Secondaries are getting increasingly specialized, as seen in the many news headlines reporting a surge in credit, infrastructure and real estate secondaries transactions. Investors are expressing heightened interest for secondaries strategies that can provide an entry point into asset classes with which they aren't familiar with. Against this backdrop, it is not surprising that secondaries have also reached a more nascent (and niche) asset class: venture capital (VC).
While the VC market has grown significantly over the past decade, it has remained an asset class that is perceived as difficult to access. The secondaries toolkit has offered risk-averse investors –such as pension plans – the ability to add the asset class to their portfolios. In this post, we will look into the latest developments in the secondaries VC market and the reasons why these have gained in popularity, before examining the potential challenges that lay ahead for a full "democratization" of VC as an asset class.
The current state of the VC secondaries market
VC secondaries account for less than 20% of the secondaries market according to Secondaries Investor. This activity appears to be driven by investors seeking to offload their private equity holdings, and continuation fund-type deals initiated by PE firms. However, there has also been a recent surge in deals focused on VC secondaries initiated by VC specialists, and a number of funds targeting venture secondaries strategies are currently being raised, targeting commitments in the range of $1-$2.5 billion.
Managing liquidity concerns in venture assets
It is not surprising that secondaries have been used to manage liquidity concerns in venture assets. While the need to generate liquidity for investors permeates various asset classes, venture capital assets in particular have become more challenging to exit.
As these assets still remain subject to higher valuations (especially compared to buyout assets), are confronted to an exit route "drought" (think scarcity of IPOs and company sales), and are subject to longer hold periods before liquidity (venture funds typically have a lifespan of ten years, plus two one-year extensions), venture capitalists are increasingly faced with pressure from investors to return capital and are resorting to the secondary market as a means to provide liquidity. VC fund managers have begun to realize the need to adopt private equity-style structures to return cash to their investors. They have achieved this objective via offloading VC fund interests in LP-led transactions, or by raising continuation funds featuring the VC firm's high-quality, "trophy" investments.
The emergence of VC continuation funds
It appears continuation funds are no longer within the sole remit of blue chip private equity sponsors, and indeed large VC firms have been announcing continuation fund transactions. Prominent VC firms and sellers of interests in VC funds are now using the secondaries toolkit as an efficient portfolio management tool, and VC continuation funds have emerged as a way to return cash to investors or roll into the fund while attracting new investors looking to invest in discounted assets with meaningful upside.
Most recently, Lightspeed Venture Partners has been reported to plan a sale of portfolio of holdings valued at $1billion and roll these assets into a continuation fund, and investors in venture firms such as Andreessen Horowitz and Thrive Capital have sold stakes in funds over the past year using the secondary market.
Benefits for buyers
A growing number of investors view the secondaries market as a way to gain access to high growth VC-backed companies that they would otherwise not have been able to acquire in a direct investment or via a primary fund investment. This may be because venture is a notoriously difficult asset class to diligence, due to the lack of information at the company level, and the market is smaller compared to the buyout market, with fewer opportunities to participate in financing rounds of sought-after VC-backed companies.
Investors who are keen to participate in the growth related to the technology sector can do so via the secondary markets (whilst benefiting from the J-Curve mitigation effect inherent to secondaries), even if they did not get a chance to get in a primary round for a sought-after technology company. Investors who are new entrants in the VC world and risk-averse may want to construct a VC secondaries portfolio that will be subject to shorter holding periods and quicker drawdowns, compared to direct VC investing.
What's more, pricing for VC secondaries interests is heavily discounted, which allows investors to solve for the high valuation of VC assets that typically permeates VC investing. In their Investor Roadmap for FY 2023, PJT Park Hill noted that pricing for venture and growth interests in LP-led transactions have been priced at a discount averaging 60-65% of the reference date NAV, while assets included in GP-led continuation funds average 57% of the reference date NAV. This is in comparison to 90-95% for buyout interests in LP-led transactions and 91% in continuation fund transactions.
Challenges and considerations
It remains to be seen whether the VC secondaries market will reach deal volume levels of other asset classes, such as credit secondaries. While the asset class has been "democratized" in some sense thanks to the increased number LP portfolio sales and GP-led restructurings, intrinsic characteristics of venture assets (such as scarcity of information and concentration of market players) means that the overall transaction size is smaller compared to buyout transactions and other strategies.
Access to top quartile performing GPs in the venture space remains limited, and secondaries trades may not always be possible given GPs tend to be restrictive as to which buyers can acquire interests in the VC fund (quite often, the only universe of potential buyers is limited to existing LPs).
Moreover, the use of continuation funds in the VC space could be controversial for LPs who do not want to chose between early liquidity at a discount and having to hold on to the asset for an extra few years, especially when these transactions allow GPs to avoid having to go to market and change the valuation of the assets.
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