Evolving VC landscape helps fuel venture secondaries

While venture secondaries have been around for a long time, especially in their direct form, there has been some reticence for fund-level secondaries in the venture space: the buying of an LP stake in a VC fund typically results in exposure to dozens if not hundreds of underlying venture-stage companies. Exposure to each company is limited, so numerous stakes are needed to create critical mass.

Furthermore, analysing all the firms for valuation purposes is lengthy, so deep discounts are usually sought when buying VC fund stakes on the secondaries market. Early-stage investments typically have limited financial information available and the businesses can be highly technical, which are barriers that most traditional investors find difficult to overcome. Many investors are also uncomfortable with companies not breaking even or having low EBITDA multiples, as is often the case with VC investments.

But as in any asset class, secondaries are still a way of getting exposure fast – and given the increased overall appetite for venture in recent years, the market is benefiting despite the hurdles. In addition, the continued decline of IPOs as an exit route for venture in Europe has been driving appetite for venture secondaries; both in terms of direct secondaries, where a VC firm comes in to buy out a founder and/or owner, but also through the use of dedicated secondary capital to buy LP stakes in VC funds.

"As companies have stayed private for longer and grown in valuation over the past seven to eight years, venture has become more attractive for secondary funds," says Gibb Witham of venture capital firm Paladin Capital. "There are more dedicated secondary VC funds coming in as early as series-B and up, through to pre-IPO."

Compared to coming into venture at the early stage, coming in later after various funding rounds gives comfort to some investors, especially given that valuations are seen as more concrete. The later years in the life of a VC fund is where the value creation is, so secondaries are an opportunity for investors to get access to this, said Lindsay Sharma from Industry Ventures when talking at Unquote's private markets conference Allocate late last year.  

Given that these funds have significant mark-ups and may not have been able to show a significant distrubition to paid-in (DPI) return because of the longer timeline, early venture investors may be keen to realise some value and sell, so may look to the secondaries market to get some liquidity.

"Funds are staying active far beyond their 10-year lives; on average 50% of the total value to paid-in by year 10 is still unrealised, and at year 15, still one quarter is unrealised. Therefore, asset managers and endowments are rebalancing their venture portfolio and becoming active sellers as these funds get long in the tooth," Sharma continued.

End-of-life boost
Just as in the private equity buyout space, there has been an increasing trend for continuation vehicles and for fund restructurings in order for VCs to keep hold of the remaining portfolio assets despite a fund coming to the end of its life.

In the venture space, there can be a situation where 75% of a portfolio has been exited and there are just a couple of pre-IPO ones left. In this way, the risk that comes with having a hugely diversified underlying portfolio, typical of a venture fund, is mitigated, as secondary capital is coming in just to restructure or to buy into a few remaining assets.

In September 2020, Pantheon and LGT Capital Partners used secondary capital to back a continuation fund for a portfolio of interests in six clinical- and pre-clinical-stage companies from Index Venture Life VI – a life sciences fund advised by Medicxi. The new €200m fund, MS1, anchored the investment together with co-lead investor LGT, with the new fund committing to invest in each of the six portfolio companies the funding required to accelerate their clinical development plans through to the next stages of value creation. The investors in Index Ventures Life VI (a 2012-vintage vehicle) received proceeds from the sale of the portfolio to MS1 and were also offered the opportunity to reinvest their proceeds into MS1.

Daniel Roddick from Ely Place Partners says that, in the venture world, after 9-10 years, the companies in a fund are unlikely to look anything like they did at the early stage, making it ripe for a different set of investors to take over.

"We are currently working on a deal with an early-stage fund in its ninth year, which is performing well but with a low DPI", Roddick says. "We ran a process on behalf of the GP to find a secondary investor to offer liquidity for the existing LPs and allow them to lock in a healthy multiple. For the buyer, most of the venture risk has been taken out with good visibility on value drivers, making it more of a growth portfolio than a venture one."

While venture investing through secondaries is not for everyone – much like its primary counterpart – there is little doubt that both GPs and LPs can benefit from the wider strategy. And with copious amounts of secondaries dry powder still earmarked for deployment, coupled with companies staying private for longer, there is likely still much to be gained from VC secondaries for buyers and sellers alike.

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