Overview of SPVs (Special Purpose Vehicles) in the investment landscape
Special purpose vehicles, or SPVs, are entities set up to invest in a specific financial opportunity such as an early-stage business. The goal of the SPV is to focus its investment energies on that target.
The SPV is a flexible instrument in private market investments like venture capital. Not only can investors pool their finances, but SPVs provide a streamlined and transparent way to access private equity. They allow investors to participate in markets that might otherwise be unavailable, and do so with smaller amounts.
Because SPVs are a collaboration among investors, the operating terms are more flexible and open to negotiation depending on the investors’ objectives. In this article, we focus on liquidity as part of funders’ goals in the SPV investment landscape.
Importance of liquidity for all investors in private markets
In the public market for shares (those listed on an exchange), shares are extremely liquid and can be exchanged for cash at the seller’s option. The private market is different. The terms under which investors can trade or transfer their shares are limited, either by constitutional documents or instruments such as shareholders’ agreements – most significantly asymmetry of information and lack of institutionalized trading market is what impedes "easy trading".
Constraints for Liquidity
Shareholder agreement (SHA) of the target
Target companies frequently limit share transfers to control who can become an investor and to regulate the power dynamics among shareholders. Often, the company must approve any sale and give the other shareholders a right of first refusal. These restrictions are commonly contained in the target’s shareholders’ agreement (SHA). The net effect is that share sales are slower to complete and there can be a discount for illiquidity.
All investors, including any SPV in the frame, will be constrained by the terms of the SHA. There are several potential configurations for share liquidity.
Here are the typical clauses in a target’s SHA that restrict liquidity:
- Restricted: a shareholder’s ability to sell is restricted, no matter who the buyer is (target/other investors must consent to a sale on a secondary market and can veto)
- Free Internal Market: shareholders may trade shares between themselves, but not sell to a third party
Shareholder agreement of the SPV
If you invest in an SPV, you are also constrained by its SHA
If you decide to invest in an SPV, you will also be bound by any SHA that’s set up to control the transfer of interests in the SPV. But liquidity may be increased due to the easier administration – for example, the target has no need to be involved with mundane tasks like updating bylaws or the cap table.
Typical SPV liquidity clauses
Investors in PE and VC should have a long investment period in mind when investing. But sometimes life happens and you need to exit. This is when liquidity clauses are important.
The SHA of the SPV usually allows transactions after approval of the buyer by the target company (they want to make sure that they’re not inviting a competitor to their cap table via the SPV).
It also often allows intra-SPV transactions between existing investors without extensive validation by the target company.
There are also often mechanisms to avoid extensive validation processes in case of death.
Common Liquidity Options for SPV Investments
Private Sales and Transfers
Process of privately selling or transferring SPV interests
An investor seeking to sell can choose to find a buyer, sometimes through a broker who will guide the parties through the process. Or an incoming investor in a funding round of the target can opt to repurchase shares from the SPV’s investors.
Buyers will carry out due diligence on the SPV and target pre-sale. A major issue is pricing and any restrictions on onward transfer.
Legal and regulatory considerations
Each type of share transfer comes with contractual and regulatory requirements, from the sale process itself to the SPV’s compliance stipulations. Where a sale is to an existing investor, the process is simpler, but all investors may need to consent to the sale.
Pros and cons of mutual agreement
Private sales offer certain advantages, such as efficiency, flexibility and liquidity. However, they have particular drawbacks, like pricing issues, limited buyer pools and resistance from the target or other investors.
Secondary Market Platform
Key platforms and marketplaces for secondary sales
Platforms now exist to facilitate transactions, permitting buyers and sellers to list bids and offers, including price and volume. These platforms include Forge, EquityZen, Caption and Zanbato.
They often provide pricing information where possible, due to the volume of sales. However, an increasing number of start-ups have clauses in their SHAs prohibiting sales on a platform without their consent.
Initial Public Offerings (IPOs):
How an IPO can provide liquidity for SPV investors
When a target achieves growth projections that might make it attractive on the public market, it may consider a public offering, or IPO, and list its shares. This is the holy grail of liquidity for SPV investors since this provides a market for their shares. On market exchanges, you have market makers who buy and purchase shares for a spread, providing liquidity. Successful VC-backed IPOs include Airbnb, Uber, Meta and Snap.
Evaluating Liquidity Options
As we’ve seen, pricing is a major issue when considering buying or selling on the PE secondary market. The more illiquid the transaction (due to restrictions on sale, vetoes etc.), the larger the price discount will be. In contrast, sales of publicly traded stock will attract higher prices because of their inherent liquidity.
Future Trends in SPV Liquidity:
Emerging trends and innovations in SPV liquidity solutions
While limited liquidity may be an issue for investors, from the target’s perspective it’s beneficial. Creating a market for shares drives a price for those shares that may prove restrictive when negotiating with investors in future funding rounds.
Predictions for the future of liquidity in SPV investments
Liquidity has been a significant challenge for investors in SPV investments. However, as the secondary market continues to grow, we expect new solutions to emerge that will make it easier for investors to buy and sell their stakes.
Conclusion
Selling SPV shares to other SPV investors is typically easier than selling shares in the target because the SPV’s SHA will have taken the desire for liquidity into account at the outset. However, liquidity outside the SPV (selling the SPV to new investors) faces similar issues to selling the target’s shares.
References
[1] https://carta.com/learn/private-funds/structures/spv/
[2] https://ownersroom.com/en/the-value-of-share-liquidity-in-private-companies/
[3] International Bar Association: https://tinyurl.com/ybfwfy43
[4] https://www.ibanet.org/The-legal-negotiations-of-exits-in-private-equity-transactions-in-France
https://www.venture360.co/blog/transferring-assets-within-an-spv
[6] https://www.morganstanley.com/ideas/private-equity-secondaries-volatile-markets
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