The advantages of secondaries in the financial markets

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One of the myriad tasks of modern finance is devising ways to turn illiquid assets into something liquid.

For example, 100 years ago, a mortgage was an incredibly illiquid asset: a bank had little choice after issuing a mortgage but to collect its monthly payments until the owner sold the house, defaulted. or reimburse it. A bank that made its bread and butter finance houses in its community put it at immense risk if the community’s economy were to experience a downturn or see a collapse in house prices. As a result, down payments have been large and banks have limited lending to relatively well-off households.

Eventually, banks began to securitize home loans and sell the monthly stream of mortgage payments to investors, which made their business much safer and, not a coincidence, allowed homeowners to get a mortgage much more easily.

A modern version of this phenomenon is evident in the aftermarket, which has become commonplace in Silicon Valley. Here’s how they work: An investor who puts money directly into a startup receives a share of the company traded at the time of their investment, with the understanding that there will be no formal market for their share until that time. for the company to go public.

There is a good reason for this insistence on long-term attachment; to begin with, it isolates the founders of the company from short-term pressures to compromise their business plan for quick cash and reduce potential long-term returns.

Equally important, long-term investing encourages investors to take a more practical approach to these investments; if the start is unsuccessful, investors are more likely to roll up their sleeves and offer advice and guidance if they cannot easily cut their losses and walk away.

The fact that venture capitalists tend to be more active than the typical stock market investor is beneficial for everyone: the investor offers their skills and experiences and not only helps the company – and its investment – but he also learns more about the company as well and is in a better position to make a sound investment decision.

While there are good reasons to encourage long-term investment, we don’t necessarily want these investors to feel that their wealth is locked in indefinitely.

It should also be noted (as i did recently) that a succession of laws has made IPOs more expensive and more difficult to complete, so startups have taken longer to move their business forward towards an IPO. Some have startups postponed this step indefinitely, choosing to avoid the increased regulatory and reporting restrictions imposed by the SEC for as long as possible.

This can create a problem for some investors, who may need to diversify their wealth or put more of their assets in something more liquid, even if (or especially if) the company is doing well: investors do not want to have the majority of their stakes in a company, regardless of its recent performance.

Investors can achieve these goals through secondary markets, a market that allows another investor to buy part of their stake in the startup.

While the fact that the secondary market is less liquid than the stock market may mean that the angel investor may not get a price that fully reflects the long-term outlook of the business, it nonetheless serves a vital purpose, and almost. everyone is better off these developments: startups still have reduced investor pressure to take shortcuts and seek short-term profits and its investors get both the potential benefits of a long-term investment and a minimum liquidity still possible.

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

As the time between starting a business and the average IPO lengthens (the average has increased by two years since 2010) the need for secondary has become more important; fortunately, the market has been able to develop them and they are now more ubiquitous than ever.

Turning illiquid assets into something somewhat liquid may not appeal to everyone (Uber

UBER
tried to prevent its first investors and employees to sell to new investors in secondary establishments early in its existence before the IPO), but the reality is that this is invariably what financial markets do and it is usually at l benefit of investors. And if that benefits investors, it means more of them will want to invest in startups or other seemingly illiquid assets that have the potential to transform our economy.


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