When a new plan to create a platform for secondary trading in private company shares was announced in the Budget (known as the Private Intermittent Securities and Capital Exchange System - or PISCES), the private investment community could be forgiven for feeling a sense of déjà vu.
Attempts to inject more liquidity into what is essentially an illiquid market have been tried before without much success, from Angel Bourse in the early 2000s via several incarnations since. Will it work this time?
There are reasons for serious doubts. The main pitfall concerns valuations. Many potential investors will rightly be asking how the value of shares being traded is going to be verified. Unlike public markets which demand transparency over a company’s financial information and performance, on private matching exchanges, the information available will inevitably be imperfect. The business itself won’t benefit from this regime because the platform is not designed to enable it to raise capital – only for existing shareholders to sell their stakes. So there is no incentive for the company to provide the kind of public disclosures that investors will need to make informed decisions on whether the price is right.
If an investor wants liquidity, the best place to find it is from other existing shareholders who may be keen to increase the size of their stake, especially if the company is performing well. They can rely on the private equity (PE) market’s tried and tested formula of valuing businesses on multiples of EBITDA, net assets or other proven industry metrics to make sure that the amount being paid is reasonable. There’s no need to fear that PE managers will overvalue the shares, because there’s no reason for them to: they won’t be getting a percentage of investors’ profit at this point, and a desire to manage the expectations of their investors keeps pricing sensible.
In the venture capital space, where profits typically have yet to materialise and so there is no EDITDA to measure against, the practice of pricing at the level of the last funding round provides a logical basis for valuing shares sold from one shareholder to another. However, taking this approach to valuations for sales of shares to new investors on a platform like PISCES may be far from appropriate. Given that major fluctuations are common in the venture capital (VC) market, particularly in the current environment, it can be incredibly difficult to price these assets accurately for a new target audience.
The structure of such investments adds to the difficulties. Almost all PE shares contain an element of gearing, and the presence of a loan note alongside the equity portion would make trading them on this kind of platform complicated. In the VC arena, the fact that there are so many different classes of shares including a right to a 1x preference on liquidation or sale, is also bound to prove challenging. No wonder these kinds of exchanges have failed to get off the ground in the past.
You only need to look at AIM to see that illiquidity remains a persistent issue – even in a functioning (if currently imperfect) public market. There is simply not enough capital available to make it efficient. There’s an argument to say that if policy-makers want to pump more liquidity into the system, they would do better to consider increasing tax incentives to encourage more investment on AIM or in private companies beyond what already exists. Currently, tax breaks (for AIM investments and for EIS and VCTs) are concentrated on new share issues, but incentives to trade in secondary shares are few and far between (barring some Inheritance Tax (IHT) relief).
History suggests that this proposal will struggle to have the intended effect. The reality of trading shares in private markets is very different to trading on public markets, and even then liquidity is not always free-flowing, as AIM attests. Unless a mechanism can be found to ensure valuations are priced appropriately it would not be surprising if both potential buyers and sellers steered clear of PISCES. Without that, it looks like this plan lacks the legs to carry it through.
If there was a real problem here, the private sector would have solved it long ago, and a solution of sorts already exists: try your fellow shareholders, using proven methods to set a fair price. Government intervention in this form is unlikely to improve on the status quo.
This article first appeared in Investment Week on 2 April 2024.