Rise in secondaries highlights tough venture market

When the dotcom bubble burst, so too did the expectancy for high returns within venture. According to a report released by the Kauffman Foundation, too much capital allocated to venture in the halcyon days of super-returns may have resulted in higher valuations and lower returns on exits. The industry's success brought on its downfall. Crucially though, the report suggests the industry itself could be inherently flawed.

Over the last two decades, the bastion markets for venture – IT and telecommunications – have matured almost beyond recognition. With no nascent sub-sectors exhibiting the promise of the stellar growth the first wave of tech investments enjoyed, the potential for rapid development and high returns is somewhat reduced.

What's more, due to the rise of open source software and the plummeting costs of bandwidth, marketing and distribution with the development of the internet, startup costs have shrunk. The sky-rocketing returns propelled by the emergent virtual economy have slowed and venture players need to adapt their focus.

Challenging venture conditions have led to a rise in secondary market activity

"We got accustomed to the road to IPO during the last bubble," explains Jean-Michel Deligny, founder and managing director of technology, media and telecommunications corporate finance advisory firm Go4Venture. "We are getting another flavour of that to some extent with the next wave of internet investment," he adds. "I think it is providing a skewed view of what venture is about if you only look at venture within internet, if you only look at the virtual economy, which has very specific economics."

What is needed, the Kauffman report suggests, is less venture funding directed towards longer-term investment plans. Nowadays, the time frame to complete a profitable entrepreneurial venture often exceeds that of most venture funds. Time is of the essence and venture secondaries may buy some time. "Yes, you could potentially enjoy infinite returns, but if you look at innovation financing in general, which many would consider the role of venture, then it takes much longer to build substantial companies," says Deligny. "And that's where secondaries become essential."

On the GP side, 2009 witnessed a climactic moment in the history of venture secondaries as 3i shook off its debt-laden venture portfolio into the hands of Coller Capital, HarborVest and DFJ Esprit. Such high-profile portfolio secondaries are rare though. On the single-asset side, secondaries inaugurate a new stage in a company's growth cycle, as it moves from angel investment to venture, venture to private equity, and ultimately considers an exit. New investors are essentially buying the growth avenue that lies ahead.

After a slow start to the year, September 2011 recorded a number of venture secondaries including Palamon and Electra's sale of sub-prime credit card provider SAV Credit to previous investor Värde Partners for £472m, and Francisco Partners' acquisition of financial services software provider eFront from CDC Innovation, Odyssée Venture and OTC Asset Management for around €40m. Finally came the €19.8m funding round for French software developer Qosmos led by DFJ Esprit, Fonds Stratégique d'Investissements and Alven Capital, which saw Soffinova Partners exit the firm. Dealflow has since continued.

Why then are secondaries becoming more frequent? "The main reason is that there was a huge wave of investment in venture in 2000 and most of the funds are 10-year funds with two-year extensions. So it's very easy to do the maths," says Olav Ostin, managing partner at DFJ Esprit Secondaries, which was born from the merger of the secondaries business at DFJ Esprit and Tempo Capital. "It looks very simplistic, but I have to say that is what is happening. I am surprised myself," he adds. "I thought that LPs would have wanted liquidity earlier but on average the LPs gave GPs the benefit of the doubt."

"It is now basically a very constructive liquidity issue, an active management strategy," says Ostin. "We are not in the situation where people are saying 'I desperately need cash and an exit'. That might come; you had that situation in 2009. But we aren't seeing distressed sellers now." It appears then, that what was originally considered a move to shift an underperforming asset is now a means of creating liquidity. "Business angels or regional funds can exit showing 3-5x returns on a very capital-efficient investment, and the big boys of venture can get in and apply their experience," outlines Deligny. "Similarly, you now see established VCs exiting to the benefit of PE funds who are quite happy to jump into growth equity situations now that debt is difficult to come by."

Nowadays though, the strategy for portfolio management is different, explains Mike Reid, managing partner at Frog Capital. "The market now is more complex; gone are the days when you could act passively, just buy the secondary assets and hold onto them. Now you really need to act like a primary investor," he adds. "The skill set you needed in an old secondaries firm was quite transactional: I come in, I do a big piece of work and I analyse the value, I put in an offer, I buy it, I do all the legal work and I don't need a team to do that much monitoring. Now you need that team to do that upfront work and then you need some quite expensive experienced people to manage those companies," Reid explains.

But for some investors this is not a contemporary trend. "Funds come to an end at a steadier pace. Yes, you get the odd 3i strategic move but generally it's more phased. Secondaries are part and parcel of the normal market," says Reid. "The recent hype around secondaries was stimulated by the credit crunch and the anticipated big wave hasn't happened. People thought there would be a wave of investors needing to exit and corporate investors deciding certain assets were non-core. On one hand we have seen small packages or distress cases happening under the radar, and on the other hand we have seen many corporate investors doing more, not less, venture capital," he explains.

Looking back though, the lack of secondaries within venture compared to private equity is striking. "I would contrast the image of secondaries in venture with the image of secondaries in private equity, where people are much more asset manager-minded," says Deligny. "The guys in private equity are like traders, they cut their losses or they close a position fairly regularly, whereas the venture guys haven't done this historically as they see this as an admission of failure. Most venture guys see themselves as the guys who hit the home run every time," he adds.

What is agreed, though, is the beneficial symbiosis between primary and secondary venture players. "Our view is that it is much more effective to look at a whole spread of deals, and combine the primary and secondary," says Reid. "When you approach a company, you want to be able to solve its capital issues. The best way to do this is to offer a range of products, not just one," he adds. Ostin agrees: "With single-asset secondaries, it makes most sense to work with the primary team. There are a lot of synergies on the single-asset side and the cross-link of information is great," he explains.

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