Secondary Markets – Do They Serve a Purpose?

Yesterday I came across this article in the WSJ where Ben Horowitz of Andreessen Horowitz expressed his concern over the emergence of secondary trading platforms for private shares.  Firms like SharesPost or SecondMarket.  And while I have a ton of respect for Ben, as an operator, technologist and investor, I don’t think that the idea that squelching secondary trading of private shares via regulation is a great one.  There are several reasons why these firms exist and I think will play an important role (one way or another) going forward.  To be certain, these marketplaces are not perfect, but regulation isn’t the answer to solving the problems that exist:

1. There is a Market Demand:  The fact is that if you or I want to invest with Ben, or the 10-15% of top VCs where much of the wealth is created in this asset class – we can’t.  Access to this asset class is woefully inadequate.  Part of the problem is the VC industry – which as a whole does a poor job of generating risk-adjusted returns (which is something I have discussed at length in the past).  Getting access through a secondary market is pretty much the only chance investors will have to get exposure some of these interesting companies before the public markets or them being sold.

2. All Markets are Asymmetric to a Degree:  The regulation of market information, e.g,. Fair Disclosure (Reg., FD), Sarbane Oxley, etc., has leveled the playing field for investors, but at the cost of information getting into the market at all.  Don’t misconstrue this as my believing these regulations are bad (I believe the benefits of the level playing field outweigh the detriments in the public market).  But the regulation brings a burden that should not be extended to private investments lest they eliminate the market completely.  Even then, asymmetric market information exists in the heavily regulated public market – e.g., professional investors have far more resources to evaluate a particular investment, or certain investors have unique information and insight (though not illegal inside information) that other investors do not.  If asymmetric information is a problem relative to returns, investors will either stop investing in this class or demand more information before investing or adjust the price paid based on different assessment of risk.  Selling insiders will always have an informational advantage – regardless of the market.  That said, investors do need to do their homework or risk the consequences.

3. Valuations Are Not Absolute and Different Depending on the Investor: The idea that an investor might be off by 30% relative to a later round is somewhat inconsequential because it entirely depends on what and how value is being set in that next round (e.g., VCs will have entirely different motivations for pricing a round relative to someone that wants access to ownership of a private company as an individual).  This is particularly true in light of returns that successful private investments garner – e.g., a 30% valuation error is pretty tolerable if the choice is a.) being able to make the investment at all, or b.) the difference between a 70% return and 100% return.  The reality is that different investors have different risk profiles and different investment horizons (both of these result in a different return expectation and tolerance of loss and illiquidity) – to argue for regulation based on the view of being an institutional player in this sector ignores the fact that there are investors of all types interested in these markets and regulation will restrict opportunities for a large number of them based on an “assumption” of the needs of these investors without actually understanding what those needs truly are.

How these secondary trading markets fair in the long term is still an open question in my mind.  Would there be a demand for these if there were a rational IPO market?  I really don’t know.  I think that over the last 8 years a lack of proper understanding of capital markets for private company investments and IPOs has resulted in creating a burning need for these firms because liquidity for private companies has been consistently underestimated, and almost certainly evaluated without a proper understanding of the tradeoffs of liquidity v. valuation v. risk across different pools of capital in the marketplace.  But I believe the lack of an IPO market is not the only reason for these firms existence and I expect them to play a proper role in the marketplace long term – either as a liquidity alternative should markets never sort out the problems associated with capital allocation to private investments or as a part of a more functional and free-flowing future capital markets for private companies.

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