Challenges and opportunities in European direct secondaries

Cipio Partners' Roland Dennert discusses the kind of deals he is seeing, the problem with unicorns and how a maturing tech industry is likely to mean larger funds in future.

What types of deals are you seeing in European direct secondaries?

The direct secondaries market is quite heavily influenced by the overall exit climate. If the environment is challenging and people hadn’t been able to get good exits for two or three years, the pressure to realise assets in a different way mounts tremendously. If follow-on funding is also difficult, it exacerbates the situation.

But today in Europe we’re in a good environment. There are new funds coming to market, so there are good opportunities for follow-on funding, and investment bankers are talking about a record 2015, a very good 2016 and a 2017 that may be even better.

So what we don’t see much of is lock, stock and barrel portfolios of directs. If they do come to market, it’s because the quality of the assets is difficult.

That said, the overall European tech economy has matured tremendously. In the last five years we’ve seen the growth of a significant stock of mature late-stage companies doing between €20 million and €200 million in revenue that have been around for several years but may not, for good reasons, exit tomorrow.

Whenever that happens there are investors who need or want liquidity a bit earlier.

From your conversations with sellers, what are the main motivations to cash out at the moment?

This is not an investor selling all they have, rather one selling specific assets for a specific reason. Maybe they’ve been in one fund for too long, maybe they want to focus on a slightly different type of asset, maybe they’ve invested in too many companies and want to realise a few to focus their attention, maybe they have a different strategic opinion on where to go with the company than other investors.

The secondaries direct opportunity in Europe’s tech space is not to acquire x or y venture portfolio, but to provide flexibility to existing syndications.

How do you tap these opportunities? Do sellers ever seek you out or is it tend the other way around?

Our numbers say there are 1,700 [tech] companies in Europe that have raised more than €10 million in institutional capital. You can make contact with them indirectly, through the investor community, or you can reach out to them and educate them on the opportunity. Many companies are not aware that buying a secondaries position is pretty common and not necessarily a negative reflection on the company. It happens to the very best companies.

It’s a bit like selling public stock. Nobody would think badly about BMW if someone wanted to sell their stock!

Is pricing frothy across the board or are there clear pockets of value?

Across the industry, the question is what do you benchmark your pricing to? At the very top end of the market, so companies valued at a few billions of dollars, transactions almost happen at a premium. Let’s say somebody has invested in the last funding round at a valuation of €1 billion – when a secondaries trade happens, it generally happens at the same valuation.

But you aren’t buying the same stock. That last funding round is the most senior stock and probably has a whole set of preferences and rights that you don’t get with the older stock [that you are buying in the secondaries sale]. This is why we don’t really like these unicorn-type transactions. We think they are probably overpriced because of this dynamic.

If you move to the less well-known companies, which are not in the newspaper every day, and where a bulk of assets are anyway, then the last round of funding is generally a good benchmark and transactions happen at a moderate discount to that.

Then there’s a third bucket, where there’s a real issue with the company. They might be sound businesses but there’s real conflict between shareholders: they can’t go left and they can’t go right. With these companies the discount can be 50 percent or more. If you do your due diligence right, you are buying into a good company that just has a difficult shareholder situation.

You closed your latest fund in July on €174 million. How is it progressing?

We’ve done three transactions so far and have invested almost 20 percent of the capital, so we are going at a good pace. I’d say we have three or four companies in our crosshairs and we think we’ll probably pull the trigger on one of them before the year’s end.

These companies are all fairly mature. They’re in the bracket of €30 million-€100 million in revenue, which is large for us. We would probably deploy €5 million-€10 million for an initial ticket and that can grow to €20 million over time.

Can you see your funds growing in size as the European tech industry matures?

Angel rounds used to be €500,000 to €1 million, now they’re more like €2.5 million. So I think in a very natural way our investment tickets will grow.

In our first fund the typical investment was €3 million to €5 million, now it’s more like €5 million to €10 million. We will probably stay at roughly the same number of companies but will move up the amount somewhat. Don’t expect us to raise €350 million the next time around, but I think we will have something above €200 million.

Roland Dennert leads transaction origination activities at the Munich-headquartered direct secondaries specialist. He started his private equity career at 3i Group doing technology and mid-market buyout deals.