Under the dark surface of the secondary market: pockets teeming with activity

August 18, 2023

Since the high-flying days of 2021, the venture capital market seems to have slowed to a snail’s pace. Deal counts, company valuations, and total funding volumes have all fallen precipitously over the last 18 months. Investors continue to stay on the sidelines, with uninvested dry powder sitting at an all-time high of $540B USD at the end of the first quarter of 2023, according to Preqin data. This downturn has been driven by a variety of factors, including the end of the zero-interest rate landscape of the last decade, Russia’s invasion of Ukraine, and the US regional bank crisis earlier this year which saw the collapse of Silicon Valley Bank. 

At first glance, the story looks to be much the same in the secondary market. Hiive's July Private Market Report shows the median bid, as a percentage of the last round funding valuation, has dropped from 50% in January 2023 to ~60% as of last month. In conjunction with falling bids, the average bid/ask spread sits just above 30% as of June 2023, which is an indication of a slow and disjointed market where buyers and sellers remain far apart. 

Not all unicorns are trading equally

However, a deeper examination tells a different story - not all unicorns are created equally. As a general rule, a smaller spread between buyers and sellers indicates a more liquid and seamless market for a security. In public markets, the volume and frequency of trading means that the bid/ask spreads for most securities are essentially zero. In other words, there is a universal market price with ample buyers and sellers on each side.

One of Hiive’s goals is to similarly establish reliable market prices for private stocks. We still have a long way to go for most of the thousands of large private companies out there, but if you stratify these securities, a significant subset has been trading with remarkably high liquidity over the past 6 months. 

The most liquid quartile (i.e. the most liquid 25%) of companies on Hiive has had a bid/ask spread of just 3.5% over the first half of 2023. Moving down from there, the second quartile’s spread is 16.7%, 32.7% for the third quartile, and finally 56.1% for the lowest quartile. This data clearly shows that there is widespread variation in the liquidity of late-stage private companies, and that the prevailing narrative of a seized-up and frozen market should not be applied with a broad brush.

Factors affecting liquidity

So, what are some of the common characteristics of that top quartile of companies where buyers and sellers are most easily finding common ground? First of all, they have deep order books on both sides of the market. The presence of several buyers and sellers standing ready to transact at a wide range of prices is key to increasing liquidity. The importance of a deep order book can be seen by examining the bid/ask spread of the most active companies traded on the Hiive platform. This is a continuously-updated list of the securities with the highest total number of customer orders to buy and sell that are open on the Hiive platform. Over the past 6 months, the average bid/ask spread for a company ranking in the top 20 most active securities was 11.7%, compared to 30.2% for all other companies. This again illustrates the importance of a deep market— thinly-traded unicorns, just like any security, have less liquid and less transparent markets. What then causes a company to have a deep and liquid order book? 

Sector outlook

Sometimes, a company’s industry can be an important factor impacting liquidity. Interestingly, several of Hiive’s most liquid securities are in the artificial intelligence industry. Companies like Hugging Face, H2O.ai, and Anthropic have had some of the lowest bid/ask spreads this year. That could indicate that liquidity is higher when buyers are “price-takers”, paying whatever price they must to gain exposure to a high-growth industry. 

Cap table dynamics

Another factor is the nature of an issuer’s capitalization table (a capitalization table, or “cap table”, is the set of all the investors, both institutional and individual, in a company). Issuers that have larger and more diffuse cap tables will generally have a more liquid secondary market due to the higher number of natural buyers and sellers for that issuer’s stock.

Management attitudes

However, one of the most significant factors is usually the company's management's permissiveness toward secondaries. While many issuers (we refer to companies in the industry as ‘issuers’ because they issue the private securities to employees and investors) permit, facilitate, and even encourage secondary transfers of their equity, a small handful remain quite restrictive. They are suspicious of secondary trading, often irrationally so, and often outright bar their investors and employees from transferring their shares. The relative permissiveness of an issuer’s management team is often public knowledge among their investors and employees, both current and former. Buyers and sellers will naturally focus their efforts on issuers that are known to have a friendly attitude towards secondary trading, as there are strong disincentives to expending time and labour researching a potential investment that will likely get shot down by the issuer. In another article, we expand further on the importance of secondary transactions for issuers, and the win-win situations that arise when they are encouraged.

Finally, a couple of factors that don’t seem to matter with regards to liquidity are company age (new entrants like Hugging Face and decades-old companies like Discord both rank highly) and valuation (the sub-billion dollar identity verification company Prove Identity and “centicorn” SpaceX both have extremely low bid/ask spreads). 

Liquidity's impact on price

Of course, liquidity and price are not independent of each other. Companies with a narrow bid/ask spread are by definition more actively traded stocks. A more active secondary market lowers the risk of investing in a company, as investors can be more confident in their ability to generate returns in the secondary market. This confidence, in turn, lowers the investor’s cost of capital for investing in a company, which can lead to loftier valuations during both primary fundraising rounds and in an eventual initial public offering.

While much of the secondary market remains in distress, large companies with transfer-friendly management teams tend to have narrow bid/ask spreads. Consequently, a liquid and healthy market has developed for their stock, which is a beneficial outcome for both the company (in the form of potentially higher valuations) and its shareholders (more transparency and confidence). 

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