The COVID shutdown and reopening created extraordinary volatility in the global economy and financial markets. Many parts of the world, especially developing countries, have not fully recovered to prior growth and employment levels. Yet, the global developed equity markets have rebounded significantly with many surpassing their previous peaks by substantial amounts. What has been surprising is the dramatic shift in the structure of the private funding markets and the rise of secondaries transactions.
In the United States, this was driven by the rapid fiscal and monetary responses to boost economic growth. The White House and Congress have put in place a number of fiscal stimulus packages to provide relief to the affected groups. As well, the Federal Reserve helped stimulate the U.S. economy through interest rates cuts and massive asset-purchase packages. To this date, the allocated stimulus exceeded $9.0 trillion, with another $4.3 trillion waiting to be utilised. The central bank’s action to lower interest rates to zero has flooded the financial markets with liquidity and driven a search for return.
Across all risk assets, we saw a demand to invest towards growth which initially favored public technology companies and alternative assets. The global rally in public technology stocks, like Zoom, Google, Salesforce, and Amazon, has been breathtaking. The global rally in alternative assets like special purpose acquisition companies (SPACs), private equity (PE) and venture capital (VC) has been equally impressive. The flow of funds into alternative assets has increased substantially over the last five years, with their global assets under management (AUM) forecasted to reach $11.8 trillion in 2021.
In our recent white paper, we break down the money surge and provide a history of the secondaries markets in both PE and VC. In this world, secondaries allow private investors to sell their stakes earlier in the sequence of funding rounds. What’s fascinating is this market demand for alpha is creating an upward and downward cascading of investment. On the upside, friends and family investors, VC, and PE are all engaging in this secondaries market. While it’s not unusual for the first two to do so, the new wrinkle is for PE to be selling ownership out of their typical 50% structure. This creates challenges as one PE firm can sell a stake to another PE firm creating a substantial increase in the valuation of the company, without a major flow of funding into the company or a substantial increase in the knowledge set brought to the company by the purchasing PE firm.
On the downward cascade of money, this is where compelling funding flows are shifting in the search for growth and alpha. Large PE firms are moving to C and B rounds with capital commitments growing from the typical $10 million VC to multiples of these levels. In turn, this leads to VC firms increasing the size of their capital commitments. Both drive valuations higher and faster as these firms search for small companies exhibiting rapid growth. The explosion in SPACs is symbolic of the demand from the public markets to participate in acquiring ownership in the funding chain. Adding one more piece, the recent ruling by the US Labor Department to clarify that 401(k) retirement plans could deploy money to PE funds adds a potential $6.2 trillion pool, which can drive significant growth of AUM.
Presently, the challenge is simply having too much capital available to deploy to fewer truly promising ideas and companies. And thus, driving valuations higher than they likely should be. With PE and VC AUM expected to more than double in 2025, this will continue to be an issue as the markets for secondaries and earlier funding rounds grow.
As we watch these developments, there are many positive economic growth developments occurring via this shifting funding structure (Adveq, 2013; Klein et al., 2014). First, there is a strong incentive to create a start-up with more readily available and earlier funding than in the past, which boosts entrepreneurship and innovation. Second, this leads to more employment and economic growth. Third, this new funding structure allows for a wider range of investors to participate in the growth of these new companies and their valuations. The entire ecosystem is becoming more efficient at getting capital deployed into earlier funding stages and driving faster growth. Finally, a deeper secondaries market will broaden the availability of opportunities for both qualified and retail investors.