How Do Private Markets Work?

As the popular saying goes, “When one door closes, another opens.”

When it comes to investments, exit is the most significant part, if you think about it. This is when you get to realise the value that you have created over the past few years. You finally get to enjoy the fruits of your labour.

In the public markets, exiting from your investment is as simple as clicking a single button. In the stock market, your order will probably get executed immediately, and your investment will be closed.

The private markets are very different, however. Liquidity is low here, and exiting from your investment requires a strategy.

In this chapter, we’re going to explore some of the most popular exit strategies in the private markets.

The table below summarises the percentage of exit types in the global private equity markets.

This type of exit happens when a startup is acquired by another company and is also called a ‘trade sale’. When this happens, the fund managers can exit from their investment and realise the profits.

The first step is to identify potential buyers for the startups. GPs use their industry network and connections to reach out to a variety of investors and companies. For example, it could be a company in the same industry looking to increase market share, or a foreign company looking for an opening in the domestic market, or the company may have technology that another company wants to acquire.

To help in the negotiation and deal structuring process, the acquiring company generally involves an investment bank or other advisor. There is an in-depth due diligence and valuation process. Only after all the parties agree to the terms and conditions is the deal finalised.

M&A exits can be a great way for funds to cash out their equity and receive a return on their investment.

Microsoft’s acquisition of LinkedIn is an example of expanding market share. Microsoft wanted to expand its reach in the business world and LinkedIn offered a very promising way in.
In 2016, Microsoft acquired LinkedIn for $26.2 billion. After the acquisition, it integrated LinkedIn with its other products like Office 365 and Dynamics 365.

An initial public offering or IPO occurs when a company lists on the stock exchange and sells its shares to the public for the first time. After an IPO, the company is changed from private to public.

This is one of the most lucrative exit strategies for GPs, as the public market may offer a better valuation than alternative exits and it can lead to significant returns if the company’s stock performs well after listing. Those who have invested in a startup during the pre-IPO period can sell their shares after the listing, or continue to hold in the knowledge that their shares are now liquid and can be sold at any time.

But IPOs can also be quite volatile. If you truly let the market decide on the stock price, then it can go either way. The stock markets are known for their volatility. If the global scenario is not favourable, for instance, the stock performance can be poor.

Let’s consider the example of Nykaa.

Founded by Falguni Nayar in 2012, Nykaa started as an online beauty and cosmetics marketplace. Over the years, it expanded its offerings, including fashion, and also established offline stores.

Nykaa filed for its IPO in 2021. The aim was to raise capital and provide an exit or partial exit for some of its early-stage investors. On the listing day, Nykaa’s shares opened at a premium of 77.87% over the IPO price and it closed at a premium of 96.27%!

This is one of the most popular exit strategies in the alternative investment space, particularly the VC space. While IPOs might be ideal, they can take quite a while to materialise. It can take over a decade in some cases.

For those investors who do not want to wait that long, a secondary sale can be an excellent method of cashing out early. Fund managers simply sell their stake to other investors, typically other funds, in the subsequent rounds of funding.

The term “secondary” in this case refers to the fact that the shares are being transacted and not freshly issued.

Advantages of Secondary Sales

• It provides an exit avenue for fund managers and gives them liquidity.
• It can be structured in various ways, such as the sale of a single company stake or a bundle of investments.
• It helps alternative investment funds nearing the end of their terms to exit investments and distribute returns to their limited partners.

Example: Byju’s

Since its launch in 2011, Byju’s has become a giant in the Indian ed-tech space. Over the years, it has raised several different rounds of funding. The Lightspeed Venture Partners first invested in Byju’s during its Series B round in 2015.

In September 2020, they decided to partially exit their stake in Byju’s through a secondary sale. The deal was sized at around $500 million.

This stake was acquired by a set of new investors like Alpha Wave and Silver Lake, and existing investors like Tencent.

Lightspeed had invested approximately $20 million in Byju’s across 2015 and 2016. This means, that in just 4-5 years, it secured a return of almost 25x its initial investment.

Now, this is obviously not an ideal situation. When fund managers invest in a startup, they do so with expectations of returns. If not a multifold return, at least a stable growth rate.
The last thing anyone wants is to have to liquidate the startup. But it serves as an exit strategy for several reasons.

It can be a means to avoid bankruptcy, particularly if the business remains solvent or near solvent. It allows some breathing room and gives owners the chance to negotiate with creditors.

It can be a preferable alternative to selling a business with significant assets, as potential buyers may not pay full price for inventory. Some entrepreneurs, after all, will prefer to acquire their assets to start anew rather than buy an existing enterprise.

Once the startup has been liquidated, it ceases to exist. The employees are laid off and the creditors are paid off. Any remaining assets are distributed to the shareholders.

Example: Toys R Us

The story of Toys R Us starts way back in 1948, as a baby-furniture retailer. Over the years, the brand grew into a household name for both children and their parents. In 2005, private equity giants KKR, Bain Capital and Vornado Realty Trust acquired the company in a leveraged buyout for $6.6 billion.

But, with the changing tides in the retail segment and the gradual takeover of e-commerce, Toys R Us ran into turbulent times. Companies like Amazon completely transformed the retail shopping experience. Toys “R” Us, with its dated stores and lacklustre online presence, struggled to keep pace.

The company was forced to liquidate in 2018. For KKR, Bain Capital, and Vornado Realty Trust, this meant a significant financial blow. They, along with other creditors, were left to divide the proceeds from the sale of Toys “R” Us’s assets, a sum that paled in comparison to their initial investment. The liquidation also had wider ramifications—tens of thousands of employees lost their jobs and many suppliers faced financial difficulties due to unpaid debts.