In recent years, the world’s fastest growing investment sector has been the secondary market – more specifically, the private equity capital segment of high-tech companies. As the start-up market continues to grow and mature, so do the direct secondary markets.
According to the international consulting firms IQ-EQ and Moonfare, the growth of the secondary market accelerated and reached a fifteen-year high in 2019 with a total transaction volume of approximately $88 billion. This reflects a substantial increase from the transaction volume of approximately $37 billion just three years earlier. According to Jefferies Investment Bank analysts, in 2021 the total transaction volume reached a new record of $132 billion, 50% higher than the previous record of 2019 and 120% higher than the previous year.
There are several factors that shape the growing need for solutions that allow private equity to be traded from one shareholder to another who steps into his shoes. The first factor is the quantity of quality opportunities in this market. The amount and aggregate value of companies considered as "Unicorns" – a privately owned company valued at over a billion dollars – is growing at an unprecedented rate. Between 2018 and 2022, the number of Unicorns in the world grew from 260 to 986. The aggregate market value of these companies grew from about 900 billion dollars in 2018 to about 3.2 trillion dollars in 2022, a growth of about 255% over such a short time span.
Second factor, is that the financial macro-economic situation resulted in the extension of the average time between the establishment of a company to its exit. The median age of technology companies at the time of their IPO tripled between 1999 and 2021, from a median age of four years to a median age of twelve years. In parallel, the value of these companies at the time of public listing increased: in 1999 the median valuation was $493 million; in 2021 it was over $3 billion.
In this new reality, there is a growing need to provide shareholders, especially entrepreneurs and employees, with a way to "cash out" at an earlier stage, without having to wait for the company’s IPO or M&A. Today, some of the companies and/or platforms active in the market strive to organize secondary rounds with private investors or venture capital funds to allow employees to exercise their shares. Given the illiquid nature of private company shares, the secondary market serves as a mechanism to provide liquidity (though limited), presenting shareholders with the opportunity to realize value and exercise their holdings prior to a full exit.
Given the results of the first half of 2022, Jefferies analysts suggest that the strong momentum of transactions in Q4 2021 continued into the first half of 2022. But they also suggested that during the first half of 2022 very little sales took place due to distress, as is usually the case during periods of economic uncertainty. That said, limited partners in private equity funds demonstrated a strong desire to close deals. Many wanted to sell part of their holdings in private equity to balance overallocation.
A discount of about 35%
The forecast for 2023 involves the continuation of extensive activity in the secondary market, with an expected total transaction volume of about 120 billion dollars for the entire year. The valuations of the companies are expected to decrease on average in relation to the years 2021-2022, which according to the analysts will lead to price decreases in future transactions.
With reference to transaction price levels, Jefferies analysts believe that they dropped substantially, similar to the way the prices of shares in the public markets dropped during the same period. Such decreases are expected to moderate during the second half of the year, as the public market is showing signs of recovery.
As primary rounds are held once every many months or sometimes years, plus as it’s difficult to measure a market decline while it’s happening, companies may avoid holding a primary round at a low valuation, even at the cost of postponing the round. At times like this, taking a look at the prices requested by shareholders in the secondary market can provide a supplementary indication to the prices in the private market.
Over the years, it has come to be expected that the price of a common stock, which is mostly owned by the company's employees and its initial entrepreneurs, would be about 30%-50% lower than the price of a preferred stock issued in the last primary round.
This is exactly what we observed at the Elephant Global Secondary Platform – our 2022 forecast demonstrated that the employees who offered their shares on the platform quoted an asking price of about 35% less than the share price in the last round by year’s end. This is in contrast to what we saw in 2021, where we witnessed an unprecedented phenomenon after the abovementioned long-term trend: instead of discount prices for common shares, most of the supply for secondary transactions came at asking prices higher than and at a premium to the companies’ last round.
Purchasing common shares in the secondary market is inherently inferior compared to the preferred shares, as the latter are entitled to participation in a fundraising round (pre-emptive rights), have priority in liquidation (liquidation preference), downside protection (anti-dilution rights) and enjoy additional rights such as access to information and more. The reversal, where instead of a discount there’s a premium even on common shares, came from massive excess demand and oversubscription for primary rounds as well as a continuous surge in prices. A capital raise that took place a quarter or two ago now seemed "old news", and supposedly its price did not reflect the valuation any longer.
This pattern changed completely during 2022 and continues even more strongly as 2023 unfolds. As the capital market crisis continues, in the high-tech industry in particular, we can see a transformation in this indicator. In the second half of 2022, the trend reverted to the previously established standard, featuring an average discount of about 35% or even more and it continues strongly in 2023 at even higher discount levels. In short, Back to Basics.
This article was written in cooperation with Chaim Schiff