Secondary Platforms Could Pose Challenges

The nature of the private-company business is changing, as a result of new entrants into the market and changing laws regarding the ownership of stock outside public markets.

For now, much of the attention is focused on technology companies such as Facebook and Twitter, whose roaring growth has stimulated interest in specialty marketplaces such as SecondMarket and SharesPost, which provide platforms for trading in restricted shares.

But as interest in such marketplaces grows, and as the Securities and Exchange Commission weighs changes in rules such as the 500-owner limit for avoiding stock registration, the evolving markets could affect the ways that buyout shops acquire and sell portfolio companies, some experts believe.

“I think there is going to be an explosion in the whole sector,” as restricted-stock companies find news ways to raise capital and achieve liquidity for their owners, said Steve Greenblatt, who heads up the equity capital market and issuer services business at Liquidnet Holdings Inc.

Greenblatt compared restricted shares to high-yield debt, which once was anathema to institutional money managers. “Now it’s part of everybody’s portfolio,” he noted.

Liquidnet, launched in 2001 as an electronic marketplace where asset managers could move large blocks of public shares without sending ripples through broader markets, announced plans in October to enter the private-company and pre-IPO stock trading business.

The move, initially targeting so-called “second Internet” companies such as social networking concerns, focuses on restricted shares or 144A placements, under a provision of the Securities Act of 1933 that allows certain private resales of restricted securities to qualified institutional buyers.

Liquidnet has identified more than 100 privately held companies that are valued at more than $100 million in this second Internet space, Greenblatt said. And where startups 10 years ago could go public in four years, today an IPO may take 10 years to achieve, he said. “The buy-side missed out on the opportunity to benefit from the growth of that company from years five to 10.”

The company has 650 asset managers participating in its “block order pool,” where the average trade is 50,000 shares, compared to 250 shares on the New York Stock Exchange, and these managers are the kind of long-term investors that tech growth companies would like to reach, he said. “This is another community we’re going to be able to build, pre-IPO companies.”

In the future, Liquidnet may branch out into other cleantech, health care and other growth-oriented industries, Greenblatt said, although he wouldn’t say when such developments might occur.

By stepping into the market for unlisted shares, Liquidnet puts itself into competition with alternative markets such as SecondMarket, founded in 2004, and SharesPost, founded in 2009, which specialize in illiquid asset classes including limited partnership interests and bankruptcy claims along with shares of pre-IPO companies.

Jeremy Smith, the chief strategy officer at SecondMarket, said his company’s platform is geared predominantly to venture-backed companies with valuations of $200 million to $80 billion, primarily technology and consumer internet companies.

Such companies have a broad shareholder base, with angel investors, venture capital firms, founders and employees who have been issued stock as a form of compensation. As a result, these companies often have 200 to 400 shareholders who may be seeking liquidity through a sale of some or all of their shares, Smith said. “That is a great dynamic for a marketplace, where you have a large number of potential sellers.”

By contrast, portfolio companies controlled by buyout firms typically lack that dynamic, he said. “Buyout companies are fairly narrowly held,” he said, thus diminishing the number of potential sellers who could participate in the market.

Besides, buyout-based businesses often have the track record and scale to have other alternatives to achieve liquidity, Smith said. “They could go public if they wanted to. They have the size,” he said. “It’s a much more of a nuanced assessment: is this right for buyout-backed companies?”

Greenblatt said Liquidnet already works with buyout firms, albeit more commonly on exits. Because of the institutional nature of the exchange, buyout firms can dispose of large stock positions after the end of a lockup period following an IPO, without roiling the public market for the company’s stock. Under the rules of the Liquidnet exchange, trades execute at the midpoint of the bid-ask range, so that when the trades are reported to the public market after they close, ticker watchers cannot glean clues about the potential future direction of the shares’ movement.

While trading in unlisted shares such as Facebook has brought new attention to these alternative markets, their emergence is probably not a threat to conventional buyout shops, said Larry Tabb, the founder and chief executive of the Westborough, Mass., research firm Tabb Group, a research and advisory firm focused on financial markets.

There is a reason these shares are considered illiquid, Tabb said. “On some of these stocks, the bid-ask spread is going to be huge.”

Instead, for the foreseeable future these alternative markets are likely to function as secondary market where private companies can take public capital on a restricted basis, Tabb sad. “As the secondary market develops, I think there will be greater demand for a primary market.”

But in the years to come, founders, owners and executives of private companies may come to view such markets as a viable option to conventional IPOs, strategic sales or buyout deals, Tabb said. “Instead of going public public, maybe there will be this junior private market that can be tapped into, instead of having to take a chunk of money from a private equity guy, where if you don’t make your numbers, you’re out of a job and you lose your company.”