As the venture market continues to grow and mature, so does its direct secondary markets. While securities are initially created in what is considered the primary market (such as through an IPO), existing securities are traded in the direct secondary markets. More frequently, investors are looking to direct secondary markets as a release valve for liquidity in venture capital—where hold times are lengthening and companies are staying private longer.

What are direct secondary markets?

Direct secondary markets involve transactions between individual shareholders (like general partners or employees) who sell/buy shares in a venture-backed company instead of selling/buying shares from the company itself.

What’s the difference between the primary market and direct secondary markets?

Put simply, the primary market is where securities (e.g., stocks and bonds) are initially created, the secondary market is where existing securities are traded.

Who is involved in the direct secondary market?

One of the main populations to utilize the direct secondary market are the employees of privately held companies who receive equity compensation. GPs and founders also commonly participate in direct secondary markets as they often have equity in portfolio companies.

What are some advantages of the direct secondary markets?

Due to the illiquid nature of private company shares, direct secondary markets serve as a mechanism to provide liquidity for those who own individual private company shares. These transactions give investors the opportunity to realize value and return capital without a full exit.

Secondary transactions can also help mitigate potential volatility when a company is first publicly listed. Shareholders who need liquidity get the opportunity to sell beforehand, which limits an early trading frenzy. Plus, a secondary sale can help gauge investor sentiment—essentially providing a sneak peek at the demand for a company’s shares—and determine a more accurate price.

Direct secondaries also allow investors to gain access to high-growth and emerging technology companies that they were not able to access in the primary markets.

What challenges do direct secondary markets pose?

One of the greatest challenges is the general lack of transparency and scarcity of information on opportunities in the direct secondary markets. This opacity can make it difficult to efficiently conduct due diligence. Further, this market poses legal and regulatory obstacles due to the complexity of shareholder agreements and their impact on secondary transactions.

Overall, each individual company’s shares have their own unique characteristics and challenges that investors must consider. Similar to purchasing just one stock, there is a lot of unsystematic risk involved in a direct secondary market transaction, depending on company-specific issues. Some investors have concerns regarding the potential for volatility due to limited supply and a generally illiquid market.

For employees who own equity in a company, it can take years until they are able to realize the value of their shares. Lengthening exit times further exacerbate this challenge as it is taking increasingly longer to receive liquidity this way.

How are direct secondary markets different from secondary markets for limited partnership interests?

Direct secondary markets involve directly held equity, while the other involves the transfer of a fund interest or indirect ownership (hence the term “direct” in direct secondary markets).

Are direct secondary markets related to secondary buyouts?

Not really, but the term “secondary” is used in a similar way for both concepts. A secondary buyout (SBO) involves one firm completely selling its ownership of a company to another firm. Secondary in both cases is referring to an additional step after an initial action. In the case of SBOs the initial action is a buyout, in the case of direct secondary markets, the initial action is the creation of securities.

What does the future look like for the direct secondary market?

The size and growth of the overall venture market suggests a bright future for the direct secondary market. One caveat is that uptake in direct secondary transactions may rely on conditions of the current exit environment. In a tepid exit environment, direct secondary transactions become even more meaningful to investors seeking liquidity—encouraging more activity.

Want to learn more about the direct secondary market? Read our analyst note.
 

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