Distinguishing between the VC secondaries versus PE secondaries markets
Private equity, in its modern GP/LP form, began in the 1960s, but it wasn’t until the early 1980s that names like KKR, Blackstone and Carlyle gained recognition. Around the same time, the first private equity secondaries funds were founded, with firms like Adams Street Partners and Coller Capital leading the way into the early 2000s. By 2011, the PE secondaries market grew 10x compared to the prior decade, reaching $24 billion in transaction volume, and by 2021, PE secondaries transaction volume surpassed $130 billion.
Due to the opacity of the secondaries markets, investors often mistakenly think of PE secondaries as being inclusive of venture capital secondaries, but there is a distinct difference between the exposures, sellers and investment firms engaged in these markets. These significant differences are not widely understood yet are critical to understanding when investing in either market.
PE secondaries involve transactions that have an underlying exposure to mature buyout-stage companies. PE secondaries firms typically source deals from traditional private equity LPs and GPs, and often implement some degree of leverage in their strategy, whether it is on the underlying asset’s balance sheet, applied at the fund level, or sometimes both.
VC secondaries, on the other hand, involve transactions that have an underlying exposure to venture capital-backed companies. Given the diverse range of shareholders in venture-backed companies (no one has control), VC secondaries investors source deals from a vast network of sellers including venture capital LPs and GPs, corporate venture capital groups, cross-over investors (eg, mutual funds, hedge funds, family offices), start-up founders, employees and angel investors, angel networks and accelerator programmes. Interestingly, many of the sellers of VC secondaries do not have buyout investments. VC secondaries firms, like their primary VC counterparts, tend not to use leverage at the fund level.
Thus, while some investors mistakenly believe the two markets overlap, there is a distinct difference in the type of company exposures being acquired, types of buyers and the different sellers in each market, and there is a different investment strategy used to generate returns.
The market for VC secondaries has historically been smaller than that of PE secondaries, simply given the fact that modern venture capital only gained institutional popularity over the past 20 years. Given the exponential growth in primary commitments to the asset class over the last 10 years, and subsequent surge in the number of venture-backed unicorns, we believe that the VC secondaries market could grow and become as large as the current PE secondaries market. As explained in our latest blog post, with over $4.6 trillion of market value held by venture-backed unicorns, we expect the VC secondaries market to surpass $130 billion by 2023.
The 30-year evolution of VC secondaries
Having operated in the venture secondary space for over 20 years, Industry Ventures has had a first-hand view of the evolution of the market, emerging from the shattered pieces of the aftermath of the dotcom bust to what we believe will be hundreds of $100 million-plus GP-led fund continuation vehicles.
LP secondaries were the first kind of secondaries transactions, pioneered in the early 1980s. It is widely accepted that the first LP secondaries deal transacted in 1979 when Dayton Carr acquired the LP interests of various venture funds from IBM. Carr went on to start Venture Capital Fund of America and launched the first-ever LP secondary dedicated fund in 1982 with $6 million. Fast forward to today, and we estimate the market for LP secondaries will surpass $50 billion in 2023.
Tail-end fund wind-downs started to emerge in the 1990s, and it wasn’t until the early 2000s that direct secondaries gained popularity in various forms. At the time, the direct secondaries market consisted of a handful of buyers focused primarily on buying the venture portfolios from corporate venture groups and hedge funds that were in liquidation. Notable examples include the sales of assets in Enron Broadband Ventures, Infospace Venture Capital and EDS Ventures, all of which Industry Ventures purchased.
In 2009, Facebook blessed one of the first company-led secondary tender offers, a type of direct secondaries transaction in which the company sponsors a repurchase of the employees’ or shareholders’ shares, as a way to restructure its capitalisation table, and companies like Twitter and Palo Alto Networks followed suit in 2011 and 2012, respectively. Secondary tender offerings reached 228 in 2018 and exploded in 2021 with over 1,100 companies/investors offering to consolidate their shares.
Over the past decade, several tech-enabled exchanges have launched (eg, Forge Global, EquityZen, SharesPost, etc) and gained some traction, with Forge surpassing $15 billion in assets under custody in Q2 2022. These platforms tend to serve smaller transactions and sellers of individually held common shares. Larger transactions also developed, in the form of direct portfolio strip-sales, out of early-stage venture capital funds in order to generate liquidity.
Option exercise and structured loans recently became popular for individuals with private shares
Over the past five years, a vibrant secured-loan market developed in the private markets. As VC-backed companies stayed private longer, shareholders in companies like Airbnb and SpaceX took on collateralised loans as a way to access liquidity and avoid triggering the Right of First Refusal from an outright sale. Furthermore, these loans are typically structured to help the shareholder avoid capital gains taxes. Although we don’t envision this becoming a standard option for investment firms, it will remain a viable tax-efficient option for individual shareholders. Given that these loans didn’t gain widespread popularity until the bull market of 2012-21, it is still unclear how they will perform in an extended bear market. Lenders typically do not hold the right to participate in subsequent financing rounds to protect their original loan principal, and most of these loans were collateralised against common shares, the most junior security on the capitalisation table, which is paid out after preferred shareholders and has fewer, or no, protective provisions.
Stay tuned for Part 2, which will outline six predictions for the VC secondaries market.
Hans Swildens, Jonathan Ting and Wade Cobb are chief executive and co-founder, senior associate and business development analyst at Industry Ventures, a San Francisco-based investment firm.