A Secondary Market for Private Equity Is Born

What happens when investors in venture funds want to sell?

It's a question that is increasingly being asked. Unlike stocks, bonds, mutual funds, hedge funds, cars, houses, boats, baseball cards or more less any other asset class, there's never been much of a resale market for venture capital. Indeed, venture capital funds aren't designed to be resold in the "secondary market" like other financial assets. The theory is that you plunk down your money, and then go away for a few years while the VCs do their voodoo. Down the road, you take delivery on a bucketful of shares of the next Cisco, yours to keep or sell.

Those rules were designed for the old pre-bubble era, though. The huge expansion of the venture capital market in recent years, combined with the subsequent tech stock bust, has created some new pressures on the institutions, companies and wealthy individuals who make up the bulk of venture investors. The upshot is, a growing number of investors are looking for ways to unload their venture fund holdings. The result: a quiet surge in the secondary market in venture capital partnership interests.

"Private equity is a trillion-dollar market, it's now an institutional class asset," says Kathleen Powers Dunlap, CEO of PrivateTrade, a startup trying to create an online secondary market in private fund interests. "In private equity, the absence of a secondary market is striking. It's been done in a one-off fashion."

Certainly, the dramatic expansion of the size and scope of the venture capital market in the last few years has created rising demand for a more active secondary market. That's a fundamental change, made possible largely by savvy investors who see a chance to generate fat returns.

Overall investing in venture capital surged in the late 1990s. Far more money is invested in private companies now than ever before. Morgan Stanley calculates that total venture dollars invested in 1999 and 2000 made up more than two-thirds of total funding of the last 25 years. That boom, of course, set the stage for a dramatic tech bust that has slammed institutions and individuals alike. And that's led a variety of investors in venture funds to start eyeing the exits.

Historically, about 3.2 percent of venture investments are resold, according to Nick Harris, a partner with Lexington Partners, one of the largest investors in the venture capital secondary market. Even if that figure stays constant, he says, the size of the market should expand rapidly because of the huge increase in VC funding in recent years. From 1995 to 1999, he notes, about $400 billion was invested in VC funds, compared to $100 billion the previous five years. "If this 3.2 percent rate holds, business could quadruple," he says. Harris says that rate could rise to between 4 percent and 5 percent, thanks to the uncertainty of venture returns in the next few years and the choppy market for public offerings.

Lexington is gearing up to meet the higher volume: Having raised a combined $2.5 billion in their first four funds, the firm is now raising a new $2.5 billion fund to invest in venture funds and other private investment portfolios. "The early interest is very high," he says. "The stars are aligned for secondaries now." One lure is the potential for strong returns. Secondary investors think they can generate annual gains of 25 percent to 35 percent after fees.

While the market may be growing, it is doing so quietly. With a few notable exceptions, transactions in the secondary market happen out of public view – press releases or tombstone ads are rare, and there are no required public financial filings. Usually, one or more of the parties – the seller, the buyer, or even the general partner of the subject fund – prefer to keep the deals quiet.

Sellers, whether individuals or institutions, may not want to tip off their need to raise cash. Funds prefer not to offer