The #1 concern of accredited investors when investing into alternative assets, specifically private market assets, is liquidity.
Most investors know that there is more value to be had by investing in private assets versus public securities. They realize that the opportunities in the private market are unique, have less competition from capital sources and have a greater likelihood to come with a strong price discount and, therefore, have the propensity to earn significantly greater returns.
The big questions from individual investors are always the same, however, when deciding whether to invest in private securities versus public equities: what does an exit look like, when will that be and how do I get my capital back if I need it? In short, how do I get some liquidity around my investment?
The goal of this article is to demonstrate the value that liquidity has and where it will come from in private markets. The technological innovations around liquidity options that are currently ongoing have the potential to revolutionize private market investing and bring this value to private market investors. Within this article, I will provide readers with the contextual information to understand liquidity premiums, how to understand what the macro value of these premiums are and provide a few actionable strategies for realizing this value in the private investing world in the years to come.
Liquidity is king
Almost any investor will feel more comfortable with their investment when their assets have readily available liquidity options. This is the rationale why many individuals only invest in public market securities where they can buy and sell in an instant.
Since the birth of the private equity industry via the explosive growth of leveraged buyout firms in the United States in the 1980s, this liquidity issue has remained an obstacle to raising capital into private equity and private businesses. Fund managers and company founders have recognized the issue and countered the objection around liquidity by aiming to compensate with heightened financial returns, as they must.
How much of a return premium is required in private market investments to make up for their current lack of liquidity?
Simply stated, private businesses and private fund managers typically must substantially outperform public securities to attract investment capital. There is a large return premium required to move investors away from a preference towards liquidity.
Take for instance a recent paper from PIMCO, one of the world’s largest institutional fixed income investment houses, titled: Liquidity, Complexity and Scale in Private Markets. Within this paper, the author goes on to describe the liquidity premium on an example bond and states that the premium necessary to move an investor from a liquid position of a 1% yield to an illiquid position was 1.8%, or a total yield of 2.8%. This of course will not be the exact premium necessary for every asset class, but it is a great example.
For the purposes of this example, a rational buyer needs a 280% additional return to buy an illiquid bond instead of a liquid bond (i.e., a readily tradable bond). That excess is gigantic, and it is purely due to the fact that one asset can be priced and sold/purchased immediately vs. another being less liquid and more difficult to price/trade.
Let’s use a real world example of one of our own portfolio companies, the Green Coffee Company, to show this situation. Let’s assume we are looking to sell a substantial portion of the coffee business in five years’ time while its equity securities remain privately held and with limited liquidity. In five years, let’s assume, we are producing an annual, recurring EBITDA of $11 million. Hypothetical buyer number one requires a 10% return on his investment, so he is willing to pay 10 times current EBITDA in the private sales market. The sales price would then be $110 million for the entire business.
For example two, let’s assume technology comes along within this five-year period and closes the liquidity gap so that private securities begin to trade like public securities with the benefit of liquidity. A second buyer has a yield requirement 280% lower than the first buyer (i.e., a 3.57% return requirement). This would result in a company valuation of $308 million instead of $110 million, resulting in an additional $198 million of value for our investors as compared to holding the securities of the less liquid company.
It doesn’t take a mathematician to show how powerful a closing of liquidity premiums in secondary markets could potentially be for individual investors. But, more importantly, the technology we are talking about is aiming to eliminate these illiquidity discounts on all private assets, into the trillions of dollars. The effect on private markets could be the largest in the history of private market investments.
Fintech is closing the private market liquidity gap
While largely an emotional response by individual investors to only invest in public securities, as we would advise investors to look at the potential for long-term total returns in private markets, fintech specialists focused on this issue are acutely aware of this aspect of the private investment market environment and have started doing something about it. Not until today has the issue been so heavily focused upon and numerous test cases to spur liquidity in private investments are being brought to market.
There are numerous fintech companies globally going after the same slice of the pie. That pie of course is to securitize all the private assets that exist globally, whether that be private equity funds, private debt funds, privately owned real estate or privately owned businesses.
The amount of total value here is impressive. As an example, worldwide private equity alone is expected to reach $5.8 trillion by 2025. In terms of privately owned real estate, the value of just the U.S. real estate market is more than $36 trillion.
According to Yahoo Finance, private market trading activity is now just only 1/300th of that of the traditional public markets. This is a result of a lack of modernization and infrastructure, legal constraints, a highly fragmented landscape and myriad niche secondary market websites with high trading fees. All these market inefficiencies create opportunities for fintechs to revolutionize the space. We love the potential of increased liquidity options for our investors.
A good example of companies looking to lead within this space is Securitize. Securitize just recently raised a $48 million Series B funding round led by Morgan Stanley. In September of this year, Securitize began its roll-out of out its newly launched ATS (alternative trading system) as it looks to provide one of the first “end-to-end” offerings that will allow retail investors, accredited investors and institutions to directly trade in anything from the pre-IPO shares of the next developing company to a syndicated real estate project. Carlos Domingo, CEO of Securitize, Inc., is looking to take the private markets directly into competition with public ones, specifically in relation to initial public offerings:
“[T]he focus on IPOs is misplaced. Today, wealth is generated by investing in early-stage companies, not mature ones. But most investors have been frozen out of these opportunities, until now. Securitize is intended to give many more investors access to alternative investment opportunities, with an aim at increasing the liquidity of the private markets overall.”
Securitize is by no means the only game in town. Even Nasdaq is aiming to extend the liquidity benefits of its public securities exchange to issuers of and investors in private securities.
We believe that the gap will close and that private market securities will continue to trade more and more like public securities as more smart companies focus on this developing market opportunity.
What would happen if private markets began to trade like public markets?
The entire thesis behind these fintech business models is to make private markets essentially behave as public markets. Theoretically, both the issuer of the security and the buyer of the security will be better off because of the implementation of this technology. We see this concretely with respect to liquidity premiums and valuations as described above.
In the instance of a private company issuing equity into the primary market to finance their business, with technology buyers will pay a premium for the liquidity benefits of being able to sell this asset for a more readily determinable price and the issuer will be able to raise more capital, at more preferential pricing, than before as the liquidity premium is priced into their offering.
Buyers will get the liquidity they desire and should benefit from the increased returns of investing in early-stage companies without the hesitancy around liquidity that may otherwise stand in their way.
Conclusion and Author’s Final Words:
Securitization is coming to private markets. That’s a fact. Institutional investors and private capital investors are deploying real capital into companies that are looking to change the private investing world to make it more liquid.
We have seen fintechs from Hong Kong, Singapore, New York City, Luxembourg and London participating in this race. Many fintechs are raising their own later stage capital rounds into the hundreds of millions of dollars. These companies are becoming incredibly well-funded. Some fintechs focus on the creation of their own proprietary blockchain, some via the creation of a unique tokenization software, while others focus on the innovation of their custody portal through which clients actually hold their digital assets. Which company will win? Honestly we have no idea. Many of these business models have exciting potential, but each is in their infancy phase of development. Numerous beta tests are prevalent and real-world transactions are being tested on the largest of private assets just now. Smaller and mid-market transactions are still several years out. That said, we have talked to many of these companies over the past year and have come to one conclusion: the digitalization of private market assets is coming, 100% guaranteed.
It will be very exciting to participate in private market investments over the coming years.
In regards to this coming change, we at Legacy Group have a few recommendations for our readers as they engage in more private company investing:
Liquidity premiums due to future efficiencies in the secondary private markets are not factored into today’s private market valuations. Take advantage of these discounts.
If our readers are to go out into the private market today and buy shares in a private business, there is almost zero probability that there will be a liquidity premium attached to the value of their capital placement for the expectation that secondary private market transactions will become more efficient in the future. But the fact remains that the secondary market definitely will be.
This is only one more reason to get into private, alternative assets for readers who have long-term investment horizons. We can’t tell you that private markets will be as liquid as public markets tomorrow, but we can tell you that some very bright individuals and businesses are working today with that goal in mind for the near-future.
Securitization of large private assets is already occurring at a rapid pace within the more developed economies of the world and they will be seen as beta tests for the smaller and medium-sized assets that will follow. For readers who will look to have private investment hold periods of five years or greater, think about pricing future liquidity into your buy decisions when you calculate just how large a discount you may be getting now.
Smaller, private investment assets will benefit more from this technology than larger funds that are already semi-liquid. Focus your investing where the most potential gain can be enjoyed.
Private investors who invest into standard, large private equity funds (assume assets under management of $1 billion+) already have semi-liquid exit options available to them at any time. There is an entire portion of the private equity industry that focuses solely on providing standard, limited partner private equity investors with liquidity in the event that they have some kind of life event requiring a return of capital. These positions are typically sold at a discount to the fund’s current net asset value (i.e., the fair market value of all the fund’s positions marked at a specific balance sheet day). Research suggests that 10-30% discounts are common among many private equity secondary trades, but the benefit is that these assets can be sold in a matter of weeks and typically at a readily estimable price.
Interests in private businesses and private real estate typically are not as liquid. If you, for instance, were holding private real estate in a third or fourth tier market, your asset may sit on the market for months, even years. Therefore, it is the less liquid assets, smaller companies and less liquid real estate that will benefit the most from the ongoing technological developments we have discussed.
Our focus at Legacy Group is in private businesses, largely in the venture capital space, largely in underserved developing markets in Latin America. Our portfolio companies are at the top of the list of companies that could explode in value solely because of the liquidity premiums attached to future secondary market technology. In fact, private secondary markets may actually compete with public market exits in the future should liquidity become sufficiently prevalent. We will be watching and our investors will be the first to know, and benefit, from the results.
About Legacy Group
Legacy Group is distinguished by a singular tradition of service to our portfolio partners; the mutual commitment to, and the seamless collaboration of, a true partnership; formidable financial and legal talent across multiple disciplines and jurisdictions; and shared professional values that focus on client needs.
We provide experience and investment to a wide range of private companies spanning many industries, including real estate, hospitality, tourism, agriculture and technology. Contact us to learn more and to discuss current investment opportunities available to you in our portfolio companies.
*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.