The news that stock trading app Robinhood may be building a platform to enable ordinary investors to participate in IPOs—potentially including its own upcoming IPO—alongside institutions has heightened existing excitement over the prospect of trading pre-IPO stock in private companies. While this may appeal most to individual investors fed up with volatile stock markets, or dreaming of acquiring stock in the next Apple or Microsoft before it goes public, institutional investors are eyeing the same opportunities.

“Over the last 20 years, public markets have been shrinking, while private markets have been growing. Fewer companies are going public—or are choosing to go public later—so more money is being created in those private markets,” says Carlos Domingo, CEO of Securitize, a San Francisco-based company that helps issuers create digital securities. “Normal investors are being left out of where that money is being made. People want to invest in private companies and want secondary markets in private companies.”

But the nature of these markets poses a plethora of challenges—structural and technical—to institutional participation. One is that these markets are by nature opaque, so introducing the kind of transparency that investors would likely demand could erode the hidden value that opacity begets.

There are already plenty of options for individual investors to participate in private stock trading, from those like Sharespost, EquiyZen and Forge Global, which allow employees of privately held companies to sell their company stock to investors who recognize that the real growth in a company’s value occurs pre-IPO. Still, while an individual can easily link these to a payment app or bank account, large institutions with legacy back-office infrastructures may find it harder to support clearing and settlement—and hence also may find it harder to start trading these markets electronically.

At the same time, though, capital markets firms are investing significant amounts in preparing to become more active in private markets. Last year, CNBC reported that JP Morgan has established a team specifically to address this “burgeoning asset class” and invest in pre-IPO companies, including SpaceX, Uber, and Airbnb. This February, the bank also took an undisclosed stake in Mountain View, Calif.-based Zanbato, a crossing network for institutional-sized block trades in private securities. Also last year, New York-based Serengeti Asset Management invested $550 million into SecFi, a platform that enables employees of private companies to buy and sell stock in the companies they work for. Private markets and platforms that facilitate access to them is one of Serengeti’s specialist areas of investment.

Why are these firms pouring money into this? Because there’s already a lot of money flowing into the private markets, and they want a slice of the returns.

Let’s take one sub-segment of the market: privately held US financial technology providers. S&P Global Market Intelligence recently surveyed private transactions in US financial technology providers, focusing on venture capital-led activity. Investors spent $17.8 billion on investments in privately held US fintech companies in 2020, $3 billion more than in 2019. While most of these companies operate in the retail investing, insurance technology, and payments sectors, around $1.5 billion of that figure went to B2B fintechs. And S&P expects these numbers to both grow further this year, and expand to encompass other forms of private markets activity.

“I do think crowdfunding and liquid markets for private securities are where this is heading,” says Tom Mason, senior research analyst at S&P, who conducted the research.

“The private markets will be a $14 trillion industry within the next two years, and will be a central driver for institutional and retail wealth creation over the coming decades,” says Eliot Hodges, CEO of Anduin Transactions, a provider of technology to help private companies and funds automate the process of submitting and capturing company information, to reduce that friction and bridge the gap between the private and public markets.

‘Private markets suck’

But—and it’s a big but—from an operational perspective, private markets “suck” and are “riddled with friction and opacity at every point in the process,” Hodges says.

“This is a highly fragmented space—there is a lot of data, but it’s not well collected,” he says, adding that up to half of all documentation on privately held companies may contain errors. “A fund administrator’s data may not sync with data from customer relationship management (CRM) systems. There is no company that has truly driven this ecosystem and created a full record of the truth.”

Data in private markets is disparate and difficult to capture. It’s like trying to piece together a 10,000-piece jigsaw puzzle.

Sara Dillon, FactSet

Hodges says there are three “critical barriers” to private markets functioning and behaving more like public marketplaces—workflow, data, and legal issues, such as common and uncommon terminology used in agreements and negotiations for private share issues and transfers.

What these details create is barriers to entry, hinging on transparency, access, and liquidity, says Domingo. “The private markets are very opaque, very difficult to access. Prices aren’t published anywhere,” he says.

That also creates a challenge for data vendors seeking—and expected by clients—to provide data and insight on private markets.

“Data in private markets is disparate and difficult to capture. It’s like trying to piece together a 10,000-piece jigsaw puzzle,” says Sara Dillon, senior vice president and head of private markets at FactSet, which in addition to providing data on exchange-traded and over-the-counter (OTC) markets, also provides coverage of private companies, private capital, and merger and acquisition activity among privately held companies.

“When trying to evaluate a private vs. a public company, you want the same data; it’s just much harder to find [on private markets], because it’s not filed in the same way. So vendors have to find a source, or find a way to accurately predict that,” says Dillon, who joined FactSet last year to focus on its private markets datasets.

Dillon notes that private markets encompass everything from retail crowdfunding to experienced angel investors and venture capital investment—each with a different purpose and investor profile—and that FactSet has carried data on private companies, private capital, and M&A activity in private markets for “a very long time,” and is now building out its coverage of “less traditional” forms of private capital, such as angel investing, crowdfunding, and incubators.

And that’s another thing that “sucks” about private markets: Until now, companies have had limited funding options once they reach a certain size. Either they IPO, or they raise venture capital (VC) funding. But, depending on the company, those aren’t always suitable.

Alexander Ross, investment director at Illuminate Financial, a venture capital firm focused on fintechs, notes that going public may be good for investors, but may not always be in a company’s best interests. “The principal reason for a company going public is its VC backer or owners looking for liquidity. But that’s not always what’s best for the company itself,” Ross says.

Jason Paltrowitz, director and executive vice president of corporate services at New York-based OTC Markets Group, which operates a public exchange-style market for over-the-counter stock issued by 11,000 companies, agrees—though, of course, that’s OTC Markets’ raison d’être.

“We are seeing a lot of instances where a traditional exchange IPO doesn’t meet the needs of growth companies or investors. A lot depends on the company itself. We come across companies all the time where the CEO says, ‘We have to list on Nasdaq because it sounds sexy.’ And sometimes advisors act not in the best interest of their clients, but in the best interests of their wallets,” he says. “At the same time, there is a tremendous amount of money in the system that is looking to invest in companies at earlier stages but could not traditionally participate in IPOs. It’s a perfect storm.”

Now, investors are lining up to pour money into private companies. But it wasn’t always like that. In the past, it was harder for private companies to raise funding, while regulators were concerned about allowing investors access to private markets, says Carlo di Florio, partner and global chief services officer at New York-based compliance advisory firm ACA Compliance.

Following rule changes governing “exempt” securities and disclosures by the US Securities and Exchange Commission (SEC), private markets are now growing faster than publicly traded markets, and have a “robust and efficient framework in place to protect investors,” says di Florio.

Prior to joining ACA, Florio served as chief risk and strategy officer and executive vice president of shared services at Finra. Before that, he was director of the Office of Compliance Inspections and Examinations at the SEC, where he was involved in establishing disclosure regulations for private equity firms and hedge funds investing in private markets—disclosures that created “rich data” for the SEC to monitor.

“We are seeing a paradigm shift that will benefit private companies because they can raise more money, and will benefit investors who have been kept out of those markets before, and will ultimately make these markets more liquid and vibrant,” he says.

Insight into opacity

Another thing that makes markets more liquid is the availability of data—from price data, to news and research that provides insight on privately held companies. Bethesda, Maryland-based MT Newswires recently launched a new service providing coverage of pre-IPO companies, responding to growing interest in gaining exposure to private markets.

MT Newswires previously only focused on publicly traded companies, because those are what its clients can trade on public markets. However, with growing investor interest in private companies going public, CEO Brooks McFeely says broadening its focus to private companies that “should be widely known” represents a natural complement to its coverage of publicly traded companies.

“It’s important for our clients who trade the public markets to be able to provide their customers with information on private companies that may be publicly available to trade in the future,” McFeely says. “The IPO market is red-hot globally, and special purpose acquisition companies (Spacs) are also gaining traction outside the US. So it was clear that the investment community needed a solution.”

As a result, MT Newswires has created a dedicated team of about a dozen journalists—initially covering the US, though the vendor plans to expand the service to Canada, Europe, and ultimately Asia—to monitor and report on pre-IPO companies that have filed an SEC S-1 form registering their intent to go public.

The vendor will take a traditional approach to reporting on pre-IPO companies, focusing on the same metrics it would provide in stories about public companies, such as revenues, margins, growth, and industry comparables, and—specifically for Spacs—company management and its experience, and what industry the Spac is looking at making acquisitions in. It will also apply the same tags to each story about a private company from the library of more than 160 tags applied to its stories on public companies, so that any search would return results for both public and pre-IPO companies.

MT Newswires isn’t the only finance-specific news service covering this space. Alpha News Stream, a Marin County, Calif.-based news curator that delivers financial headlines via APIs, also curates content from news sites and blogs covering early round, venture-backed companies as well as public and pre-IPO companies, says founder Frank Cioffi.

“Much of the news private equity players consume is about companies at their earliest stages,” Cioffi says. “I expect the demand for keeping abreast of such companies will only grow.”

That’s where Alpha and MT Newswires differ: In contrast, McFeely says MT Newswires’ clients are more focused on publicly traded companies—and therefore on those private companies about to IPO—rather than strictly private equity and VC funding for early stage companies.

“Our clients are not really looking for information on those kinds of companies—they’re too early stage, too speculative, and there’s not enough information available,” he says.

Digital disclosures

Obtaining more information on private companies of any scale is burdensome and time-consuming for potential investors, news providers, and potential vendors, especially since most private companies don’t produce anything near the same level of disclosures as public companies, and which often only share that information specifically to potential investors.

These levels of disclosures—from annual and quarterly financial statements, to disclosures of new shareholders or company activity—are often new to private companies and come with a cost and administrative burden that prompts some companies to stay private longer to avoid them.

How to be a public company is learned over a period of time. Companies that list too early don’t have the skillset yet. Raising money from an investor and servicing that investor afterwards are two different skills.

Jason Paltrowitz, OTC Markets

“How to be a public company is learned over a period of time. Companies that list too early don’t have the skillset yet. Raising money from an investor and servicing that investor afterwards are two different skills,” says OTC Markets’ Paltrowitz, who was at the company when it went through its own IPO.

Decisions like whether a company’s founder should remain as CEO, whether a company needs a board, or needs extra resources, like employing an accounting firm to take care of timely filings, are all things that must be bootstrapped, and where companies must put systems in place to address.

There’s also the issue of determining what and how much data is appropriate to disclose: Should it be the same as the requirements for publicly listed companies, or should each venue set and manage its own requirements?

“A company will have to supply the kind of information required by investors,” says Jeff Le Sage, founding partner at Liquid Stock, which acts as a primary investor, allowing companies and employees to exercise stock options and private shares as capital for financing. “I’m not proposing more government regulation, but I do believe investors will start to demand more information—and then it’s a question of how much information companies are willing to disclose. It won’t be a one-size-fits-all approach.”

Anduin’s proposition is to automate and speed up that disclosure process, making it easier for firms to generate and share data, and lowering the barrier to fundraising for companies who feared the burden of information disclosure.

“It starts with getting an LP’s data out of Excel. A lot of the processes that underpin those companies today are in Excel, powered by humans and email. Excel is a powerful tool, but it was never intended for managing a GP/LP relationship,” Hodges says. “If you can digitize the documents, so LPs don’t have to fill out the same information more than once for different parties, then you can unlock and automate downstream processes, such as know-your-customer (KYC) and capital calls, portfolio reporting, and compliance reporting.”

Then there’s the issue of what to do with that data once it becomes available—and in many cases, investment firms receiving the data just put it right back into Excel. Gurvinder Singh, CEO of New York-based trading, risk, reporting, and data management solutions provider Indus Valley Partners, agrees that digitization is key to allowing firms to react to “the allure of private markets.”

The main issue is that because these assets lack standards and are not yet traded digitally, firms are running funds of private stocks in spreadsheets, Singh says, which simply can’t support a fund with a target of growing from $5 billion to $30 billion. Also, necessary functions such as valuation and risk management can’t be relied on to work at that scale in spreadsheets.

“The fundamental technical hurdle is that the terms and conditions (T&Cs) of one deal and another are completely different, and there is no way to digitize and track how those T&Cs are changing, so you won’t be able to risk manage those positions. Do you keep doing it manually in spreadsheets? You need a flexible platform where you can model deals and covenants,” Singh says. “You need the flexibility to pull in data from multiple sources, and to perform lineage, governance, and analytics so you can trade, manage risk and reporting, and allow investment managers to get out of spreadsheets.”

So, over the past three years, the vendor created a platform dubbed IVP for Private Funds, which consolidates this data into an integrated managed service workflow, order management system, and data hub, which is now used by between 15 and 20 clients.

The new stock markets

These efforts support the full digitization of private securities, which Securitize has secured licenses to do, and works with private companies to issue some of their stock as digital securities. But to gain liquidity, those securities require a place to trade. Frustrated with opaque existing marketplaces that support private trading but don’t supply exchange-like levels of information such as trade data—how many shares traded, and at what price—Domingo decided to build his own marketplace. Securitize Markets obtained a license to operate in November, and since then it has been implementing a technology platform and hiring staff.

Another company starting its own platform for accessing private markets is InvestX Capital, a Vancouver-based company that has spent the past seven years acquiring holdings in large private companies and creating a marketplace for that slice of stock among broker-dealers, who can then offer the stock to their investor clients. Now, the firm has released a technology platform, dubbed Gem, which automates parts of the process by which these firms trade and settle these securities.

So far, these late-stage, private equity-funded companies have only been available to a small group of large investors. These private companies have been staying private longer—and that small group of investors have been the beneficiaries.

Marcus New, InvestX

“The late-stage venture asset class is a $2 trillion market, and a lot of that is executives and employees sitting on their stock,” says InvestX CEO Marcus New. But interest in these companies specifically is growing because 2020 saw many of these pre-IPO giants doubling their set IPO price—some on their first day of trading—once they decide to go public, including several healthcare and pharmaceutical companies, as well as Airbnb and cloud operator Snowflake.  

“So far, these late-stage, private equity-funded companies have only been available to a small group of large investors,” New adds. “These private companies have been staying private longer—and that small group of investors have been the beneficiaries.”

Broker participants can access Gem’s price discovery platform, which operates in a private environment for its participants, and includes a Level-2 screen similar to what traders would be familiar with for on-exchange trading, as well as an auction mechanism.

But while transparency and liquidity are big challenges, New says the biggest problem for broker-dealers is integrating any trading in private securities into their existing records systems in a compliant manner. “Most sell-side firms are trying to figure out how to get into this market. They see this as a massive asset class,” he says.

To do this, InvestX developed a proprietary Fix-based protocol that integrates with firms’ existing back-office systems and fits their normal processes “like a glove,” New says. “Gem helps brokers electronify all those back-office processes. We standardize them, so everything works for the dealer,” New says.

InvestX identified that one of the hurdles to adoption would be the ability to integrate a new type of trading into firms’ existing processes—particularly the ability to risk manage and settle trades using their existing middle- and back-office setups.

S&P’s Mason also notes the importance of this aspect of trading, and warns that—in addition to front-office differences—back-office elements that are commonly understood in the public markets may be more challenging for private securities, and make it harder to migrate them to electronic trading. “The custody and settlement aspects will definitely be a hurdle,” he says.

Enter the big guns

The Depository Trust and Clearing Corp. (DTCC), the largest US provider of post-trade processing infrastructure, is already working on an initiative to overcome this hurdle, which will apply tokenization to private stocks beyond just pre-IPO giants. 

DTCC has already developed a prototype of the new service, dubbed Project Whitney, which is running on the Public Ethereum blockchain network—though with an off-chain stock record—and has since added support for Hyperledger Fabric and R3 Corda blockchains. Its core comprises an Amazon Web Services (AWS) quantum ledger database to provide an immutable stock record, a compliance rules engine to capture and apply any rules surrounding an issuance—for example, if the issuer prohibits transferring that security within 12 months—as well as issuer security masters and investor registries, and API connectivity. Once tokens are “minted” on the network, ownership and trades can be managed across peer-to-peer transactions via digital wallets, or organized secondary markets conducted on an alternative trading system (ATS).

“Project Whitney originated a couple of years ago, when we started to look at the future of markets and digital transformation, and the tokenization and digitization of assets, and this spurred us to look at the private markets space,” says Jennifer Peve, managing director of business innovation at DTCC. “With companies staying private longer, those companies are generating more value pre-IPO, which is incentivizing institutional investors to increase the capital they allocate to those markets.”

But with regulators concerned about broker-dealers’ ability to meet SEC custody and control requirements on a public blockchain, Whitney needed smart contract keys and private keys to ensure controls, and the rules engine provides “proactive compliance” in the form of a pass/fail indicator that determines whether a transaction can go ahead. Whitney also helps issuers and others fulfill KYC and anti-money laundering (AML) requirements by knowing who owns their stock.

“The platform can democratize access to early-stage companies and provide compliance and risk management around that,” Peve says. “For example, verification of regulatory and product-specific suitability requirements for all asset transfers such as where an investor resides, or the security lock-up period. Today, compliance controls are reactive by nature, manual, and as a result, costly from an operations perspective. In addition, compliance and suitability rules are bespoke and issue-specific, with no central catalog or repository.”

DTCC began development in January 2020, completed the prototype in March 2020, released a case study in May, and engaged in client outreach with stakeholder groups—including broker-dealers, transfer agents, custodians and ATSs—about how they could use it, and what it would need to integrate with. Peve says DTCC is now having discussions on the next steps required to move Whitney forward.

DTCC isn’t the only organization that believes blockchain can provide a solution to the challenges of private markets. For John Wu, president of Ava Labs, an open-source development framework for creating financial apps and blockchains, this challenge was a big factor in his decision to get involved in blockchain.

“I was a tech investor. I ran public and private companies. And between 2010 and 2017, I noticed that companies were staying private longer, and the amount of money invested in private markets was growing,” Wu says.

But as he tried to build a portfolio of investments in private companies, he realized there was “a big tech gap” between the current private markets and an efficient system for both investors and issuers. Wu envisaged that giving private shares a digital asset “wrapper” would enable them to be traded on an ATS, while using the blockchain for clearing and settlement could drastically reduce settlement times.

“Currently, private markets participants have to wait between 30 and 60 days to settle. We can take that settlement process down to a day or two, and then you have a system very similar to what people are used to in the public markets,” he says.

A private-public hybrid future

Making private stocks tradable in a way that’s familiar to those who trade publicly listed equities will require technology from the front office to the back office to be reshaped to mirror that similarity. Technology and integration challenges aside, a key requirement is gaining more transparency into private companies, Wu says—though he notes that ramping up disclosure requirements (and costs) would negate one of the advantages of staying private.

Ironically, increasing transparency and access would also negate the opacity and exclusivity that make investing in private stocks appealing and profitable.

However, New still believes that automation will ultimately drive down the cost of participating in the private equity markets as it creates more participation, liquidity, and transparency, and force existing options for participants—such as employee stockholders looking to cash out their private stock—to become more competitive. “We believe the market is over-inflated for a reason—because it is not automated … and because it’s lucrative for others to keep it that way,” he says.

What New is suggesting is that those who have led the way in opening up private markets to new investors want to increase participation without increasing transparency or lowering costs—in short, to keep those markets exclusive and illiquid, and protect their positions as gatekeepers to private stocks.

The problem is that without those going hand-in-hand with more information and easier access—the prerequisites for the creation of true secondary markets and the participation of institutional investors—these markets will remain largely private and underdeveloped, hindering companies’ ability to raise funds beyond VCs and IPOs, and missing out on billions of dollars of potential investment. Still, those potential billions are a huge incentive to everyone—from Anduin to DTCC and more—to create more transparent and accessible markets for private securities.