“Structured Liquidity”: Why We're Long-Term Believers, Part 1

October 22, 2014 Shareworks Marketing

This article was written by Jeron Paul, the founder of Capshare (now Shareworks by Morgan Stanley).

Despite huge (and even growing) obstacles, entrepreneur liquidity options will flourish over the next 10 years.

This is the first in a series of articles that will share some thoughts about the secondary market, its evolution and history, and its likely future.  It will briefly discuss the history of my exposure to secondaries and a brief history of the secondary market as I see it.

First, a bit on my background. I went to Harvard Business School and like so many of my classmates at the time, I wanted a job in one of the (“holy”) trinity of sectors: venture capital, private equity or hedge funds. My personal dream was to get a job in venture capital in Boston or SF. I remember the moment that I gave up on that dream speaking with a classmate who had two Masters degrees from MIT, an MD from Harvard, and who was, at the time on track to graduate with an MBA with highest distinction who also was looking for a job in VC. That evening I realized that my wife and child needed a lot more of my time than I was giving them. From that evening on, I basically gave up on trying be a Baker Scholar, stopped really working that hard on my case work, and focused instead on trying to start a successful company–another viable path into VC. I started two companies: Boardlink, eventually spun into Thomson Reuters, and Scalar, a specialty valuation services firm. After working for a year at Thomson, I got a call to join a regional VC firm in Utah, where much of my extended family lives. I packed up my small family and moved from Boston to Cedar Hills, Utah. After working for 5 years as a Principal at the VC firm, I saw that a partner path wasn’t likely for a variety of reasons and rejoined Scalar, the company I founded while at HBS. Scalar was just at a critical point of pioneering 409A valuation services and the decision to re-join ended up being the best career move of my life. I realized the passion I have for starting and growing great businesses. Scalar also afforded me the money and, eventually, the time to start investing on my own. I started a small, just under $3MM, secondary direct fund called Stockbridge Equity Partners. I have never liked the term “secondary” or the slightly more descriptive term “secondary direct” to describe what we do at Stockbridge. Rather I like to use the phrase “entrepreneur liquidity fund.” We provide liquidity solutions to entrepreneurs. In fact, when we started Stockbridge we bought many of the domain names that refer to entrepreneur liquidity. When we founded Stockbridge, we felt like we were possibly early pioneers in a new asset class. I know that sounds grandiose, but entrepreneur liquidity funds truly are something different than VC and they truly are something different than PE. The key question isn’t whether or not they are unique but rather whether or not they can ever scale beyond being just an interesting idea.

Now, a really simplistic and brief primer on “secondaries.” The phrase secondary is designed to contrast with “primary.” A secondary investment is basically an investment that doesn’t result in the primary issuance of new ownership but rather the sale of an existing ownership stake to a new buyer. In many ways it is just another word for a “buy out” but secondary investors originally looked very different than traditional buyout investors. In my mind, there are 3 basic types of secondaries that correspond to the evolution of the secondary market:

  • The buyout of entire portfolios of PE or VC investments from General Partners
  • The “direct” buyout of the ownership stakes of VC or PE firms in portfolio companies, but not entire portfolios
  • The buyout of any shareholder’s stake in a private company

In the early days a very small group of financial institutions, most notably banks and insurance companies, began to opportunistically buy entire, private equity and VC portfolios from General Partners, who, for a variety of reasons, felt it was better to sell their portfolios than keep managing them. These deals happened at enormous discounts. This led to the formation of divisions within these financial institutions who found that they could make outsized returns by doing these kinds of deals.

The secondaries business is like so many other “consolation prize” businesses–it was always and still really remains much less “sexy” than its primary cousins–VC and PE–but in many ways it has been more successful. Secondaries deals by definition occur after a primary issuance. They typically occur when an original shareholder 1) has a liquidity emergency, 2) no longer believes that the equity is very valuable, or 3) when the shareholder has run out of the patience required for getting to a “natural” liquidity event–the sale or IPO of their company. In each of these cases, the buyer is in a position to negotiate for significant discounts to the “fair” value of the seller’s asset. Further because secondaries typically occur well after primary investing, the underlying company whose stock is being sold, often has markedly lower “j-curve” risk. J-curve risk is typically associated with venture capital-backed companies and refers to the period of losses that occur in most venture-backed companies before they achieve enough success to be clearly profitable or at least valuable. Most would agree that some kind of similar “j-curve risk” exists in PE deals. In any case, secondary transactions end up looking kind of brilliant from a risk-reward perspective, even relative to their more sexy primary cousins. They are deals that are actually closer to having liquidity events than their primary counterparts and they are generally priced at much steeper discounts. So the basic math is lower risk and faster returns at a much lower price relative to primaries. It doesn’t take a genius to see the opportunity in these kinds of deals.

As the financial institutions who experimented with these early secondary deals realized the returns opportunity in buying these assets at huge discounts, they began to institutionalize. John Hancock Insurance spun out HarborVest and the era of institutional secondary firms was born. Until fairly recently these portfolio deals represented almost the entirety of the secondary market. However, a decade or so ago, several scrappy players like Saints Capital begin experimenting with a new kind of secondary deal called a “secondary direct.” These were deals where instead of purchasing entire portfolios from VC firms of PE firms, the secondary buyers just purchased the VC firm’s or PE firm’s interest -directly- in the underlying portfolio company. Many of these deals also created enormous profits for investors. These deals looked almost the same as portfolio deals but now instead of buying an album in order to get one great song, these firms could invest in the one or two deals that looked the most promising and often forgo buying the other portfolio assets.

Finally, this led to the most recent innovation in secondaries, “secondary directs” where the buyer actively seeks the opportunity to buy the shares of a non-institutional shareholder. In many ways this is logical extension of history of secondaries. I like to call these deals “entrepreneur liquidity” deals because they provide liquidity to entrepreneurs themselves as opposed to the investors in the entrepreneur’s company. These deals are fraught with business and legal risk and in the deal-makers vernacular are particularly “hairy” in large part because when institutional investors invest in a company, they usually negotiate for significant legal protections that make it difficult for any other type of shareholder to get liquidity without going through the institutional investors. However, due to enormous demand from both entrepreneurs and from those looking to do “entrepreneur liquidity” deals, the market has grown. In the next post, I will talk more about how it has grown in recent years. I will talk about SecondMarket, SharesPost, Shareworks Startup Edition, and the current state of entrepreneur liquidity investing . Probably in a third post, I will talk about the future of the business including “structured liquidity” programs, a really cool idea that I think could work for many businesses.

–Jeron Paul, Founder of Capshare, now Shareworks Startup Edition


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