What Is Secondary Liquidity?

The term secondary liquidity refers to the liquidity that comes from the secondary market or a public stock exchange. It represents the value of securities traded, including stocks, exchange-traded funds (ETFs), and mutual funds among others. This form of liquidity is generated from everyday investors who sell their shares to each other or through a market maker. Shares move from the primary market, where initial public offerings (IPOs) take place, to the secondary market after institutional investors sell their securities.

Key Takeaways

  • Secondary liquidity refers to investors who sell their shares on the secondary market to buyers on a public stock exchange.
  • This type of liquidity is generally used by large investors and founders to cash out their stake in a company.
  • Private transactions can also generate secondary liquidity when an investor sells their stake to a private equity fund or alternative investor.
  • The challenges surrounding secondary liquidity include the absence of transparency and the lack of enough participants in the market.
  • Buyers and sellers who participate in the secondary market include the issuing company, its founders and employees, as well as retail and existing investors.

Understanding Secondary Liquidity

Secondary liquidity is used by investors on the secondary market, where shares change hands between buyers and sellers on a stock exchange. These shares become available after major investors and corporate founders cash out their equity holdings in a company. These holdings are normally acquired during an IPO on the primary market.

Here's how it works. When a company goes public, the underwriting investment bank and/or syndicate of securities dealers sell initial shares to investors on the primary market, which is mainly comprised of institutional investors. These investors may want to sell these shares to other investors on the secondary market.

This market typically refers to transactions that take place on a public exchange. There are normally more market participants on this market than there are on the primary one. Transactions can occur privately as well when an equity investor sells its commitment to a private equity fund or an alternative investor. These holdings are much less liquid than those acquired via public exchanges and are typically intended to be held over the long term.

Secondary liquidity presents a number of challenges from a regulatory perspective. Some of them include the absence of transparency and information regarding the finances, and illiquidity or lack of enough participants in a secondary market to conduct trades. Secondary liquidity also does not come with the same set of protections available to investors who liquidate their holdings in public markets.

A liquid secondary market is essential for the IPO market because increased interest in new securities is generated by higher liquidity.

Special Considerations

There are different types of buyers and sellers on the secondary market and the reasons why they participate vary. The following is a brief list of certain market participants and their motivations.

The Company

The corporation behind an equity issue is one of the main buyers and sellers on the secondary market. As a seller, the company tries to attract the most attention to increase the size of its investor base. As a buyer, though, it tries to prevent share dilution, which happens when it issues new shares on the market, thereby decreasing the ownership of existing shareholders.

A company's founders and its employees may also be among the main sellers. They usually unload their shares as a way to get access to capital or to diversify their holdings.

Retail and Existing Investors

These two are among the largest groups of buyers on the market. Retail investors purchase shares in order to invest in companies that have the potential for the highest growth. Existing investors, or those who already hold shares in a particular company, buy more shares to increase their stake in a company.

Example of Secondary Liquidity

Here's a hypothetical example to show how secondary liquidity works. Let's suppose the founder of a company is in urgent need of funds for personal use. They can sell a portion of their equity holdings on the secondary market to raise the required amount of capital.

Real World Example of Secondary Liquidity

Secondary liquidity generally occurs in the case of rising valuations for startups. Ride-sharing company Uber (UBER) was considered a very hot startup for the investment world.

Several early investors, such as Benchmark Capital and First Round Ventures, cashed out some or all of their stakes in the startup in January 2018. Japanese private equity firm SoftBank Group purchased their holdings as part of its investment in the company.