The secondary market for private equity—and to a lesser extent private credit and real estate—seems to be having a moment, and perhaps for good reason. And the ability of well-heeled individual and institutional investors to trade shares of private companies is increasing in reaction to this trend.
For the last decade, some of the most desirable companies in the U.S., which in the past would have proven their worth with a bell-ringing IPO, have been staying private longer, industry sources say. Much longer.
In 1996, 739 companies went public with an average age of five years. In 2022, 181 companies went public with an average age of 13 years.
“This is a big shift,” said Kelly Rodriques, CEO of Forge, a secondaries marketplace and data provider headquartered in San Francisco. “So they’re going public at billions when they were previously going public at $500 million.”
The asset classes most acutely feeling the impact of this shift are the small-cap and mid-cap arenas, leaving today’s investors hungry for opportunity as they consistently run up against a shrinking pool of options.
“Investors wanting small- and mid-cap exposure have less choice,” said Michael Bell, founder and CEO of Denver-based Primark Capital. “If historically advisors had an allocation to small- and mid-cap of 12%, today it’s still 12%. However, the number of investment options is dramatically reduced and there’s a lower quality of earnings as well.”
The reason for that is small- and mid-cap companies don’t need to hit the public equity market to enter a new phase of development and growth, he said. They can do that—not just as well, but even better sometimes—privately.
“Through the ’90s, companies were going public at a rate of three, four, five companies every single week. Remember the New York Stock Exchange? A big party every day because someone was launching a new issue,” Bell said. “That funnel has reduced to a trickle. For those companies, the only continued access to capital markets was through going public. Today, there alternatives—much cheaper, more efficient alternatives—in private equity.”
Companies that stay private are not subject to the regulatory scrutiny of the Sarbanes-Oxley Act, or the increased costs of being a public company, or the quarter-by-quarter evaluation of analysts, he said. As a result, companies are staying private well into their maturity, “and all of that massive growth potential from early-stage companies is getting bled out.”
“The Microsofts of 30 years ago, they’re not going public anymore at the early stage. So who has had the opportunity to enjoy that dramatic growth of those early-stage companies? Well, the big institutions like CALPERS and CALSTRS, because they’ve had the ability to invest in private equity,” he said. “Our focus is to make those private-market investment opportunities available all investors.”
The benefit is not just on the buy side, sources said, but it can been a boon to a company’s founders, employees and limited partners who may have a hard time waiting more than a decade for a formal liquidity event.
As such, a slew of matchmakers is appearing to ensure that supply meets demand, and not just for large pension plans, endowments and a few deep-pocketed family offices. Marketplaces like Nasdaq Private Markets, iCapital and Forge can give a cash-poor software engineer with $8 million in desirable stock an opportunity to liquidate that treasure when needed.
For investors who prefer a fund environment, Primark manages a mid-cap private equity interval fund available to individuals through an advisor and with a $5,000 minimum investment. The fund invests in deals sourced by Meketa Investment Group, an investment consultant to large pension plans with $1.7 trillion under its advisement, and offers quarterly liquidity.
And new to the market is Axxes Capital in Miami, which launched in January 2022 with the intent of rolling out a series of private-market funds that are, like Primark, available only through financial advisors.
One thing sources are quick to note is that while the current stagnant IPO environment is helping create the demand for secondary private equity opportunities, this asset class isn’t going to evaporate when the IPO market gets some juice again. These investments, they said, represent a major shift in accessibility and are here to stay.
“Even if you saw a couple of big IPOs, I don’t think it takes away the opportunity because a lot of these companies are able to stay private longer because they can get capital, which means they control their destiny better,” said Tony Davidow, senior alternatives investment strategist at Franklin Templeton Institute, an independent investment research hub in San Mateo, Calif. “When you go to the public market, it’s a different beast. You’re beholden to shareholders and meeting quarterly, earnings and revenue calls, and it changes the way you run your business.”
Market Size And Pricing
Part of Davidow’s mandate at the FT Insitute is to help advisors think through the complexities of alternative assets, including where and how much to allocate.
“We think secondaries look attractive. It’s not just that there’s more supply in the secondary market, there are also more attractive valuations, and I think that’s really appealing,” he said. “And it seems to me that people are starting to recognize this once-niche industry as now becoming a much bigger part of the private-equity ecosystem.”
Among the believers are Franklin Templeton itself, which in April 2022 acquired Lexington Partners L.P., a manager of secondary private equity and co-investment funds that now sits alongside other alternatives acquisitions in hedge funds, real estate and private credit.
Private markets advisory firm Campbell Lutyens, headquartered in London, pegs 2022’s total volume of secondaries transactions at $106 billion, second in size only to 2021’s $135 billion. And Triago, a global advisor on private equity funds and secondary transactions with U.S. corporate offices in New York, narrows the field even further, saying private equity secondaries totaled $103 billion in 2022 and $121 billion in 2022.
“Those investors are getting access to a return series, a return stream, that is much higher than the public counterparts for a lot of different reasons. They’re getting access to a non-correlated asset class,” Bell said. “And they now have the ability to get access to products that only institutions could get access to previously.”
Forge’s Rodriques said dismal market performance across the board in 2022 has paved the way for what he’s calling “The Great Reset” as skyrocketing valuations leading up to the pinnacle of 2021 are being reset under new market dynamics.
“If a company raised money in 2020 at a big valuation and came back a year later and raised it in 2021, just the delta between their valuation the previous year and in 2021 could be double the size of the valuation of the company,” he said. “So what happened was in 2021 at the end was everything came crashing down both in the public and private markets and you saw the public markets start to recover, but the privates stalled. Very few companies were actually able to raise money in 2022.”
A perfect example of this is Stripe, a global company that provides online payment processing and e-commerce solutions, founded in San Francisco but now headquartered in Dublin, Ireland. In March 2021, the company raised $600 million to accelerate its momentum in Europe. This gave the company a valuation of $95 billion. In March 2023, Stripe held another round of funding to provide employees with liquidity. The company raised $6.5 billion at a valuation of $50 billion.
Unlike the public markets where there’s obvious liquidity and daily pricing, what a private company thought it was worth in 2022 and what buyers were willing to pay were quite far apart. “You saw bid-ask spreads in the 30s,” Rodriques said.
More recently, Forge has reported that those spreads are closer to 18%, and renewed buy-side interest is coming into the market. Buyers represented just 26.4% of activity in October 2022, but represent 42.3% of activity as of June, according to Forge data.
“We’re seeing a handful of names really start to perform: Instacart, Space X, Klaviyo, Epic Games, these are all companies where their pricing is improving and their year-to-date performance is starting to move the market,” he said.
The Private Market Is Here To Stay
While Rodriques said he believes the reset on valuations will last about a year before they start taking off again and the IPO market springs back to life, Bell said he thinks equities are in the early stages of a mega-trend shift into private-market investments.
“For a long time there was a mega-trend shift to low-cost beta products, and today what we have left is basically low-cost market exposure in almost all portfolios. All portfolios look fairly generic. Fairly commoditized. Everybody’s kind of holding the same thing, right?” he asked rhetorically.
The question this then poses to the consumer is somewhat existential for financial advisors, Bell continued.
“If everyone is holding iShares or Vanguard ETFs, what’s the value an advisor’s bringing? The advisor who’s listening will offer a lot more financial planning, and that’s a growing part of an advisory practice,” he said. “But also clients are starting to ask, ‘How can I get access to private real estate? My friend has told me they’re getting access to private credit investments.’ Or early-stage IPOs, or private equity. ‘How do I get that?’”
There has been a dramatically increasing level of product development in making these products available to high-net-worth, accredited investors, and even non-accredited investors at times, he said.
“And that’s where we focus our effort. Right now advisors across the private-wealth spectrum have less than 5% of their assets allocated to private market investment opportunities,” he said. “We believe over the next 15 years or so it will not be uncommon to see allocations of 20% or 25% into private market investment opportunities.”
One hurdle that an advisor might consider exploring with a client is the actual need for liquidity, which is the private market’s Achilles heel for a lot of investors.
“With the individual investor, there’s a possibly perceived need for liquidity from dollar one to the last dollar invested. But history shows us that’s really not the case,” Bell said.
Most advisors don’t direct investors to move all of their assets to cash, though at times they may suggest adding to a cash position, he illustrated.
“But those assets that are at the bottom of the portfolio as longer-term assets will always stay invested,” he said. “So that’s something I think has to come out [through education], and advisors have to position these as long-term investments, not a trade.”
The Primark fund charges 3.09% in total annual fund operating expenses (including a 1.50% management fee), which Bell said is more than offset by the access it provides without an advisor and client dealing with the cumbersome aspects of private equity investing: high minimums, K1s, lots of due diligence and lots of paperwork.
“We’ve taken that investment and packaged it into a mutual fund, an interval fund, that’s a point and click solution,” he said. “An advisor can go on, point, click and buy today, without any of those restrictions. And now you can offer this asset class as a distinguishing investment from your traditional low cost, ETF, beta-driven investment portfolio.”
What The Future Holds
Should the secondaries private equity market become as democratized as Bell and Rodriques hope, the effect could be to keep some leading companies private not just longer but indefinitely.
“As long as they can raise capital, they don’t need the public market,” Davidow pointed out.
Already the public markets have seen a contraction in the number of companies traded. The Wilshire 5000 index, for example, was named for the 5000 broad-market stocks it contained at its 1974 launch. By 1998, the index’s roster had swelled to more than 7,500 stocks.
As of March 2023, it contained just 3,480 stocks, according to Wilshire.
This presents a challenge to public market investors, especially those who focus on small- or mid-cap investing. But a pendulum swing to private markets may not be the answer, said investors like Brian Smoluch, CFA and co-founder of Hood River Capital Management, a small-cap public markets investor in Palm Beach Gardens, Fla. Its U.S. small-cap growth fund manages $1.6 billion in assets, according to Morningstar.
Smoluch admitted there are fewer small-cap companies now to choose from, and in that sense his job is harder than it used to be, but insists the attraction of the public markets should not be dismissed.
“Small-cap companies are growth companies. They’re more innovative and attached to areas that are growing faster than the GDP. And management is aligned with the shareholders,” he said. “You can get similar returns on the public side as on the private side, and you have real liquidity. That can be a big advantage given how often small-cap companies make mistakes and how fast the world can turn.”
His fund has average total annual returns over 10 years of 13.30% compared with the Russell 2000 Growth Index benchmark, which returned 8.83%, accordding to Morningstar. Fees are an adjusted expense ratio of 1.090%.
“And what’s a private equity investment going to return, say 15%? We get slightly less returns, but a lot less risk and lower fees,” he said.
On top of that, the transparency can’t be beat, he said.
“With public stocks, you get financials on everything. Everything is transparent,” he said. “With secondaries, you’re not going to be able to pull up a private company’s financials."