The collapse of the $13 billion Woodford investment fund is a taste of what a private equity liquidity crisis will look like

Woodford’s Equity Income Fund has declined from about £10 billion ($13 billion) to about £3.7 billion after a rash of investors pulled their money.
The fund has frozen redemptions because it is not liquid enough to meet its clients’ demands for their cash.
Woodford invested in too many illiquid, private, unlisted stock offerings.
The so-called "secondary" market for private equity isn’t as liquid on the way down as it is on the way up, sources tell Business Insider.

The collapse of Neil Woodford’s £10 billion ($13 billion) investment fund has given us a glimpse of what the market might look like if — or rather, when — a downturn comes to the opaque "secondary" market of unlisted private equity stocks.

Woodford’s Equity Income Fund is now down to about £3.7 billion after a rash of investors pulled their money. That triggered a freeze on redemptions, and the remaining investors are now stuck inside the rapidly declining fund. Investors don’t know when they will be able to get their money out.

Now, the short-sellers are circling the rest of Woodford’s empire.

The redemption freeze came because cash-out demands were coming in faster than Woodford was able to sell the equities it held.

To a layperson, that sounds weird: Why would stocks be difficult to sell?

Woodford wasn’t tested by a stormy market — it sank in calm seas

The answer is that over the years, Neil Woodford — the fund’s founder — drifted out of investing in publicly traded stocks (the household name companies in the FTSE 100 or the S&P 500) and into illiquid, non-public, unlisted companies. The company now says it is trying to exit those positions.

The Woodford collapse is important because it happened in benign conditions. The S&P 500 is up 1% year to date. Woodford wasn’t tested by a stormy market — it sank in calm seas.

A vast amount of money has gone into this non-transparent world in recent years. Today, private equity deal value runs at about $100 billion-plus per quarter, according to PwC. Private equity groups raised about $45 billion in new investment funds in the first quarter of 2019. The market is so big that privately held stocks can now trade in a similar way to regular public stocks — but the buyers and sellers tend to be other big-time institutional investors or high-level professional investors. The majority of retail investors don’t get a look-in.

Typically, these companies are often tech startups who are selling stock and options privately to venture capitalists. Those VCs are eventually hoping the company will go public with an IPO, years later, after the value of their stake has increased multiple times. Uber was a recent example of that. It took $25 billion in venture capital funding before going public at a valuation of $82 billion.

With companies staying private longer, how liquid is the market for unlisted stocks?

Or at least, that was the expectation until a few years ago. More recently, many of these companies have declined to go public, and instead stayed private. They are able to do that because of that continuous influx of new investment funding for private equity. Old private investments are replaced by new private investments, and as long the value always goes up everyone is happy.

The question, of course, is how liquid is the market for unlisted stocks? As Woodford found out last week, the answer might be: not very.

The main difference between public and private equity is that publicly listed stocks can be sold at the push of a button online, to any stranger willing to buy. Private equity can only be sold by arranging a private deal with another professional investment company, and those deals tend to require minimum sizes that start in the millions.

There is a lack of liquidity, in other words, because it is difficult to exit privately held stock quickly. That’s the risk.

SnapLogic

At a tech conference in Lisbon late last year, SnapLogic CEO Gaurav Dhillon explained to Business Insider why he thought these illiquid equities were so popular.

"The private equity industry has grown to the point where it owns significant amounts of capitalization in an illiquid manner"

"Believe it or not there’s a lack of midcap technology companies in the public markets. There is so much public money chasing too few midcap companies, which is probably driving some of the secondary markets, some of the froth. And that is because many of the legacy companies were taken private. So there is no longer a place where a pension fund or a mutual fund can go to park its tech allocation," Dhillon says. "Those investors wind up taking stakes in pre-IPO tech companies."

"So the private equity industry has grown to the point where it owns significant amounts of capitalization in an illiquid manner in its private equity holdings, so that’s putting pressure on mutual funds to find places to invest and some of them are coming in to pre-IPO stages," Dhillon says.

Until recently, this has meant good times for anyone owning pre-IPO stock. Executives, VCs, or employees of companies like Uber or Snapchat, have always been able to cash out their private holdings, at a profit, whenever a new round of investment came in. Uber had 23 such rounds before going public.

You cannot just sell at the push of a button

So much money has washed through this market that on most days it "feels" as liquid as the S&P 500.

But two more tech executives, speaking privately to Business Insider at the same conference, laughed darkly at the idea that unlisted stock was as liquid as the regular kind. A typical rule, one pointed out, is that an employee with options in their pre-IPO company will only be able to sell if they get the permission of their CEO or the chairman of the board. You cannot just sell it at the push of a button.

That’s one reason why the public has been discouraged from trading private stocks. It’s too risky. And that raises questions about why Woodford was encouraging retail investors from Hargreaves Lansdown to park their money in funds whose strategies included unlisted stock.

Dhillon says it’s a good thing that retail investors are out of it.

"If there’s a downturn then we’ll all feel, oh my God, I’m glad we regulated them out — because they’re [retail investors] not fit to judge these things."

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