The New Financial Matchmakers
The rise of private market networks is changing the capital markets and opening up new opportunities for business leaders and innovators.
In that ancient, un-networked world where public stock markets evolved, such markets were the only way that nascent companies could reach huge numbers of potential investors, and that investors could trade with one another. Investment bankers and their well-established interrelationships provided the only practical path for finding merger or buyout candidates. And the key technologies for marketing your new hedge fund or selling your limited partnership interests were the (land line) telephone and your broker’s Rolodex.
Surprisingly, perhaps, that world has survived largely intact to this very day, but it’s all about to change. Now, private market networks (PMNs), such as SecondMarket, AxialMarket, and Angelsoft, are starting to do for the capital markets what eHarmony did for dating.
The idea of using the Internet to match buyers and sellers of financial products is not new, of course; it’s been talked about since eBay got started in the mid-1990s by creating a liquid market for broken laser pointers and PEZ dispensers. Innumerable online bulletin board services for investors have been launched, with limited success. But a new generation of private securities platforms has begun to emerge over the past few years that provides much more: opportunity discovery and recommendation engines; analytics and evaluation tools; secure virtual diligence rooms with tiered access rights; industry benchmarks and comparables; standardized documentation and fee terms; deal, and deal flow, management systems for both the buy and sell sides; and lists of experienced service providers to consummate transactions. These platforms also offer a reach equal to that of the Internet itself, something not even public exchanges can offer.
One might think these developments are simply a natural consequence of the adaptation of the investment world to a networked, online environment. But that would understate both the reality and the ramifications of PMNs. The fact is that these new networks are enabling, and are enabled by, some fundamental changes in the life cycles of businesses and investments.
Let’s look at early-stage venture capital as one example. In our time of hyper-rapid change, corporate organisms are becoming more like fruit flies than elephants: Intense evolutionary pressures favor more, shorter generations of faster, lighter companies. And indeed, as David S. Rose, the founder of Angelsoft, points out, the capital necessary to launch new companies is falling by more than an order of magnitude per decade, while, at the same time, accelerating societal and technological changes limit new companies’ expected life span. That means many startups are too small to interest most venture capital firms, and at their zenith they may still be sub-scale for either an initial public offering or a traditional investment bank M&A process. And the few startups that reach truly large scale often neither require the massive capital that IPOs offer, nor wish to forsake the luxury of private life for the glare of the public company spotlight. As a result, even the most successful new companies frequently seek to satisfy their (relatively modest) liquidity requirements through private transactions.
Enter PMNs. Against this backdrop, they help entrepreneurs and angel investors find one another without the intervention of venture capital firms; provide liquidity for employees and early investors in pre-public companies (as was true with Facebook long before its much publicized Goldman Sachs deal, and remains true for other “hot” pre-public companies like Twitter and Zynga); and allow business owners to find strategic buyers or merger partners.
The impact of PMNs outside the world of operating businesses is no less dramatic: They help match investors with hedge funds and private equity funds, and create secondary markets for both; offer liquidity for out-of-favor financial instruments such as failed auction rate securities and collateralized mortgage obligations (CMOs); and raise the prospect of active markets in traditionally illiquid assets such as art and wine.
Leading PMNs include Angelsoft, IndieGoGo, and Kickstarter (early-stage funding); SecondMarket (the largest PMN, operating in several asset classes); SharesPost (later-stage pre-public stock); AxialMarket (lower mid-market M&A); EquityNet (multi-stage equity); the New York Private Equity Network (private equity partnership interests); and Hedgebay and Lincoln Square (hedge fund investments).
Although still small by Wall Street standards, PMNs are indeed growing quickly. For example, the number of ventures applying for funding through Angelsoft now exceeds 4,000 globally every month; the companies listed for sale last year via AxialMarket had combined revenues of approximately US$30 billion; and SecondMarket closed some US$3 billion of transactions in illiquid securities in 2010, including several hundreds of millions in equities of late-venture-stage companies.
AxialMarket provides a good example of the genre. This network allows business owners and their representatives to offer their companies for sale to hundreds of institutional buyers, including public corporations looking for new technologies or products, and private equity firms with cash and management teams. When a company joins the network and provides its basic information, the system automatically generates a traditional “teaser” (a one- or two-page brief that outlines an investment opportunity without identifying the company) and then suggests particular acquirers based on the potential buyers’ previously registered preferences. The listing company can choose which of these should get the teaser, and the recipients that are interested in the opportunity can then execute online nondisclosure agreements to gain access to company management and virtual diligence rooms. Both sides can manage and monitor progress of the deal through the platform. Of course, eventually, humans do meet to negotiate and document the transaction; but the discovery and initial evaluation processes are huge improvements over conventional practice in the mainstream capital markets.
Business leaders should welcome these developments. Aside from online brokerage accounts, the vast majority of “innovations” in the capital markets world over the past 30 years has centered on creating and packaging securities that distribute risk in narrow asset classes, such as home loans. Although these innovations have contributed mightily to Wall Street profits, they have done very little for new business formation, and have in fact done much harm. These days, the overall economy is awash in liquidity (bank reserves exceed $1 trillion, up from about $50 billion in mid-2008), but these dollars currently appear dedicated to pursuing the purchase and sale of zero-risk Treasury assets, financing investments in higher-yielding foreign investments, and chasing hot commodities. Meanwhile, the Street’s creative energy has turned to computer systems that trade massive quantities of shares thousands of times per second to exploit microscopic arbitrages. New alternatives are needed, not just for the sake of the entrepreneurial economy, but for investors: cash-generating businesses are, after all, more reliable inflation hedges than talismanic metals.
Some reasons that PMNs should prove very successful are obvious: Just as eHarmony allows serious singles to find each other, perform a little due diligence, and establish an initial relationship, so PMNs allow companies and investors to locate each other and then efficiently narrow down the field of potential business partners. Today, 20 percent of all romantic relationships in the U.S. begin online, and there is little reason to suspect the corporate analogs will be less successful. And, of course, private market networks not only perform introductions better than traditional intermediaries (because of their reach and speed), but they are also inherently less expensive, replacing humans and office space with nearly free network connections and servers.
More subtly, PMNs also perform the important function of disambiguating which fees are paid for what. For example, company owners normally pay big investment banking fees for basic knowledge of how the sales and money-raising processes work, access to the relevant institution’s relationship network, and the banker’s skill in structuring and negotiating the best possible deal. In a robust PMN, the first two elements are eliminated from the equation. As PMNs proliferate, bankers will be competing for fees based on more fundamentally valuable skills — those relating to creating the best possible deal structures and terms for their clients.
Fortunately, the regulatory situation concerning private market networks appears relatively clear. Because the new generation of PMNs allows both sides of a potential transaction to discover each other — but generally does not provide execution capabilities — PMNs normally will escape characterization and regulation as “exchanges.” Conversely, because even private securities transactions must generally be conducted by registered broker dealers, consummation of PMN-initiated transactions will generally be concluded by regulated entities, so that appropriate protections should be in place. Nonetheless, the access to capital that PMNs can provide is likely to generate some issues, as illustrated by the SEC’s investigation of so-called “secondary secondary” transactions — such as Goldman Sachs’ recent Facebook deal — that appear designed to avoid the 500-shareholder limit beyond which private companies must report their financials. We are likely to see fewer of these deals going forward.
PMNs offer a powerful vision for a more effective, efficient global capital allocation system. The history of the Internet tells us that, if left to develop on their own, PMNs will proliferate and help accomplish the transition from an industrial to an informational economy. Perhaps the biggest risk to this optimistic scenario is that legislators and regulators will intervene and overreach in the name of “protecting” high-net-worth investors (as the original Dodd–Frank bill would have) and “strengthening” existing institutions and processes by effectively limiting competition (as the final bill did). If government officials around the world allow this new global network to multiply the natural power of capitalism, if the requisite levels of transparency and trustworthiness are fostered in the design of these systems, and if business leaders and investors recognize the value of more direct interaction, then the new networks for allocating capital will rapidly take their place alongside more established exchanges — and could even begin to displace them.