Navigating the Liquidity Landscape

A new theme is coming to the fore in private capital markets: early investors, LPs, employees and founders are seeking liquidity and a broad and creative market has developed to fulfill these needs, for the benefit of both shareholders and issuers.

The boom of 2021-2022 brought a spike in valuations and capital raising, especially in high tech and growth-oriented verticals, and many late-stage private companies have since struggled to justify or transact at such valuations. Capital raising has moderated and largely returned to pre-COVID levels, while the exit environment remains challenging. In tandem, companies are staying private for longer. The bar for successful IPOs remains very high, curtailing access to this traditional path to liquidity. Combined, these forces are increasing shareholders’ demand for liquidity and pressure on companies and management teams to provide an actionable monetization path.

Private capital markets have evolved and now offer a range of creative solutions to address this ongoing demand for liquidity. A few examples:

• Direct Secondary: Dedicated secondary firms or other investors purchase equity stake directly from shareholder(s) to provide liquidity. These transactions exceeded $75 billion in the past year, which is more than double the prior five-year average¹. The benefit of this approach is that it does not modify existing economic or security terms or governance, and may not require any company involvement. The downside of this approach is that it doesn’t necessarily avail the company of any of the benefits of a new security and investment partner.
• Synthetic Secondary: Company issues a new security and with the proceeds purchases or redeems existing equity to provide liquidity to shareholders. The key benefit of this approach is that the company can structure a new security package to optimize terms and governance and attract a broader universe of investors.  Furthermore, so long as selling shareholders receive fair market value for their equity, the company can justifiably issue the new security at a higher valuation, for example if it has higher liquidation preference and/or greater governance.
• Hybrid Capital / Structured Equity: The advent of more flexible mandates and investors’ ability to trade upside participation for downside protection take synthetic secondaries to a new dimension. A company with certain attributes can now provide liquidity for shareholders by raising structured equity with little to no dilution, no governance and minimal covenants, and effectively arbitrage the capital structure for the benefit of pro forma shareholders. They can also avoid establishing a valuation of the company, which can be especially useful in an environment where many companies haven’t yet caught up to valuations set in the peak of the market. Finally, these types of instruments can also be pre-wired to facilitate conversion upon an IPO.
• Continuation Vehicles / GP-Led Solutions: Private equity sponsors and VCs may set up a continuation vehicle or SPV to offer LPs liquidity in a single or multiple companies. The benefit to the company and management is that their GP partner remains in place and the new secondary investors can provide additional dry powder for growth.  In parallel, the GP benefits as it remains in an asset it likes and can reset its fund economics.
• Margin Loan Against Private Stock: Some creative capital providers are offering this sophisticated solution. While not a large part of the market today, it is a growing solution that may appeal to investors with short-term liquidity needs while they hold an investment longer-term and participate in the upside.

Furthermore, companies may also fund shareholder liquidity with traditional debt (to optimize cost of capital and dilution) and / or include a primary equity capital raise for growth.

This is just a brief summary of the private capital markets solutions available to address the current structural needs and solutions for liquidity. Interested in learning more about these solutions or others that may be suitable for your strategic needs? Contact Baird’s Private Capital Markets team to discuss.

Gavin Kolt Managing Director Head of Private Capital Markets - Equity

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