Claire Cain Miller penned a story in last Wednesday’s New York Times concerning the development of private markets for venture-backed equity investments. The article raised several important issues, but I’d like to provide further color beyond my quotes in the story. Private markets, their opportunities and risks are very complex: my belief is that while it would be great for a “third exit” to emerge, its realization remains far, far away, except for the most popular, “branded” private companies. Think Facebook, Twitter and the like. Legal and regulatory issues are a problem. Scaling is a problem. And the demand side is a problem. For these and other reasons, I believe it will take years for a true alternative means of liquidity to emerge.
Not a Technology Problem
First off, let’s be clear: this is not a problem that subjects itself well to a technology solution, at least not now. The hardest issues with these types of transactions are operational: compliance with transaction documents, e.g., Right of First Refusal provisions, etc.; transfer and custody of physical stock certificates; receipt of stock powers; alterations to books and records; collection of sufficient information about the company to make an educated investment decision, etc. Due to investor demand and regulatory limitations, technology as a vehicle for price discovery hasn’t really been necessary. So those that consider this a technology problem to be solved are far off the mark. Think of one of the single most successful financial start-up of the past decade: Gerson Lehrman Group. The company is worth over a billion dollars. The vast majority of this market value is not attributable to technology, but to making a match between information seeker and information provider. The technology that has been built in recent years is nice but certainly not a key driver of firm value. The largest and arguably most successful company in the private/illiquid asset space, SecondMarket, has painstakingly built an back-office environment to rival that of a small broker/dealer. Companies that are at all successful in this space will have significant infrastructures to handle the operational requirements of trade execution and settlement. Everyone else is simply pretending.
Not a New Idea
Making a match between a large seller of restricted/private stock and a buyer. Hmm, that sounds familiar. Who else does this? Right, Mergers & Acquisition bankers and block desks. Depending upon whether the sale is to a strategic buyer or a financial buyer, Wall Street has long dealt with exactly the problems these private exchanges are purporting to solve. If it’s employees with small holdings ok, not the same, but if it is a venture firm like Union Square Ventures, Kleiner Perkins, or DFJ looking to find an alternative path to liquidity, they can always call up their friendly investment banker and place the stock through them. Bankers can do the job of price discovery just like a listed market, and the prices will be much more reflective of the kind of size the sellers want to move than a shallow indicative level that doesn’t do the venture firms much good. It will take years to cultivate a truly new investor base, e.g., high net worth retail, to take up the stock. Moving large size in private companies tends to be an institutional phenomenon, those same institutions that are currently no bid in the largely dead IPO market.
Depth in Demand Does Not Exist
The investors that generally drive the IPO market – not high net worth individuals but mutual funds, hedge funds and other institutional investors – are largely on the sidelines. There is a massive emphasis towards liquidity in today’s environment, and private company stock is not high on most institutional investors’ shopping lists. So in the absence of these key players, are accredited investors (in Securities Act of 1933 terms) really sufficient to pick up the slack? It’s not as if angel investors have been deploying large amounts of capital, and those “super angels” that have been bridging the gap between founders and institutional rounds are primarily “first-money-in” investors; they are not looking for Facebook stock at $4 billion or Twitter stock at $350 million. So the fact that there isn’t a vibrant IPO market says to me that there isn’t a deep private company stock market, either. In the absence of real demand, all the recent buzz in this space appears to be a solution looking for a problem.
The Regulatory Environment is Hostile, and the Trend is Not Your Friend
All of these private markets are predicated upon either the Accredited Investor or Qualified Institutional Buyer (QIB) rules; these provide safe harbors from a host of SEC reporting and disclosure requirements, on the assumption that investors in these buckets are sufficiently sophisticated to make investments in risky, unregistered securities. These restrictions, coupled with the 500 investor limitation pursuant to the Securities Exchange Act of 1934, sharply limit the potential parties that can underpin the demand for these private markets. In effect, for the volume of these markets to scale, the same institutional investors mentioned above need to participate. And if they won’t buy shares of more profitable, less risky IPO companies that will provide detailed SEC-compliant disclosures, then why would they be motivated to invest in less profitable, riskier private markets companies with limited disclosure requirements? Answer: they wouldn’t. Further, in order for these markets to truly flourish, rules such as the 500 investor limitation would need to be relaxed. But with today’s environment awash in scandals, trillions of losses due to illiquid and non-transparent asset portfolios and the taxpayer and Congressional backlash arising from the bailout, is anyone really in a position to ask for relaxation of rules that are designed to protect investors? Good luck. The timing could not be worse.
Private Markets Could Work – Someday
The key needed for these markets – any private market – to succeed is real and durable demand. When that will emerge I do not know, but I am pretty confident it won’t be for another 18-24 months, at best. Another factor are the public company listing, filing and compliance requirements. Sarbanes-Oxley (Sarbox) has certainly raised the bar for companies going public, and represented one of the key motivations for markets such as GSTrUE and Opus-5 to emerge. But if Sarbox were rolled back or recast in such a way that compliance was less complex and cheaper to implement, then the need for private markets might go away. I don’t buy the argument that a “long tail” of demand exists for non-brand name private companies, except insofar as these companies are raising capital, not for investors who are looking to sell out. Just as with GSTrUE, the companies that were able to be placed were top-shelf names with big brands and significant pent-up demand. This kind of dynamic does not exist in the long tail. It seems to me that Internet investors are seeking to apply web logic to a Wall Street phenomenon. Sometimes characteristics of the online world don’t necessarily apply to the offline world. I could be wrong here, but I doubt it.
The Bottom Line
I appreciate the desire for a third path to liquidity, and acknowledge its importance, but you can’t manufacture demand where none exists. Demand will pick up at some point and these markets will be viable, but their growth will be sharply capped due to both the “brand name” and “head of the tail” phenomena and the regulatory environment. So this is one to keep an eye on, but my sense is that this third path simply won’t become viable for a long, long time.