Although high start-up valuations are making direct secondaries investments more challenging, they are also making the exit environment more attractive, explains Zach Abrams, managing partner at Stratim Capital, which provides liquidity to shareholders and venture capital investors in privately-held companies.
What do you think of valuations’ current levels?
Valuations are high right now, very high. I do not recall a mindset like this in the venture community since 1999, where market sizes are being dramatically overestimated, business models are based on practices that are not remotely scalable and valuations are totally unrelated to performance. We know how it ends, it is just a matter of when.
How did we get here? It always starts with a few success stories. In the peer-to-peer category, we have Uber and Lyft, and also AirBnB, all businesses that came about as a result of government regulation that has distorted markets. For example, in San Francisco they have consistently raised taxi fares, to “force” people to ride buses. So now we have a plethora of private “taxis” like Lyft Line, Chariot and so on.
We also have a growing population of people in their 20s, 30s and 40s who are spending discretionary income on comfort and convenience. They work longer hours and prefer to take car services, order meal services, and rent dresses instead of go shopping. On the enterprise side, the biggest trend is away from large IT organisations in favor of renting software based on how much you use it. All these dynamics drive new business models and allow start-ups to compete with larger players.
How have these high valuations impacted the direct secondaries market?
When valuations get this high, it becomes a little more difficult to get secondaries deals done for institutional buyers like Stratim Capital. We have still found some good deals in the past year, usually as a result of some of our outbound efforts or from referrals for sizes below the radar of the big mutual funds and other investors that seemingly don’t care about valuation. The one benefit of this environment is that it’s easier for our companies to get funding. Also, as the exit environment becomes more attractive, which usually coincides with high valuations, we get realisations on our investments, which benefits our limited partners.
Are secondaries sales to insiders or secondaries firms?
My impression is that insiders tend to buy low-risk secondaries. For example, when we acquired shares of an ad tech company in 2013, none of the insiders such as early venture investors exercised their rights to get the shares. But by early 2014, on another transaction at a higher price for shares of the same company, we suddenly had the venture firms on the board trying to exercise their rights of first refusal. We found out later that the company was already in negotiations to be sold.
We are also seeing more secondaries as part of primary rounds, but that just goes along with high valuations and the balance of power shifting to sellers. Company management teams are asking for a higher secondaries component of deals, and late-stage investors are allowing it to increase their capital invested.
Has the recent stock market volatility made those valuations any more attractive?
There are some signs that sellers are getting more nervous, which generally does result in better valuations. We do expect valuations will come down sharply as the new year comes and results at public companies come in below projections. We also expect the impact of poor performing IPOs, like Twitter and Box, will drive private prices lower.
How has Stratim needed to adjust the way it invests as a result?
We have tried to be consistent in how we evaluate opportunities in both strong markets and more volatile ones. In the last two years, we have done more smaller transactions in order to build positions over time and we have partnered with management teams at our portfolio companies to get deals done at prices we are both happy about. Our reputation has been that we are never the highest price but we tend to stick to our price throughout the process, which is not always the case with secondaries buyers. We are trying to stay disciplined in our approach.
I will say that the recent growth of “forward contracts” that appear to circumvent rights of first refusal and other transfer restrictions appear to violate company bylaws and also may not comply with other regulations. We do not engage in these types of transactions but we have had sellers tell us that they have been approached. We don’t think this is a positive development, and I expect it will result in legal consequences. I also wonder if companies, which are trying to eliminate the secondaries market for their shares with restrictive language in their bylaws about “acceptable buyers” for example, which is a disservice to their employees and a benefit to their directors, may end up having issues with the government over restricting trade. It is expected at the end of a bull market to have people pushing the legal limits.
All of these market distortions make it harder to do business in the short term but will likely result in a positive dynamic as they fall apart and the market becomes more efficient, as it almost always does.