This article appears as part of affiliate title Private Equity International‘s March GP-led Secondaries Special Report.
Venture capital and GP-led secondaries have been two of the most powerful recent trends in private markets. As venture continues to expand – 649 funds globally raised a record $131.3 billion in 2021, a 46 percent jump from the $89.9 billion collected the previous year, according to data from affiliate title Venture Capital Journal – the secondaries-fuelled liquidity mechanism is slowly catching on, though it must contend with nuances absent from the land of buyouts.
The growth in primary venture activity is spilling over into venture secondaries. In 2021, the segment scored $24.1 billion of transaction volume, 18 percent of the total $134 billion transacted by the secondaries market, according to investment bank Greenhill’s full-year report. This compares with $11.4 billion for full-year 2020, which equated to 19 percent of total volume.
Emblematic of that growth is StepStone Group’s StepStone VC Secondaries Fund V, its first fund since acquiring VC secondaries shop Greenspring Associates. The vehicle has collected north of $2 billion, more than double the previous record holder for a dedicated blind-pool venture secondaries vehicle: the $850 million Industry Ventures Secondary Fund IX, which closed in March 2021. As an independent manager, Greenspring collected $800 million for its fourth, most recent programme.
More venture than ever
There is a corresponding expansion in venture capital secondaries following the overall growth in the asset class, according to StepStone partner Brian Borton. He notes that there are more venture funds, more activity and more financing rounds than ever, which is allowing companies to stay private for longer. There is also an increasing awareness of the secondaries market on the part of sponsors, though VC is “three to five years” behind where the buyout market is in terms of education, familiarity and comfort doing GP-led deals, adds Borton.
GP-led transactions, and single-asset deals in particular, have caught fire in private equity secondaries because sponsors, which have traditionally sold to other sponsors, want to hold their assets longer than their limited partners are used to. However, there are several nuances of venture investing that bear consideration when discussing the efficacy of GP-led secondaries transactions for the asset class.
“These are not portfolios that you can take a quarterly report and understand really anything about the companies,” says Borton. “You don’t have ownership, valuation, financial metrics.” It is incumbent on secondaries buyers to have the specialisation necessary to understand the companies, triangulate how to get the information and underwrite them credibly, he adds.
These inefficiencies lend themselves quite well to GP-led secondaries, which as a result “make more sense for venture than in buyouts”, says Borton. The universe of GPs is extremely diversified, with a large portion having fund sizes below $200 million. The long holds necessary to achieve strong venture returns are not always compatible with the life of a fund.
An LP base disproportionality made up of high-net-worth individuals and corporates with shorter-term orientation than institutions, limited transparency in the venture ecosystem, and the opportunity for valuation arbitrage resulting from last-round financing and other metrics unique to venture also make the asset class particularly compelling targets for GP-led transactions, according to Borton.
StepStone has observed more strip sale-style transactions than single-asset continuations, owing to the diversification inherent in the former. In January, the firm announced it was the sole buyer in a $160 million strip sale recap on Vertex Ventures Israel’s fourth fund. In that deal, existing LPs retained 65 percent of their exposure while participating pro-rata in a 35 percent sale to StepStone’s flagship venture secondaries fund. The interests were then moved into a new vehicle that Vertex Israel will continue to manage alongside fund IV, according to Borton.
The proceeds were distributed as a liquidity event to Vertex Israel LPs, and a small portion of the deal value was reserved for follow-on investment, given the portfolio is generally quite mature with limited need for cash, he adds.
Diversified GP-led deals afford secondaries purchasers more down-side protection while taking multiple shots at potentially out-sized results, according to Borton. Although, “more routinely” in venture capital than other asset classes, out-sized returns can be a double-edged sword in terms of portfolio construction when they bump up against allocation limits.
GP-led deals are a way for managers to preserve the integrity of that construction even as assets size out of the fund. In such cases, says Borton, “it’s very common” for early-stage investors to create special purpose vehicles to house their pro-rata rights and then raise capital from existing LPs around the opportunity, protecting the main fund from distortion. These SPVs are distinct from their private equity continuation vehicle cousins, which focus on providing liquidity to LPs.
Such special purpose vehicles are opportunities for relationship building, not unlike co-investments, and will have equivalent or more LP-friendly economics than the main vehicles do. That tends not to be true for private equity continuation vehicles, which often have carry economics in excess of the underlying fund. In private equity, there is considerably less uncertainty around these deals: most companies transacted upon by continuation vehicles have already made at least three times their initial investment, sources have recently told affiliate title Private Equity International.
Much GP-led venture secondaries activity is done out of the US, as European LPs tend to be less up to speed on the intricacies of venture investing, according to Olav Ostin, managing partner at London-based venture firm TempoCap, which invests on a primary and secondary basis in European technology businesses.
While TempoCap has done at least one GP-led deal, providing liquidity to LPs during earlier covid dislocation, Ostin cautions against getting swept up in the hype. “I think a GP-led should be done for a good reason,” he says. “LPs need to be careful that there’s a very strong alignment of interest” between themselves and the GP.
A sponsor must also consider how many companies it can manage at a time. Solutions that do not decrease the managerial burden for venture GPs, which continue to raise new primary vehicles and invest in new companies, will be less attractive than they are for private equity sponsors, according to Ostin. For that reason, he says: “I think the biggest tech investors are unlikely to do a lot of GP-leds or continuation vehicles.”