What are direct secondary markets?
As the venture capital market continues to grow and mature, so do its direct secondary markets. While securities are initially created in what is considered the primary market (such as through an IPO), existing securities are traded in direct secondary markets. More frequently, investors seek to lead secondary markets as a release valve for venture capital liquidity, where holding times grow longer and companies stay private longer.
What are direct secondary markets?
Direct secondary markets involve transactions between individual shareholders (like general partners or employees) who sell / buy shares of a venture-backed company instead of selling / buying shares of the company itself.
What is the difference between primary market and direct secondary markets?
Simply put, the primary market is where securities (e.g. stocks and bonds) are initially created, the secondary market is where existing securities are traded.
Who is involved in the direct secondary market?
One of the main populations to use the direct secondary market are employees of private companies who receive compensation in shares. GPs and founders also commonly participate in direct secondary markets, as they often hold stakes in portfolio companies.
What are the advantages of direct secondary markets?
Due to the illiquid nature of private company stocks, direct secondary markets serve as a mechanism to provide liquidity to those who hold individual private company stocks. These transactions give investors the opportunity to realize value and repay the principal without a full exit.
Secondary transactions can also help mitigate potential volatility when a company is first listed on a stock exchange. Shareholders in need of liquidity have the option of selling in advance, which limits an early trading frenzy. Additionally, a secondary sale can help gauge investor sentiment, essentially providing insight into demand for a company’s shares, and determining a more accurate price.
Direct secondaries also allow investors to access high growth and emerging technology companies that they have not been able to access in primary markets.
What challenges do direct secondary markets pose?
One of the biggest challenges is the general lack of transparency and the scarcity of information on opportunities in direct secondary markets. This opacity can make it difficult to conduct effective due diligence. In addition, this market poses legal and regulatory obstacles due to the complexity of shareholders’ agreements and their impact on secondary transactions.
Overall, the stocks of each company have their own characteristics and challenges that investors should consider. Much like buying a single share, a direct secondary market transaction involves many unsystematic risks, depending on the specific issues of the company. Some investors are concerned about the potential for volatility due to limited supply and a generally illiquid market.
For employees who own shares in a company, it can take years before they are able to realize the value of their shares. The lengthening of exit deadlines further aggravates this challenge as it takes longer and longer to receive liquidity in this way.
How are direct secondary markets different from secondary markets for limited partnership interests?
The direct secondary markets involve shares held directly, while the other involves the transfer of a fund interest or indirect ownership (hence the term “direct” in direct secondary markets).
Are direct secondary markets linked to secondary buybacks?
Not really, but the term “secondary” is used similarly for both concepts. A secondary redemption (SBO) involves a business completely selling its ownership from one business to another business. Secondary in both cases refers to an additional step after an initial action. In the case of SBOs, the initial action is a repurchase, in the case of direct secondary markets, the initial action is the creation of securities.
What future for the direct secondary market?
The size and growth of the overall venture capital market suggests a bright future for the direct secondary market. One caveat is that the adoption of direct secondary transactions may depend on the conditions of the current exit environment. In a lukewarm exit environment, direct secondary trades become even more meaningful to cash-seeking investors, encouraging more activity.
Want to learn more about the direct secondary market? Read our analyst note.