Merits of new exchanges

The proliferation of new private securities exchanges could help private equity firms become more institutionalized and function as a first step prior to a public listing, industry players say.

Private exchanges seem to be popping up everywhere. Last week, Los Angeles- and New York-based financial services holding company Zealous Holdings said it has seen “strong initial interest” from parties including private equity firms for its new electronic marketplace – dubbed ZATS – for restricted and illiquid securities.

ZATS is the fourth such marketplace announced this summer, all of which follow in the footsteps of Goldman Sachs’ private trading platform, GSTruE, which began trading this May. Bear Stearns, NASDAQ and a consortium made up by Citi, Lehman Brothers, Merrill Lynch and Morgan Stanley have all developed their own private exchanges, whereby qualified institutional buyers can trade in securities unavailable on public markets.

The private exchanges could be a significant new development for buyout firms, more and more of whom are weighing the merits of public floats to raise permanent capital and tap franchise value. But at this stage, it is too early to tell just how useful the new platforms will be, industry players and observers told PEO.

It remains unclear whether such market will have sufficient liquidity, said Michael Littenberg, a business transactions attorney at Schulte, Roth & Zabel. And if the new platforms prove less liquid and less efficient than public markets, shares might trade at a significant discount, said John Ayer, a Ropes & Gray partner who also works in business transactions.

Private markets can be an attractive option for private equity firms that want to raise permanent capital, but prefer to avoid the disclosure and reporting demands associated with listing their management companies on the public markets. Oaktree Capital Management cited this as one of its reasons for listing on GSTruE in May, and Apollo Management – whose co-founder Leon Black has also expressed reservations about the scrutiny that precedes a public listing – is reportedly preparing to follow.

According to reports, Apollo is approaching the Goldman exchange as a precursor to a public listing – which may be one of the most important ways a private equity firm can benefit from a private exchange, according to Ayer.

If a firm can get an initially attractive valuation on a private exchange and raise capital more quickly due to the less complex disclosure regulations, then it might prefer to list on a private exchange initially, even if its shares trade at a discount relative to what they could sell for on the public market, he said. And there is no reason why a firm cannot later list on a public exchange, Ayer added.

“The larger private equity shops are on something of an inexorable march to becoming more like institutionalised money management firms, which means they’re going to want, over time, more permanent capital,” Ayer said.

A spokesman for the California Public Employees’ Retirement System echoed Ayer’s prediction that private exchanges would help to institutionalise private equity.

“We see this as an evolutionary development,” the spokesman said, noting that while it is still evaluating the new private exchanges, CalPERS thinks they may provide the pension fund with more “efficiency and nimbleness” in its investment activities.

Private exchanges could also help alleviate concerns that US regulatory requirements, particularly Sarbanes-Oxley, are making the US less competitive in the securities and investment banking sectors, Littenberg said.

Another advantage, said a general partner at a major private equity firm that declined to be identified, is that on the private market, firms interact with more sophisticated investors, who have a better understanding of the nature of a private equity firm’s business and appreciate that the results are often variable in the short term.

But the downside, the GP said, is that firms who list on private exchanges have less exposure to interested investors than they might on a public exchange.

“This is not a platform that people are watching on Bloomberg,” the GP said.

All parties interviewed said they expect to see consolidation of the exchanges in the future. Convergence would improve liquidity and create a more vibrant, efficient market, Ayer said. But for the moment, he said he sees no problem with the growing number of private exchanges.

“It’s not such a bad thing that there are several of them up front, because everyone is trying to figure out what’s the best technology to make these things work,” he said.

Littenberg added that the initial scramble might be a response to high demand on both the buy side and the sell side.

“I think the way some platform operators are looking at this is that it’s better to have a toe in the water and get some market share,” Littenberg said. “You can always combine with another platform down the road if it makes sense.”