Second-Guessing SecondMarket

This week, the CEO of SecondMarket, the secondary market for illiquid assets, traveled to the World Economic Forum in Davos, where SecondMarket was given a “technology pioneer” award.

The distinction didn’t come as a surprise to anyone in Silicon Valley. In the process of fueling the celebrity of companies like Facebook and Zynga, whose secondary shares trade through its platform, SecondMarket has itself become a hot commodity. In fact, according to SecondMarket’s chief strategy officer, Jeremy Smith, the company recently placed “certain limits” on its own secondary market shares, adding the same restrictions that companies like Zynga have instituted over concerns that employee shares are being bought and sold willy-nilly.

There’s good reason for the hullabaloo. Though six-year-old SecondMarket makes most of its money trading alternative assets like distressed securities, its sales of private company shares, which it began brokering in the spring of 2009, have been explosive. At the beginning of last year, 6,500 participants were buying and selling startup shares through SecondMarket. By year end, that number had soared to 35,000. SecondMarket’s transaction volume grew meaningfully in 2010, too, hitting $157.8 million in the fourth quarter — more than double its third-quarter output.

Much of that growth centers on a few companies, such as Facebook, which accounts for 40 percent of SecondMarket’s transaction volume. But it’s also a reflection of an influx of institutional investors. Bloomberg reported last week that Tiger Global, a private equity firm in New York, has spent $164 million to build a 1 percent stake in Facebook and is trying to increase its position. Meanwhile, Robert Heim, formerly an attorney with the SEC’s Enforcement Division, told me earlier this week that he’s working with “hedge funds and other asset managers” that are increasingly interested in acquiring positions via the likes of SecondMarket.

Even the most obvious knock against SecondMarket – that it will have a hard time imitating its success with Facebook — is debatable. After all, if Facebook goes public and performs well, the risk appetite of investors for secondary shares could increase. “As long as the SEC doesn’t intervene, I think there will be a demand for these private marketplaces even after Facebook is public,” Heim said.

That’s one perspective. Another is that SecondMarket’s prospects could flag after the likes of Facebook, Zynga, and LinkedIn — whose S-1 filing is reportedly imminent — go public. While it’s easy to imagine other startups proffering their shares on SecondMarket, it’s harder to believe they’ll receive the same attention and demand as their uniquely successful predecessors, which have received not only glowing press, but also, in Facebook’s case, its own Oscar-nominated movie.

The market that SecondMarket is addressing remains small, too. While Smith suggests that SecondMarket could wholly replace the need for companies to go public, Doug Chu, head of the NYSE’s Silicon Valley office, says, “We’re much more concerned with the exchanges around the world. The public markets equal trillions of dollars [of available capital]. I wouldn’t confuse the public markets with exchanges like SecondMarket.”

Not last, facilitating secondary share trades may not prove lucrative enough to buffer the company if the markets once again take a downturn.  SecondMarket receives a commission of between 3 and 5 percent of every transaction, and while it expects its private company stock business to triple over the next two years, its total transactions thus far have been roughly $500 million. By my math, that translates into just $25 million.

Indeed, SecondMarket’s seemingly bright prospects aside, the only constant in investing is the cyclical nature of markets. Says venture capitalist Venky Ganesan,  “Markets loosen and valuations rise. Then the big companies go out, then the imitators, then the idiots. When the idiots go out, then you know we’re at the end of the cycle.”

Btw, VCJ readers can access a new, detail-rich feature story on SecondMarket, Sharespost, and Xpert Financial right here.