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The Benefits Of Secondaries In Financial Markets

By News Creatives Authors , in Business , at October 12, 2021

One of the myriad tasks that modern finance accomplishes is to conceive of ways to make illiquid assets into something that is liquid. 

For instance, 100 years ago a mortgage was an incredibly illiquid asset: A bank had little choice after issuing a mortgage other than collecting its monthly payments until the homeowner sold the house, defaulted, or paid it off. A bank that made its bread and butter financing houses in its community exposed it to an immense amount of risk if the community’s economy were to suffer a downturn or see a collapse in home prices. As a result, down payments were large and banks limited loans to relatively well off households. 

Eventually, banks began to securitize home loans and sell the monthly flow of mortgage payments to investors, which made their business much safer and—not coincidentally—made it much easier for homeowners to obtain a mortgage. 

A modern version of this phenomenon is evidenced in the secondaries market, which have become common in Silicon Valley. Here is how they work: An investor who puts money directly into a startup receives a share of the company negotiated at the time of his investment, with the understanding that there won’t be a formal market for his share until the company does its IPO. 

There’s a good reason for this insistence of a long-term attachment; for starters, it insulates the founders of the company from short-term pressures to compromise their business plan for a quick buck and reduce potential long-term returns. 

Just as importantly, the long-term investment encourages investors to have a more hands-on approach to such investments; if the startup falters, the investors are more likely to roll up their sleeves and offer advice and counsel if they can’t easily cut their losses and leave. 

The fact that venture capital investors tend to be more hands on than the typical stock market investor is beneficial to everyone: the investor offers his skills and experiences and not only stands to help the company—and his investment—but he also learns more about the company as well, and is in a better position to make a sensible decision with regard to his investment. 

While there are good reasons to encourage long-term investing, we don’t necessarily want such investors to feel that their wealth is stranded indefinitely.  

It’s also worth noting (as I recently did) that a succession of laws has made IPOs costlier and more difficult to do, so startups have been taking longer to advance their company to an IPO. Some have startups have postponed that stage indefinitely, choosing to avoid the increased regulatory and reporting strictures that the SEC imposes for as long as possible. 

This can create a problem for some investors, who may need to diversify their wealth or put a greater portion of their assets into something more liquid—even if (or especially if) the company is doing well: investors don’t want to have the majority of their holdings in one company, regardless of its recent performance. 

Investors can achieve these goals via secondaries—a market that allows another investor to purchase a portion of their stake in the startup. 

While he fact that the secondary market is less liquid than the stock market may mean that the angel investor may not be getting a price that fully reflects the long-term prospects of the company, it serves an essential purpose nonetheless, and nearly everyone is better off that these develop: startups have still have reduced investor pressure to take shortcuts and pursue short-term profits and its investors get both the potential benefits from being in a long-term investment and a modicum of liquidity still possible. 

Secondaries also arise for leveraged buyouts, where investors take over an existing business, restructure the company, and then wait for its valuation to increase accordingly before selling out. 

As the time between a company’s inception and the average IPO lengthens (the average has increased two years since 2010) the need for secondaries becomes greater; fortunately, the market has been good at developing them, and today they are more ubiquitous than ever before. 

Turning illiquid assets into something that is somewhat liquid may not please everyone (Uber

UBER
tried to prevent its early investors and employees from selling to new investors in secondaries early in its pre-IPO existence) but the reality is that this is what financial markets invariably do and it’s generally to the benefit of investors. And if it benefits investors it means that more of them will have an appetite to invest in startups or other ostensibly-illiquid assets that have the potential to transform our economy.

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