Javier Avalos, co-founder and CEO of Caplight, on building synthetic derivatives of private stock
Javier Avalos is the CEO and co-founder of Caplight. We talked with Javier to learn more about the growing sophistication of the private markets, and how the risk management techniques used by large public investors—your Fidelitys, T. Rowe Prices and Ontario Teachers’ Pension Plans—might become available for all investors in the private markets, including startup founders and their employees.
- Our clients are institutional investors in nature. Many of them take on the persona of hedge funds, very large multi-stage VCs, large public investors, some of the folks who typically look like limited partners. I've already mentioned pensions, endowments, insurance companies, and even the large banks, via either their direct investing groups or their private banking clients. All of these groups, clearly, are institutional in nature. They're professional investors. They have this infrastructure available to them in other asset classes, and it doesn't make sense that they don't have the same tools available to them in private markets.
- If you think about what secondaries consist of, it's the brokered activity of “try to match a buyer and a seller.” But a secondary is also a tender. It's a company supporting their employees or their early shareholders getting liquidity through a company-sponsored tender offer -- that's secondary trading by definition. I think what you're starting to see is the emergence of all of these different use cases becoming productized and competition over who's going to own which vertical. Forge is competitive with Carta on their company-facing side of the business, as is Nasdaq Private Market, as is Figure. We're going to continue to see groups emerge, tackling different verticals.
- synthetics, which is where we spend our time, is a further evolution to this marketplace because it removes a lot of the friction that exists with the actual execution and settlement. Think about the steps of a transaction that need to be completed in order to take that transaction from pre-idea stage, meaning the client doesn't even know they want to do a trade yet, to closed deal, done and dusted. In an issuer with a liquid market, meaning a company that has pretty robust trading on the secondary side of things, price discovery is probably, from a chronological point of view, a very short part of that transaction. It's pretty well-known where the actual asset is trading hands based on recent data points in the market, from around the market of where people are buying and selling that security. If you want a cross to happen, you know that you need to be at least on par with where the market is. So in the liquid names, that's a very short part of the actual execution of the trade.
- Tell us about your background and what you were doing before Caplight.
- With that background, why was it important to you that something like Caplight exists?
- Including risk management, what are some of the common use cases for investors to use Caplight?
- Caplight is not just building out a marketplace for derivatives, but all the plumbing that goes under it, so prime brokerage, settlement, data, research. Why is it important to build out a full stack of infrastructure?
- When people on the outside see Caplight, they might see light tech wrapped around a services business. Can you talk about what is technology and what is services in what you do, and how this scales with headcount being the main driver?
- Switching gears slightly, platforms like Forge and CartaX have made a directional bet on secondary that doesn't seem to necessarily be panning out. Is secondary trading dead, or is the thesis around secondary dead?
- Could you talk more about the indications of interest model, matching buyers and sellers for spot secondary sales, strengths, drawbacks, etc.?
- Most of the other platforms either have an issuer-centric focus or they have to interact with stock transfer restrictions, ROFRs, things that happen while the deal is still open as you say. Your approach goes around companies in a way, so how does it impact companies? Do you collaborate with these companies on price discovery, or are you totally at arm's length with no interaction?
- Caplight allows institutions to trade in synthetic derivatives of private stock, and someone like Carta is really focused on making the infrastructure such that the underlying stock is more liquid and more easily transferable. Do you see a world where either Caplight is building infrastructure or Carta is building something similar to Caplight? Do you think of companies like Carta or Forge as competitive?
- Can you talk about a little bit about the evolution of private markets investing in general, where it started and where it is now?
- There's a lot of hesitancy around investing in private companies, and that rests on a lack of information available. What kinds of data inputs do you use to help the two parties in a transaction arrive at an agreed-upon valuation for the company? And how do you think about the possibility for funds to exploit insider information?
- Public equities funds are increasingly crossing over and investing in the private markets or at a minimum researching private companies to better understand emerging opportunities in public markets. Can you talk about what you're seeing in the private markets today as far as what kinds of firms are trading and the kinds of activity from that public crossover world?
- Could you talk about what investors are looking for in short exposure in privates? Why, what are the dynamics, and how do you think that will change private markets?
- Are SPACs still as attractive for investors and companies as they may have been this time last year?
- Switching gears to TAM expansion and the future, how do you think about expanding from covering private company securities to possibly other illiquid privately held assets, like real estate?
- Caplight is part of this trend of private markets growing more mature and more similar to what we see in terms of infrastructure for public markets. What other kinds of developments do you see in the future for private markets that don't exist today?
- Investors have been more active in late-stage private companies with the broadening of access to secondaries. How do you see the wide availability of synthetic derivatives on private company stock changing the investing strategies of VCs, hedge funds, crossovers and other private markets investors?
Tell us about your background and what you were doing before Caplight.
I've been working in the private markets since early 2017. Before starting Caplight, I was the head of Marketplace and a senior vice president at Forge. Forge, as most people know at this point, has become one of, if not, the largest marketplace for buying and selling pre-IPO stock. I'm very proud to say I was one of the earliest team members there. I helped build out that trading platform from sub-$50 million of annual transaction volume to well over a billion dollars traded annually. They've put out some numbers that I think speak to volume being north of $4 billion this year. I’m very excited for what we built there and got a front row seat to seeing the marketplace for secondary trading on pre-IPO securities develop.
With that background, why was it important to you that something like Caplight exists?
My co-founder Justin and I identified a couple of things that ultimately led to Caplight. First, witnessing the continued growth that was happening not just in secondaries and secondary trading, but in primaries as well, with increasing participation in the VC asset class from non-VC investors. Secondary trading being defined as existing shareholders of private company stock selling their shares to investors, differentiating that from primary fundraising, which is the companies themselves raising money.
Groups like Tiger, Coatue -- the big crossover funds -- get a lot of the buzz, and they should be. They're doing a rapid clip of investment into the asset class. But we started paying attention more to the non-crossover and non-traditional VC investors who are participating and making investments in the space, so your traditional public investors -- the BlackRocks, the Fidelities, the T. Rowes -- some of the large pension funds like Ontario Teachers’ up in Canada, and some of the endowments as well -- university endowments like Harvard and others.
It's really hard to imagine these groups making such large investments without an eye for risk management. The opportunity that we saw when we were sitting in Forge was really that this market is not going anywhere. It's going to keep getting bigger. The companies are adopting it more. The investors are certainly adopting it more. And it needs a risk management layer.
When we started to play with that idea, we started to think about what having the ability to hedge or move quickly in and out of a position would add to the private markets. It really excited us about the opportunity to create these hedging vehicles, because we thought that would lead to further deployment of capital into this asset class. With unicorns in aggregate being over $3 trillion in value, it just didn't make sense to us that that exists long only, where the only option is to buy and hold.
I think, fundamentally, that makes sense for traditional venture capitalists who are providing a lot of strategic value to the companies. It makes sense that they're long-term alliance with the companies. But there's another type of investor that needs to consider risk management and really wants the ability to rein in some of their portfolio risk, and that doesn't exist anywhere else. So the opportunity to build that at Caplight, we thought, would create the ability for more investment to deploy into the asset class and make the entire private markets better.
Including risk management, what are some of the common use cases for investors to use Caplight?
We formally started the company in February and didn't launch until May, so we really only started collecting real orders and building out an order book since May. What we’ve seen over less than a year of doing this, what jumps out in the order book is this gravitation towards hedging transactions.
That manifests in a couple of ways. The first is call overwriting, which is selling a call option where you already own the underlying stock. “Covered call writing” would be another way of putting that. And increasingly recently, given some of the public market volatility that we're seeing, protective put buying, which I think is a really interesting new development in the market. If you pushed me on why puts are interesting, I think it fundamentally changes the risk reward math that comes into the VC asset class. We could talk more about puts and why they're important, but I would say those are the two biggest use cases in terms of how an order manifests when someone is interested in hedging.
Caplight is not just building out a marketplace for derivatives, but all the plumbing that goes under it, so prime brokerage, settlement, data, research. Why is it important to build out a full stack of infrastructure?
I think that this question has a lot to do with the client community that we've decided to serve, at least to start with. The short answer to your question is we have to be the one-stop shop for our clients to get as much value from Caplight as they possibly can.
Our clients are institutional investors in nature. Many of them take on the persona of hedge funds, very large multi-stage VCs, large public investors, some of the folks who typically look like limited partners. I've already mentioned pensions, endowments, insurance companies, and even the large banks, via either their direct investing groups or their private banking clients. All of these groups, clearly, are institutional in nature. They're professional investors. They have this infrastructure available to them in other asset classes, and it doesn't make sense that they don't have the same tools available to them in private markets.
So being able to offer a hedge fund the ability to trade in the private markets, using assets that are already held in prime brokerage, was really important to us, because if we're not doing that, it means that the hedge fund is less likely to go through the friction of putting one of these trades on. We want to make their lives as easy as possible. For us, it wasn't even about trying to figure out all the bells and whistles that could exist in Caplight. It was just a simple, “Well, what would our clients want to experience?” When you put on that lens, it's a no-brainer to have all of these different pieces of infrastructure in the same place.
When people on the outside see Caplight, they might see light tech wrapped around a services business. Can you talk about what is technology and what is services in what you do, and how this scales with headcount being the main driver?
I'll give you where we are right now and where I think this is going to go, because I'd be lying if I said that there wasn't a huge service component right now. We are taking the whole mantra of “do stuff that doesn't scale early” to an extreme. In some of the projects that we have going on, it's also helping us learn who our clients are at their core, in terms of what they really want and what use cases will be most applicable to solve real problems that they have, mostly as it relates to risk management. And it's also helping us learn who our partners are and which groups are going to be the most helpful in turning this into a marketplace that can actually be electronically traded.
All of the service part of our business right now is slowly already morphing into being automated. One example of that: our first couple of orders that came in were heavily manually presented to our client base to go run a price discovery exercise, meaning if someone came and wanted to sell a call option on some asset, we didn't know what the price of that call option should be. There are different places that you can look to tell what the price of the underlying stock might be, but that's not a one-for-one equivalent on a derivative of that stock. So what the team and I would do is basically go and run what looks like an auction process -- granted via phone calls and emails to clients -- but still an auction process, nonetheless. We'd go out to 25 or so people who made sense as participants in that type of auction, and we'd collect bids from them over the course of a week or so. If there was a match, then that would move on to the next phase, which was more of execution.
That is a very repeatable process that can exist in a technology venue, so one of the first tools that our team is building on the product side is, not surprisingly, an auction tool. And the learnings that we have from running a handful of these auctions manually and seeing which ones got the most engagement, which ones didn't and evaluating what those reasons are, has helped us build a really slick auction tool that's going to make it easier for the clients to get feedback on their price discovery questions a lot faster. That's one example.
I would say that similar thinking applies to initiatives we have on the data side of things. So, how do we pull in as much data from other places but also make the entire ecosystem better by sharing that data out in the right way with people? For modeling tools that we're building out, how do you work with a client to understand what the downside looks like on their portfolio? Build a custom Excel model for them, if needed, and then learn, when you see a couple clients ask for the same thing, that “Okay, this is actually a software tool as well.” That's something our team spent time building. These are all examples of us starting with something that is very clearly in the services category, but within iteration two or three of it, starting to figure out that this is something that follows the same set of steps every single time. This is a tech product.
Right now, I think that we split time pretty evenly between service-type work and technology, but I would be very concerned if we were just trying to build technology without trying to get these reps in front of clients and partners. At scale, what you're going to see us look like is a very dev-heavy organization, where there is probably always going to be a 3:1 ratio of people who are technical to people who are not. That's starting to play out on our team right now. We need an early support team, meaning we need people who can fill roles that look like compliance roles, that look like legal, that are not technical in nature. Even right now, we're about 50-50 engineering and non-engineering. I think that we need that core group that is non-technical to lay the foundation, but beyond that, we're going to be scaling by adding technical talent.
Switching gears slightly, platforms like Forge and CartaX have made a directional bet on secondary that doesn't seem to necessarily be panning out. Is secondary trading dead, or is the thesis around secondary dead?
It's an interesting question, and it's one that I bet would catch a lot of eyes if it was put into a headline somewhere. “Secondary trading dead” -- that’s a clickbait headline, for sure. I think that the numbers themselves allude to the fact that secondary trading is very alive and well. Forge put out some public preview of their Q3 2021 results. I don't think it included volume specifically, but it did include revenue. And I think it spoke to $95 million of revenue in the first three quarters of the 2021 year. You can do some quick math. If you assume that there's a brokerage model in place there and they're booking some percentage of volume traded as revenue, you could back out what a volume number might look like, and it's clearly going to be in the billions of dollars.
Carta put out some stuff around the activity they've seen with tenders recently -- that number also looked to be north of $4 billion. Nasdaq Private Market put out some stuff earlier this year when they were announcing their spin out from Nasdaq parent co with their bank consortium backers -- that was also in the multi-billions of volume traded. And notably, a new entrant to the market of traditional secondaries, Figure, the Mike Cagney-led company, put out some stuff earlier this week that certainly caught our team's eye. It also had a four handle on it in terms of the billions of dollars traded already.
If you think about what secondaries consist of, it's the brokered activity of “try to match a buyer and a seller.” But a secondary is also a tender. It's a company supporting their employees or their early shareholders getting liquidity through a company-sponsored tender offer -- that's secondary trading by definition. I think what you're starting to see is the emergence of all of these different use cases becoming productized and competition over who's going to own which vertical. Forge is competitive with Carta on their company-facing side of the business, as is Nasdaq Private Market, as is Figure. We're going to continue to see groups emerge, tackling different verticals.
I think that overall for us, we're happy with the added validation that these groups are bringing to the asset class, as indicated by the success they're having with the sheer volume that they're trading each year.
Could you talk more about the indications of interest model, matching buyers and sellers for spot secondary sales, strengths, drawbacks, etc.?
We've mentioned the Forges, the Cartas, the Nasdaq Private Markets, and I'll throw Zanbato in there as well. They're large and have very notable backers, also tech-enabled. What these groups have in common is they’re tech-enabled platforms for trading in this asset class, but they're not the first methodology of trading in this asset class, they're not the first venue. Before these groups existed, you had the traditional brokers -- your large legacy broker dealers who have very large teams of brokers, either in an independent sort of contractor relationship or as full-time employees, who were trading this asset class before there was any sort of tech-enabled trading.
The reason it's important to add them to the mix is that this market has been brokered from the days of Facebook being private for longer than the norm at the time. It's probably not the right expectation to think that a very illiquid, hard-to-price asset would just flip to electronically traded as soon as someone decides to build an online trading venue for it. I think that it's important to keep that in mind when you're evaluating how to go about serving the secondary marketplace, because my view would be that if your sole purpose is to build a really slick online trading product, but you don't understand the marketplace at all and who the market participants are and what each of the stakeholders is driven by, including the companies themselves, you're probably going to miss the ball.
To get all the way back to your question: how does brokering work and how do the indications of interest in matching work? Not dissimilar from other brokered markets like real estate, for instance. A skilled broker -- emphasis on skilled -- builds true relationships with the clients that she or he serves and figures out where they can be most helpful. For the broker that hopefully results in an actual order, which oftentimes looks like, "I am underexposed to this company that I want to be exposed to. How do I get more exposure to that?" A skilled broker then hopefully uses the network and the relationships that she or he has to go figure out where there could be a potential cross in the form of going and seeing what some of their other clients may be willing to do by way of selling that same security. There is a repeatable process that happens there, which is why it does lend itself to being online traded.
I think the key difference between those who are tech-enabled and those who are not is going to come out to sheer speed: being able to take in an order and very quickly have a response in terms of what price the market can bear, even within the platform itself, versus having to wait days or even weeks for a broker to come back with an answer. That's certainly a positive evolution to the market that I think some of the larger platforms have brought over the past several years. But at its core, it's still brokered activity, meaning every trade you're doing is bilateral -- there has to be a buyer to every seller or else the trade doesn't work.
I think that synthetics, which is where we spend our time, is a further evolution to this marketplace because it removes a lot of the friction that exists with the actual execution and settlement. Think about the steps of a transaction that need to be completed in order to take that transaction from pre-idea stage, meaning the client doesn't even know they want to do a trade yet, to closed deal, done and dusted. In an issuer with a liquid market, meaning a company that has pretty robust trading on the secondary side of things, price discovery is probably, from a chronological point of view, a very short part of that transaction. It's pretty well-known where the actual asset is trading hands based on recent data points in the market, from around the market of where people are buying and selling that security. If you want a cross to happen, you know that you need to be at least on par with where the market is. So in the liquid names, that's a very short part of the actual execution of the trade.
What is a lot longer is how that trade actually gets closed. It’s not like in the public markets, where if you want to buy something, you go into your Robinhood account or your Fidelity account, you do some research on what you want to buy, how much you want to own of it, and if the price is good or not, once you've made your decision, the trade's basically over. You've clicked your button and you own Apple or whatever you're looking at buying. The reason the private markets remains so uncertain -- I've heard several people refer to it as unreliable at times -- is once you've done all that work in the private markets, you've agreed to a price, you've done all the price discovery, you've got your block set up and ready to go, now you're stuck waiting for the actual shares to physically transfer from one group to the other.
What comes with that time of waiting for the process to unfold is that you're not actually closed on the deal. While you can try to get comfort by signing documents that say you have an intent to close as a trade, until the shares have actually transferred, you’ve signed binding documents that the company has signed off on as well in some cases, and money has actually moved hands, that trade is, in my view, open. There's an adage for folks who work on transaction-based desks that “time kills all deals.” If you're waiting an additional two, three, four or twelve weeks from the time you agreed to the price for your deal to close, you are inherently adding risk to the trade.
Synthetics remove a lot of that. They're not going to alleviate the first part of the transaction. For now at least, you still need a matched transaction. You need a buyer to every seller. You still need to run a price discovery process for names that are less liquid, and that can take some time. But because what is being transacted is an actual economic contract, you can close and settle very quickly. In our view that makes for trading dynamics that resemble much more closely the public markets, and because of that, they will be strongly preferred by institutional investors who are purely financially driven, versus sitting around and waiting for physical transfer of stock to happen and potentially kill their deal.
Most of the other platforms either have an issuer-centric focus or they have to interact with stock transfer restrictions, ROFRs, things that happen while the deal is still open as you say. Your approach goes around companies in a way, so how does it impact companies? Do you collaborate with these companies on price discovery, or are you totally at arm's length with no interaction?
We like to look at ourselves for now as company agnostic. What gets us excited in terms of what we're bringing to the marketplace -- the “innovation economy” as it's sometime referred to, or just private markets in general -- is, and you have to look a little bit high level here, the access that we're creating to this asset class that otherwise wouldn't exist.
The reason that's important goes back to some of the earlier statements I made. By creating these risk management products, we're making it easier for institutional investors to increase their exposure to this asset class. Again, what gets us excited about what Caplight can bring to make the innovation economy better is hopefully this means we're bringing investors who look a little bit different or haven't participated in direct private company investing to the magnitude that they want to be, which creates more fundraising sources and potential partnerships for the private companies themselves.
That's a long-winded way of saying that right now we are not directly working with any of the issuers. I think that there's a strong likelihood that that changes. I've always thought that, and now I'm convinced that that's going to happen sooner than we originally anticipated, because a big user of these hedging and risk management tools exists within these private companies. First and foremost, our client base is institutional investors. But what we're seeing happen is another segment of the market is asking us to serve them. That wasn't our intention when we set out, but it's very interesting to think about what Caplight products could do for people who spend every single day living and breathing these private companies. Specifically, we've had several engagements with private companies who have come to us saying, "We want to do some sort of liquidity event for either our senior team or our entire employee base, whereby they're not actually selling their stock, because we want them to remain incentivized to make the stock price as good as it actually can be, but they're at least protecting downside."
When our team started to explore what use cases may be most sought after from two-legged individuals or employees, founders, management teams, etc., it struck us that it doesn't make a lot of sense that venture capital investors get liquidation preference, which we all know to be the legal protection in place that protects the VC from taking the risk of investing a substantial amount of money into a private company that could, at some point, be worth zero dollars. Liquidation preference is going to give them a sort of embedded put option in the case that things go sideways or down, more specifically. The design of the liquidation preference is meant to have the venture capital investor recoup some of that investment.
It's really interesting that that concept doesn't exist for employees or for common shareholders. If you ask me, I think that's unfair. I think that employees who spend every single moment thinking about how to make their company better should benefit from something that looks like that. When you think about what a put option might be able to do to change the dynamic there and make the employee base, or common shareholders more generally, sleep better at night, knowing that they've protected their downside risk while still being able to participate in all of the upside that their labor is hopefully going to result in, that gets us pretty excited. The message seems to be resonating with some of the companies that we're talking to as well.
Caplight allows institutions to trade in synthetic derivatives of private stock, and someone like Carta is really focused on making the infrastructure such that the underlying stock is more liquid and more easily transferable. Do you see a world where either Caplight is building infrastructure or Carta is building something similar to Caplight? Do you think of companies like Carta or Forge as competitive?
I think about Carta and Forge as offering similar products to different clients. I think that right now we are not competitive with either of them. Our model is not one where we want to be selling directly into the companies or their employees or their other common shareholders right now. Will that change over time? It could. Some of the use cases that have been brought to our attention and that the market seems to be asking for would put us more down that path. But I think that both Carta and Forge have built very strong products and very strong client followings, and our goal is not to go and try to disrupt that in any way. At our core, we are serving institutional investors to accomplish their risk management goals.
Do I think that we could work very well together? Absolutely. I think about some of the tooling that I've seen or heard about Carta adding to their platform, such as the ability to finance option exercises. That tells me there is clearly a path for us to do something similar with a Carta, Forge, Nasdaq or whoever it ends up being. The ability to embed some of these risk management and eventually structured product tools within a platform that is already getting a lot of engagement from similar potential customers is something that I couldn't pass up an opportunity to explore, because, first and foremost, that helps us get our product out into the hands of customers that could really benefit from it. And that's ultimately where the mission is.
Can you talk about a little bit about the evolution of private markets investing in general, where it started and where it is now?
Yeah, how much time do you have? I'll start at Facebook, which I think, if you asked people who are vets of secondary trading, is probably where many of them would start. It's really a reaction to legislation. The JOBS Act made it easier for companies to stay private longer, take on more shareholders, and not have to go public until certain milestones are met. That continues to be the framework by which many of these late-stage private companies remain private. They just don't have to go public and don't want to invite the additional scrutiny that comes with being a public company.
You see this manifest in Facebook's staying public longer than many of its predecessors had -- the Googles, Apples, Microsofts, Amazons, etc. And a market opened up. There was a natural market for people who wanted liquidity for their stock, who had been at the company for a long time, or early investors who had had a fantastic return and were looking to lock in some of those unrealized gains and turn them into realized gains. This market developed in a very brokered manner, where much like real estate agents, these brokers who were serving their clients would go and look for a market in a block of shares.
This business ended up being very lucrative. Spreads were wide, meaning where someone wanted to buy something was oftentimes far away from where someone wanted to sell something. The skilled broker who can make that bid-ask spread compress is rewarded by a pretty large portion of that spread in the form of commission dollars. Entrepreneurs caught onto that, and you see early groups like SecondMarket being spun up. We've spent a good amount of time with the early team at SecondMarket to learn their story. Ultimately, they ended up being acquired by Nasdaq, but I think SecondMarket was pivotal in terms of saying this could be an entire business, and the goal was to put that into an online trading forum. Then, you see groups like Equidate being spun up, which was my employer and became Forge Global, as we know it today. SharesPost is part of the early group. They were around even before Equidate. Then there are some other groups that haven't been mentioned in this conversation already, like EquityZen, for instance.
You see the attempt, at least, of trying to take this very brokered, very manual service business, and put it into an online, somewhat automated trading venue. The initial step towards automation is you let clients tell you what they want to buy or sell, how much of it, and what price, basically with an online form. You allow that to catalyze, showing that opportunity to everybody else in the market who could be participants on the other side. Now you're talking about creating a trading system. So you start to see these platforms get licensed as alternative trading systems (ATSs).
Then you start to see more of them pop up. The groups who are popping up are entrenched platforms that are serving the private markets in some other way. You see Carta acting on a CartaX. You see Nasdaq dedicate an entire division in Nasdaq Private Market, which, as I mentioned, acquired SecondMarket. Then you see that being spun off to give it more autonomy and more freedom to build out a marketplace separate from the exchange business, which I think, as an outsider looking in, was important to the development of their secondary trading business. You see a group like Zanbato, who's built a very strong platform in terms of making it a focal point for people who want to participate in this asset class to go and check where things are trading and be able to put a trade on very quickly.
And of course, Forge trying to be the one-stop shop serving companies through Forge Capital Systems, serving accredited investors, institutional investors, employees, and other shareholders by matching buyers and sellers, and adding a custodial layer, which -- at least based on a reading of what's out there publicly -- lets them do more with custodying assets and then wrap the whole thing in a data layer.
When you start from Facebook, you get to this massive market in increments. It's like each step has, “Okay, this seems to be working. How do we take this to the next level by adding on some other feature or bundle of features?”
For us, it was very clear that the private markets aren't going to exist forever in the spot trading way, to put it simply. It doesn't make sense that, with all the innovation that's happened in this asset class, starting from Facebook, it would just exist forever in its current embodiment. For us, it was very clear that further innovation had to happen here. That's where we're picking up the ball and running with it, in doing this crazy idea of trading derivatives on private stock. For us, it just seems so obvious and natural.
There's a lot of hesitancy around investing in private companies, and that rests on a lack of information available. What kinds of data inputs do you use to help the two parties in a transaction arrive at an agreed-upon valuation for the company? And how do you think about the possibility for funds to exploit insider information?
It's a very important consideration for the secondary markets in general, but also for Caplight specifically. Building a derivative layer on a market that already exists almost compounds the need for something resembling information symmetry amongst all parties. It's something we've spent a lot of time thinking about.
I think that part of what we're doing with starting institutional only is acknowledging that institutions have better access to the information that's required to form an investment view than the retail investment community. We want to start there because we've identified a massive need with that client type and believe that they're an underserved community, despite all the resources that they have. But a part of that decision is also, as I mentioned, acknowledgement. These are going to be the groups who are able to have a better view on how a company is performing and to formulate an investment idea based on that view. On top of that, they will have more resources to be able to assess what the current spot price is on that asset, which is a very necessary input into deciding where you want to buy and sell a derivative on that asset.
We're starting with institutional to give ourselves a little bit more time to figure out how we make our marketplace work for the retail community. We don't want to barge into the retail community without having solved the information asymmetry gap, because it wouldn't serve retail clients in the way that they should be served, and I don't think the SEC would like it very much.
But it's not acceptable for us to just say, "Well, institutions will figure it out. They'll get the information, and our job is done here by just serving institutions." That's not an acceptable answer either. So we are working this information asymmetry from a company fundamentals perspective, meaning, “How do I know what the value of a company should be based on the performance of that company?” That in itself is a massive problem, and it is not the core problem when it comes to private market investing. It is not the core problem that Caplight is trying to solve. So what we're doing is we're finding really forward-thinking, innovative groups that are making that their core problem -- shameless Sacra plug. We're really excited about partnering with groups like Sacra, who can be a voice of thought leadership in this asset class and who can provide the market much needed information that starts to resemble transparency into how a company is performing.
Now, that information is not always perfect in the sense that it's still difficult to get the information directly from the companies, but at least you have a professional that is a dedicated research analyst pulling in every piece of possible information that can be pulled in and turning that into a nice output of, "Here's how to use this information, what to make of it, and how to formulate a view as someone who wants to be an investor or even is already a shareholder and maybe wants to be a seller." The market needs more of that. We're looking for it. I mentioned Sacra and also groups like Data Lagoon. PitchBook and PrivCo are sort of obvious in terms of their coverage of the asset class. That's a big mandate that we have at Caplight: finding the best companies that can partner with us and help decrease this information asymmetry gap that is holding back the private markets generally.
Public equities funds are increasingly crossing over and investing in the private markets or at a minimum researching private companies to better understand emerging opportunities in public markets. Can you talk about what you're seeing in the private markets today as far as what kinds of firms are trading and the kinds of activity from that public crossover world?
It's probably not surprising that the companies that tend to be most active across the private markets and the secondary trading markets specifically, and also are the most active on Caplight, are the largest, latest-stage, most well-funded companies that have the most investors and the most shareholders, meaning there's the most float or actual shares there to trade.
There's also a big informational component that comes with that. With the well-funded, very late-stage company -- I'm talking $10 billion plus valuation, as far as last private primary fundraising goes -- what comes with the very large valuation is a sense of comfort or transparency at least, in that there are other professional investors who do have full access to the information and management teams who are underwriting these companies and deeming them X valuable. That is now an anchor point for me as somebody who's on the outside looking in, who doesn't have that full information to get comfortable myself. That is a pretty strong mark as a starting point to research that I need to do now independently as an investor to make sure that this is actually risk that I want to take on.
If you look at CB Insights’s unicorn list and you work your way from biggest to smallest, you see the concentration of where private markets trading is in that first 25 especially, and then it slowly trickles off the further down that list you go. That said, we've seen orders come in for billion-dollar companies to do derivatives on, whether that's looking for long exposure because you’re really bullish on a company -- you want to buy a call option because you think this thing is going to be a hundred billion dollars, so you buy the call option at a billion dollars strike; that's a way to really lever a long position -- or “I was the very first institutional money into this company, and I'm sitting on a 2000% return. I need to think about my investors, and this is my first fund. If I can lock in my fund’s return based on this massive position, that makes my life a lot easier.” I think we'll eventually get there in terms of being able to transact in earlier-stage companies. But for now, across the board you see activity concentrated around typically the 25 biggest.
Could you talk about what investors are looking for in short exposure in privates? Why, what are the dynamics, and how do you think that will change private markets?
It's funny. It doesn't make a lot of sense to think about naked shorting privates until you see the VIX spike and the S&P and Nasdaq selling off every day. Then you start to remember, "Oh, wait. Assets can lose value pretty quickly."
I will quantify this and say that we have seen zero orders so far that express naked short views, meaning we have seen zero data points of somebody who's come to us and said, "I want to be directional short on this company where I don't have other exposure that would hedge that short." We've seen a large number of short orders come to our marketplace, but because none of them are naked short, that tells you that all of that short activity is hedging, which is short activity -- you're interested in lowering your exposure to something.
The hedging manifests in the form of call selling, which is a very common one. You own the asset. There's a way to turn that into an income producing asset by selling out-of-the-money call options. If the underlying asset goes above that strike and it goes into the money, then you've basically given away your upside beyond that point, but you're typically sitting on a large return already so that trade-off makes sense.
The product that we're very excited about right now is put option buying. That hasn't existed as a product that VCs can have in their arsenal. When we were developing this product, we sat with a number of VCs who didn't even really know why they should be interested in a product like this. The VC asset class is one where you really have to juice your home runs because there are so few of them. If you look at the 80-20 rule, if you have a portfolio of ten VC assets, two are going to end up being your fund returners. It doesn't make sense to give away the upside on any of the assets if there's a chance that that asset may be one of those two fund returners. It took us a little while to understand where the VCs were coming from on that, because none of them articulated it like that to us. But when we realized where the reluctance to giving away upside was coming from for the VCs, it became very clear that the business model doesn't work if they accidentally give away their upside on a name that ends up becoming the fund returner.
We had to figure out which product does make sense, where they can still protect returns that have been created. That is very fitting for a put option. With a put option, you're outlaying an amount of cash in the form of premium to protect the value of your asset below a certain level, but you still get to participate in all of the upside. So you don't risk giving away your home run on accident, because you wanted to manage your risk of it. But you still get to make sure that, if a black swan event happens, like a Katerra or a WeWork -- at least from a private market investor consideration, that was a pretty big black swan event, going from above $40 billion value to sub-$10 -- you're not exposed to any of that by adding an insurance contract basically onto your position, but you also know that you're not giving away the home run, which is something that we've seen resonate with VCs.
Are SPACs still as attractive for investors and companies as they may have been this time last year?
I think SPACs are another tool in the tool chest. I think that any company that considers SPACs should obviously consider every other route to accessing the public markets, including a direct listing or a traditional IPO, or potentially even just staying private. There's still cheap access to private funding for most companies.
Just with the volume of SPAC deals that are happening, you're seeing what seems to be a saturation of new tech issuance into the public markets. We did an interesting analysis on IPO performance for tech companies this year, and while the blockbusters get a lot of attention in the aggregate, something like 50% trade below their original IPO issuance. If you add SPACs into that, it's far worse. I think that what you need to evaluate still is the fundamentals of business. You're adding on top of regular market risk technical risk when you're looking at SPAC investments.
I guess the summary there is: they’re valuable in that they add a tool to the toolkit. The sheer number of them seems to have saturated the public markets, and just like every other financial transaction, they need to be considered pretty carefully.
Switching gears to TAM expansion and the future, how do you think about expanding from covering private company securities to possibly other illiquid privately held assets, like real estate?
We're already being asked for some of this, which is really cool. Part of why it's cool is it makes our decision, and my decision, on where to go next a lot easier when you have potential clients already pulling you for something. We haven't got the pull yet from real estate, but where we've seen it pretty strongly so far are LP stake transfers. The use case here would be, you have an investor into a VC fund or even a private equity fund that wants to decrease their exposure to that. Either they want liquidity and they want to sell the position outright, or they simply feel like they're overexposed to VC as an asset.
We've had this conversation a number of times with people who are very large LPs -- your endowments, your insurance companies, and especially your pensions. I like how one client put it. Their feedback was, “We love the VC asset class. We're investing in the VC asset class directly. We think that the returns that are available in private companies far exceed what's possible on publics, which is very common knowledge at this point, but we are overexposed at the portfolio level, because our VC allocation is exposed to VC and our public and hedge fund investor allocation are also investing in late-stage private companies that are in the VC asset class. Every one of our manager allocations is owning the same private companies, which means that, as a whole, our portfolio is overexposed to negative shocks to the VC asset class. What do you have that helps us?”
That's a case where they don't want to sell outright their exposure to the asset class because they still like it, but they want to be able to risk manage. It goes back to this theme of being able to tactically shift your risk exposure at the click of a button, which is really where we want Caplight to go. So we're thinking through what structured products, like baskets, could look like for these types of investors where, by basketing different company exposures, you can create long or short indexes to help LPs quickly manage their private company risk. That's one place we are absolutely going.
Then beyond that is, “Okay, but a lot of the core technology we're building can still help price assets that are illiquid very quickly, so we could also be helpful for outright stake transfers.” When I say stake transfer, I mean an LP into a private equity or VC fund selling their exposure to that entire fund, selling the LP interest. That is a very large business that is heavily brokered and very manual at this point, and I think the tech that we're building will help make that process a lot simpler and a lot easier.
Caplight is part of this trend of private markets growing more mature and more similar to what we see in terms of infrastructure for public markets. What other kinds of developments do you see in the future for private markets that don't exist today?
I think research is a huge one, and I think that it's still in the early phases. I go back to the comments that I made around Sacra and some of the other groups that we're looking to partner up with. There's a massive opportunity here, with sell-side research being such an engaging tool with the investment banks in terms of going and serving their clients. It just seems obvious in the private markets that something like that would exist.
Outside of that, I think there's a really big opportunity for data. I know a couple of groups are out in the market with their own data product, and that's really important work and it's bringing value to the markets. I still think that there's an opportunity to consolidate everyone's information in a way that doesn't hurt any of the people who are participating by sharing that information, but that makes the entire market, including the people who are sharing the data, way better and easier to transact.
What I've learned in private markets in the past five years is, as much as you can reduce the friction, reduce it, because something else will come up that presents itself as a problem that you weren't anticipating. So where you can make the whole process smoother, do it. It seems like needing, on a transaction-by-transaction basis, to go out and scour several different platforms for data, just to answer your own question on where you would be comfortable pricing something, is a somewhat unnecessary requirement to trading in this asset class.
Investors have been more active in late-stage private companies with the broadening of access to secondaries. How do you see the wide availability of synthetic derivatives on private company stock changing the investing strategies of VCs, hedge funds, crossovers and other private markets investors?
I think that VC as a product, if you will, is really important to helping companies innovate and to creating game-changing companies. When I talk about VC as a product, I don't mean money. That's not the product. The VC product is the expertise that comes with that early-stage investor and, beyond the expertise, the desire to help a founding team and an early team build something that can change the world. That's what the product of VC is.
I get excited by Caplight because I think that, if Caplight works in the way it should, the VC product gets better, because it removes a lot of the competition that is being created for VCs to try to get into the best possible deal they can when they have to compete with so many different types of investors who are not really coming into the mix for necessarily the same thing. Their products are more capital-based, so it's access to cash, it's access to resources. That’s a little bit of a different product. I think that that product is still helpful, and it helps a growth company grow and scale and get their product into more people's hands. There's certainly value in that, but it's different from the other product that I described -- of the domain knowledge, the expertise, and the willingness to roll up your sleeves and sit side by side with a founder to help them solve whatever problem is on their plate. If Caplight exists in the way it should, the groups who are more financially motivated and who are really trying to hit certain return profiles to serve their clients who are their LPs and fiduciaries will have a venue to do that on a pure economic basis that doesn't touch and interfere with the VC product.
That's a long-winded way of saying that I think that people who want to specifically be financial investors shouldn't actually own private company stock. They should be able to trade the value of those shares, but without ever touching them. The people who want to invest in the private companies because they want to be true partners to the companies themselves should then have more leeway to deploy those dollars, build those company relationships and ultimately build those companies, because of the reduction in noise that's happening.
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