Privately held companies are delaying their initial public offerings (IPOs) and staying private longer, sparking a seismic shift in how investors access and participate in private equity markets.
Considering that many companies experience significant growth in value prior to their IPO1—as was the case for Uber, AirBnb, Lyft, and many others—the implications are clear: a large amount of wealth creation is happening outside the realm of the public markets, and investors who can participate in pre-IPO markets may enjoy an advantage over those investing solely in publicly traded firms.
How We Got Here
It may seem counterintuitive for an otherwise prosperous startup to delay its IPO. Going public generally grants companies access to public capital markets, boosts credibility in the public eye, and provides added exposure on a national or even global scale.
Still, commentators have noted the tendency of companies in the last 20 years to delay or forego these events, opting instead to pursue additional capital from private sources like private equity financing and venture capital.
The main catalyst for this shift can be traced back to the passage of the Sarbanes-Oxley Act of 2002, which introduced sweeping reforms to existing securities regulations following a string of financial scandals in the early 2000s. Although passage of the Act led to increased corporate responsibility and more stringent accounting laws, it also increased the costs and administrative burdens associated with going public, creating new barriers for rising companies with less ready access to capital.
There can sometimes be other motivations at play, too. For example, some founders may be wary about the sensitivity of market valuations to quarterly earnings reports or may simply value their independence from public shareholders.
What Does This Mean For Private Equity?
It has become clear that the marketplace for private equity investing is changing. There is now a greater number of highly valued private companies operating today than in the past, including more “unicorns” (private companies valued at $1 billion or more). In 2010, only one company had earned that distinction; today, there are more than 700.
This carries implications for early investors and employee shareholders, particularly those who committed at an early stage and now find themselves stuck in illiquid, highly concentrated positions.
In the past, these individuals could have expected to wait a relatively short amount of time for an IPO to materialize, at which point they could liquidate some or all their holdings. Since the time horizon to an exit is now much longer, as the chart to the right shows, shareholders of private companies who need liquidity for their shares are increasingly turning to the secondary market to sell them, even at a discount to fair market value.
Finding Attractive Opportunities in the Secondary Markets
In our view, both of these groups—outside investors who wish to participate in private companies’ pre-IPO growth and the employees of those companies looking for liquidity—may benefit from participating in secondary private equity transactions.
These funds purchase existing private equity holdings, either from early investors or from employees looking to monetize their equity shares before the company goes public. The companies in question tend to be further along in their lifecycles compared to their early-stage counterparts; most are relatively large, established, fast-growing revenue businesses with valuations of $1 billion or more. In this way, investors in secondary private equity funds can access the equity of private companies that would otherwise be inaccessible and participate in their pre-IPO growth.
Compared to traditional private equity, secondary private equity funds have the added advantage of increased diversification and shorter investment horizons (providing a faster return of capital). They can also have less of a J-curve effect, as investments in secondary funds may be more seasoned and mature. Importantly, early liquidity comes at a cost to the seller, meaning secondary funds are often able to buy positions at a discount to current value.
For all of these reasons, we see tremendous opportunity in the secondary private equity space and the potential for outsized returns above the public markets. Westmount has the experience and capability of identifying, vetting and investing in several secondary private equity funds with strong track records of success and specializations in fast-growing sectors. In fact, two previous investments in secondary funds that Westmount made in 2020 have already generated 110% and 100% cumulative gross returns as of June 30, 2021.2
Westmount clients have the opportunity to invest in these secondary private equity investments (at lower investment amounts) through a network of managers that have been identified and vetted by our Investment Committee.
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1 SharesPost, Pitchbook, Y-Charts, Nasdaq, SEC Edgar. Total 479 U.S. Venture-Capital-Back Private Companies that executed an IPO from Jan. 1, 2010 through May 31, 2020. Last private financing prices adjusted for subsequent stock splits to allow for appropriate comparisons. Only includes formerly VC-backed, U.S. companies listing on the NYSE or NASDAQ. Analysis tracks the change in price for an individual share at last private financing, and therefore does not factor in potential tax implications or management and performance fees that may be associated with investments in private markets.
2 Refers to two fund investments Westmount made in 2020 in HighGear Ventures Secondary II, which has a gross return multiple of 2.1x as of June 30, 2021 and Sweetwater Private Equity Fund II, which has a gross return multiple of 2.0x as of June 30, 2021 according to the managers’ 2nd quarter 2021 reports.
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