The Facebook IPO is an excellent, although somewhat exceptional, example of the benefits of private-equity investing: it offers a vehicle for investors to profit from the growth of closely held companies, as opposed to investing in companies available to the masses.

The investors who purchased $450 million worth of Facebook shares in January 2011 at a $50-billion valuation will see a nice double in just one year. Stories like this have created burgeoning interest.

Most private companies are earlier-stage enterprises that prefer to avoid public-market scrutiny until they’ve gained the capitalization of public peers. Analysts who follow public companies often pressure management to provide quarterly guidance, which can distract from creating longer-term value. And staying private a little longer is better than going public too soon.

Private-equity investors

Accredited individuals, mutual funds, hedge funds, family offices, sovereign-wealth funds, private equity funds and more are flocking to private-equity investments because of their attractive return potential. In response, private equity funds have grown in popularity over the years as a one-stop shop for people to access a pool of private investments.

With the number of investors participating in these private pools growing, some issuers are finding they don’t need to go public at all to access capital. In Calgary last year, Laricina Energy successfully raised $520 million from a variety of investors at a record valuation, making it one of Canada’s largest equity issues of 2011.We expect Laricina will conduct an IPO in 2012 at an even higher valuation. Large private-equity funds and venture-capital investors have traditionally dominated direct investments in private companies—until now. The likes of Warburg Pincus, Blackstone Capital Partners, BlackRock Financial and KKR have historically skewed issuers’ valuations in their favour.

Due to the huge amount of capital required to participate in such deals, individual investors were priced out of these offerings. Osum Oil Sands in Canada, for example, raised $500 million solely from institutional investors in January 2012. However, there’s a new entry point for individual investors: the Canadian grey market.

The grey market

In this market, investors can purchase shares in a secondary transaction from another shareholder who is seeking liquidity, much like a stock-market purchase. Conversely, investors can purchase shares directly in private issuers through a private placement, much like an IPO, or a treasury private placement of a public issuer.

Since many private companies have a time horizon of three to five years before a liquidity event (either an IPO or corporate sale), a liquid secondary market has evolved to facilitate trading in the shares of these private companies. To monetize their investment, investors contact grey-market brokers to locate buyers for their shares. Brokers typically have in-depth knowledge.

In Canada, investment dealers have financed private companies like Laricina Energy and TORC Oil & Gas, while also making a robust secondary market for the shares. This has helped dealers to gain a significant presence in other private companies’ shares, the value of which, like the traditional stock market, is determined by the views of buyers and sellers.

These opinions are based on an issuer’s operational results, commodity prices, sentiment, and so forth, which all play a role in the value that parties are willing to assign to those securities.

Expanding the grey market

The grey market has now gathered steady momentum as a secondary exchange for private company shares. Some estimates put Canada’s grey market at $500 million in notional value per year.

This figure is up considerably from previous years and is expected to continue to grow as knowledgeable private equity brokers attract increasing numbers of buyers and sellers prepared to transact on the shares at varying price levels.The corresponding market depth has created liquidity and marketability in an investment that has historically been difficult to trade. This has created a virtuous circle: knowing that an option for liquidity exists encourages more investors to participate in private investments.

In turn, astute brokers and their firms have created detailed analyses of closely held firms, enabling their clients to actively invest.

As issuers look to raise additional capital, they often rely on brokers to create demand for shares. Although the identity of each party in a private transaction is kept confidential, transparency of the grey market has grown through detailed fees, number of participants, historical trade data, increased regulatory scrutiny and an enhanced compliance regime.

Grey-market brokers facilitate the purchase and sale operations to ensure that both parties are well protected and that the transaction meets stakeholder needs. These functions are often carried out by a team that specializes in this area.

Because private-company shares are typically held in certificate form, the grey-market broker arranges for a transfer agent to re-register the shares in a buyer’s name while flowing the sale proceeds to the seller.

The broker will collaborate with various internal departments and external organizations to meet the requirements. As a result, the fees applied to such transactions can be slightly higher than full-service brokerage rates on public equities. Depending on transaction terms such as volume traded, issuer share structure, and vendor jurisdiction, fees could increase.

Upon an IPO, an issuer may ask private investors to sign a lockup agreement whereby the investor’s shares become unrestricted in stages. For example, one portion could become freely tradeable each calendar quarter. The issuer may request this lockup to avoid having shareholders with a very low cost base exit too quickly, causing an adverse impact on price. Despite the issuers’ public listing, these restricted shares may have a further grey market.

The upside of private investments

Issuers seeking to raise capital often discount the offering price relative to comparable peers in order to attract buyers. To reflect the reduced liquidity of these equities, private issuers may be forced to further discount their offering. Investors then benefit from a valuation pickup when the company is taken public or bought out.

Private companies have some liquidity levers they can pull: an IPO, reverse-takeover, merger and corporate sale.Calgary-based Sunshine Oilsands conducted a private equity issue at $5.25 per share in January 2010, followed by another round at $9.68 per share in February 2011. Earlier this year, the company priced its IPO at $12.62. The grey market for that company’s shares followed the placement prices higher by trading more than 7 million shares in the past 18 months.

Investors with appropriate risk profiles should consider investing in a private company. If liquidity is essential, determine the scope of the grey market for the shares in question.

Rahim Chatur, CFA, DMS is Vice President, Private Equity with Macquarie Private Wealth.