buyout) or shares in the new company.  Depending on the specific type of secondary, an exit may also occur via a ‘sponsor-to-sponsor’ transaction (generally where one PE firm sells its secondary position to another PE firm).  

Time Horizon: By default, the time horizon of a secondary deal will be shorter than the ‘primary’ investment. The exact time horizon is dictated by the specific deal, asset class, and investment vehicle (SPV versus specialized fund, etc). But typically, startup secondary transactions are looking at hold times of a few months to a few years. While fund secondaries may look at more like three to five-plus years.  

Risk: All investments have risk, and investors should carefully consider the unique risks to each deal. That said, the point of secondaries is to acquire an asset that is somewhat de-risked already. In the case of startup companies, they are further along their growth trajectory, likely have customers, revenue, and a business model, and may be soon approaching a public listing. Investors can have greater clarity on what they’re buying than they could with Seed-stage or Series A financing rounds. 

Correlation: Secondaries have some positive correlation with the public markets, but there is nuance as every deal is different. As one investor puts it, “As a startup gets closer to IPO, their correlation with public equities goes to 1.”  If public equities are surging and startups are proactively going public, prospective sellers of secondary deals may instead elect to just wait. If they do decide to sell, the seller may expect a significant premium to the last valuation in order to part with their shares. 

If public equities are down and/or few companies are going public (two scenarios that are not necessarily correlated), it can create a buyers market. In such scenarios – existing shareholders may see their exit timelines extend and encourage them to participate in a secondary sale (if they, for example, need to finance a new mortgage now). In these scenarios, sellers may offer discounts to the last valuation. Recent data from Forge shows that, in conjunction with a decline in the public markets, secondary prices have also compressed, though at a slower rate, and the number of sellers offering discounts to entice buyers has increased (from 34% in February 2022 to 43% in March 2022). Similarly for portfolio / fund secondaries, discounts have reportedly increased in recent months – as there are fewer buyers at these stages, and GPs / LPs interested in accessing early liquidity are starting to offer steeper discounts than in the last couple years. 

Yield: With private equity secondaries, there is usually no cash flow from the asset. It’s possible that some private companies may decide to share a dividend with its investors, but this is uncommon. 

Taxes:  Every country’s tax code is different, and this article will not discuss taxes in detail. Because secondaries can span so many asset classes and equity types, there is no definitive tax burden. In the case of private equity and pre-IPO shares, it's likely that U.S. investors will fall under long-term capital gains. But depending on the specific deal, there may be dividends, UBTI, royalty income, etc with their own tax implications. 

Minimums: Today, investors can add secondaries to their portfolio for as little as $10,000 via online investment platforms, and with select deals the minimums may be even lower. These platforms bundle multiple investors into special purpose vehicles to make larger transactions in pre-IPO companies (and in many cases, these platforms partner with Assure to provide the back office formation and administrative support). Each platform has its own approach, with some specialization in particular distribution paths (for example, InvestX prioritizes working with broker dealers to syndicate deals through the wealth management industry). 

At Assure, some of our non-platform clients are also proactive secondaries investors – ranging from specialized secondary funds, to VC and PE firms setting up continuation vehicles for their top deals, to merchant banks, broker-dealers, and individual dealmakers who spot unique secondary opportunities. These minimums scale according to their target deal sizes, with minimums in the millions becoming commonplace for certain fund-based strategies. That said, the median minimum across Assure’s secondaries SPVs is $10,000 with an average minimum of $22,000.

What’s Unique to Secondaries as an Asset Class

J-Curve mitigation: One of the more unique characteristics of secondaries is the goal of mitigating, or skipping, the ‘J-curve.’ The  J-curve is a well-documented concept in startup, venture capital, and private equity investing that essentially argues that performance in the near and mid-term is negative as more cash is required to support high-risk investments (via capital calls, pro rata maintenance, etc). And only after several years does the investment start to show a positive rate of return. Secondaries, by investing much later in these funds and deals, can help investors avoid experiencing the lowest areas of the ‘J’ (of course, with less risk may come less upside potential). 

Hypothetical J-Curve - Secondaries

Other Considerations and Challenges in Secondaries Investing

Price discovery: A major component of secondary deals is price discovery. Because the market for each deal is episodic instead of ongoing (like public equities), there isn’t consistent price discovery. What is usually known is the last valuation of the company or the fund (and its underlying companies). For startups – that last valuation is likely the last financing round or a 409a valuation. For funds, it's likely the last quarterly or annual financial statement delivered to investors. From there, prospective buyers and sellers must work towards an agreed price – that may not reflect the last valuation. Company growth, hype, sector trends, unique IP, limited public data, market factors, anticipated time horizon, company or fund age, buyer interest versus available shares, and personal circumstances, can all affect whether a fair price can be determined and agreed upon by all participants. Facilitators can help here – online investment platforms look to gather key metrics from their pre-IPO deals in order to determine a reasonable price and help close the transaction (learn more about how they think on the Assure virtual panel:  Bringing Liquidity to the Private Markets). 

"Pricing any portfolio is tricky – you have to assess the market, consider underlying deal quality, look at any prior valuation data, and then start thinking about write-offs, write-downs, and overall portfolio discounts. When it comes to GP portfolios and venture capital secondaries, we apply some skepticism to GP marks and determine a discount. We then need to incorporate an illiquidity discount. Of course, the degree of discounting ebbs and flows alongside buyer competition, and public equity performance.” 
– Dave McClure, Practical VC (A VC Secondaries Fund) 

Block size: Block size – or the number of shares available to sell – matters. If there is only limited interest from sellers, a secondary deal can be oversubscribed and drive bidding competition to win the allocation. Some secondary transactions consist of nothing more than a small slug of a founder’s equity that is bundled into the company’s next financing round. In other cases, a large cut of employee equity may be acquired by a large institution, with the remainder available to others (funds, platforms, etc). 

Legal Agreement Terms: There are specific rules around secondary sales that can be unique to each deal. Rules usually depend on prior investment agreements, limited partner agreements, etc. Existing shareholders / investors can just readily sell their equity to anyone who wants to buy. For example, a prospective seller may need to garner board approval, manager approval, general partner approval, etc. Prospective investors may similarly be subject to approval. 

Fees: Funds, online platforms, and broker dealers can all assess fees in exchange for supporting and processing a transaction. Fees can vary widely – from ongoing management and carry to one-time transaction fees. With some platforms, fees can decline for investors deploying larger check sizes.

Requirements

Accreditation: Secondary deals are mostly restricted to accredited investors. There are a few exceptions today built around Reg CF and Reg A such as StartEngine

Check Sizes: Typical investment check sizes range widely, from as little as $10K to $100M+. Online platforms typically set their minimums between $10K and $100K, while specialized secondary funds could set larger minimums at their discretion. 

Patience: Moderate. The nature of secondaries is to enter into a specific asset in the late-stage of its growth curve. By definition, you are not the first investor. As a result, the expected hold time is lower than any initial investor in the same asset. But hold times can still vary widely, from a few weeks or months, to several years. 

The Role of Secondaries in Your Portfolio

Different investors have different portfolio construction strategies geared towards their specific goals and needs. Whether Secondaries are a part of an investment portfolio, and their specific allocations within a portfolio, is typically driven by an investor’s desire for access to pre-IPO growth potential, diversification, exposure to less correlated assets, ability to bear illiquidity, tactical considerations, and desire for total return.

Secondaries can sit in multiple locations in your portfolio, depending on the specific asset class. Given this article's focus on private equity secondaries, such investments would sit in the private equity allocation. Credit Suisse notes that their clients tend to have ~8% of their net worth allocated to private equity, though some clients allocate much more (October 2020). 

Below is a hypothetical investment portfolio for a family office, highlighting where secondaries may exist. 

Secondaries-UNHWIAllocation

Accessing Secondaries

Secondaries can offer a compelling approach to alternative investments for investors. Shorter hold times, greater clarity into the target assets, risk mitigation, and pre-IPO access are just some of the reasons investors may find secondaries appealing. 

As discussed earlier, there are a plethora of ways to access secondary investments. You can use secondary platforms, allocate to specialized secondary funds, find secondary deals via niche secondary networks, etc. 

At Assure, many of our clients use SPVs to syndicate investments in secondary deals. We have clients that are secondary funds, GP pro rata networks, merchant banks, broker dealers, as well as online platforms facilitating secondary access at scale.  Assure makes their administrative process easy – it manages the legal container, capital calls from investors, ongoing accounting, and annual tax preparations to streamline the back office experience for secondary investors.

 

Subscribe below to receive these articles via email.

Topics: Analytics, Alternative Assets

SUBSCRIBE:

SUBSCRIBE