Industry Ventures on the present and future of VC secondaries, part 2

Hans Swildens, Jonathan Ting and Wade Cobb of Industry Ventures give six predictions on the rapidly growing VC secondaries market.

Looking into the next decade, we offer six predictions of how the VC secondaries market may evolve:

1. We predict that LP interest secondaries will increase in volume, but transferability will increasingly be restricted. 

Similar to the direct secondary share market, we see increased adoption of right of first refusal provisions in LP agreements. ROFRs haven’t typically existed in VC funds. Until recently, we’ve only seen ROFRs implemented by a dozen or so firms. As the market becomes more sophisticated, both LPs and GPs are requesting and adding ROFRs to their LP agreements. We are likely entering a new era of how LP interests are transacted where the majority of LP secondaries deals will likely transact either within the existing partnership base or to new, GP-designated LPs. While we still expect LP secondaries transaction volumes to grow exponentially, outsider access to the best funds will become highly restricted.

2. The number of supersized GP-led fund continuations will dramatically increase.

In the first half of 2022, approximately half of buyout fund secondaries were GP-led, 80 percent of which were in continuation vehicles. GP-led continuation funds have historically been rare in VC, but as the asset class matures, a similar dynamic is developing.

The average tech company now takes 12 years to IPO, and GPs that hold large unrealised positions in top unicorn companies may be forced to roll their holdings into continuation funds as their traditional 10-year fund structures expire. We estimate there to be approximately $320 billion of unrealised value still held in 2010-13 vintage funds (9-12 years old), and over $1 trillion in vintage 2016 and older. NEA’s $1 billion continuation secondary in 2019 was a landmark transaction at the time, but with so much value concentrated in near-expiring funds, we think it will be the first of many.

GP-led transaction types:

GP-led transactions have historically been avoided in VC. This was a function of (i) VCs being concerned that founders may interpret it as a signal of distress or lack of commitment to the long-term (ii) early-stage companies were typically exiting within a 10-year time frame, the term life of most VC funds, and (iii) VC was a relatively young asset class and the majority of funds were yet to reach their term life. These factors are no longer true. In 2019, New Enterprise Associates disclosed a landmark secondary spinout and sale of almost $1 billion-worth of legacy fund assets. We think this transaction marked an inflection point, signalling Silicon Valley’s endorsement of working with secondaries funds on continuation vehicles, portfolio restructurings and strip sales.

3. Corporate Venture Capital (CVC) funds will adopt a hybrid LP model, ultimately creating a new market for secondaries investors.

Over the next decade, CVCs will increasingly raise outside capital and adopt a hybrid LP model. We are already seeing early pioneers take this approach – examples include Airbus Ventures, which has Hawaii Pacific Health Retirement Plan as an LP, and Swisscom Ventures, which was historically a single-LP evergreen fund and now pulls 75 percent of funds externally.

This shift towards a hybrid LP model that balances strategic with financially driven motivations and uses a limited partnership to hold investments (versus held directly on their balance sheet) will:

  • Help the CVC and parent gain flexibility around capital funding requirements;
  • Allow CVCs to raise larger funds and deploy capital even if the parent reduces their allocation into the fund over time;
  • Enable the CVCs to hire and retain more experienced talent through the implementation of performance fees;
  • Allow the parent to validate and benchmark the CVC unit’s track record versus peers.

This model will also drive engagement with secondaries funds, as a financing partner and LP. CVCs raising outside capital will likely select secondary fund partners to facilitate LP liquidity and capital management needs, as a means to maintain a level of financial independence from the parent. For example, rather than relying on the parent balance sheet, CVCs can leverage their secondaries partner for follow-on or special situation funding needs. This structure also gives the corporate parent flexibility to sell partial LP stakes, to raise cash or manage risk, while still maintaining broad exposure versus having to sell assets entirely.

Over time, CVCs will look almost identical to traditional VCs, with multiple LPs operating under a traditional GP/LP fund structure with carried interest. From a secondary perspective this will open the door to CVC LP secondaries – a new market opportunity.

4. Tech private equity buyout activity will continue to expand and represent over 25 percent of VC exit volume.

There were approximately 1,800 VC-backed companies valued at over $500 million last year. Despite it being a record-breaking year for public listings and M&A, only 10 percent of these companies went public and another 5 percent were acquired. Even in the most bullish markets, the traditional paths to liquidity are not wide enough to accommodate even a fraction of the volume of VC-backed companies accumulating in the backlog. With the IPO market in flux and tech stocks down considerably from their peaks, which directly impacts a strategic buyer’s ability to finance an acquisition, we believe VC-backed companies will be forced to consider the private equity buyout market as an alternative path to M&A liquidity. With over $730 billion in dry powder to deploy, buyout is one of the few, if not the only, market with enough capital to absorb the growing volume of VC-backed companies. Thus, over the next decade, we believe M&A by tech buyout PE groups will account for upwards of 25 percent of venture capital exit volume.

5. Large publicly traded asset managers will buy venture capital firms, paving their way into the venture capital and technology growth markets.

In a prior blog post we discussed the exponential growth in venture deals carried out by non-traditional VCs (hedge funds, mutual funds, family offices, etc.). While a few of these groups have already established themselves as reputable direct venture investors, we have tracked an adjacent group of entrants that are subtly buying their way in via acquisitions. We see acquisition appetite coming from three fronts: name brand asset managers that are looking to enter venture capital, top-tier adjacent category investors (private equity, hedge fund, credit, etc) who want to diversify their offerings, and possibly larger venture capital firms that want to build out a diversified venture platform. The chart below shows notable acquisitions of venture capital firms done by large asset managers in just the past year. While these acquisitions have been focused around sector specialists, we see this appetite broadening across larger firms (with $2 billion-plus in AUM) and more generalised venture capital platforms and lenders.

6. A handful of large multi-strategy venture capital firms will go public, similar to what happened with PE buyout firms over the last decade.

Over the past few years, a number of VC firms have begun diversifying their strategies. Sequoia Capital created the Sequoia Fund, an evergreen fund to hold public securities, General Catalyst registered as a Registered Investment Advisor, allowing it to hold non-qualifying assets, and Andreessen Horowitz notably hired the CIO of Jordan Park to build out its in-house wealth management division. This diversification will allow these firms to expand their asset base beyond just venture capital and help to position them as more generalised asset managers, and more favourably in the public markets.

While public venture capital partnerships have existed (eg, Internet Capital Group and Safeguard Scientific), most have either failed due to timing, or remain subscale. Historically, PE firms needed more than $30 billion of AUM to consider an IPO. As the venture capital asset class has grown, and many firms diversified across multiple fund offerings, a few have reached sufficient scale to IPO. In fact, it has been reported that growth-equity firm General Atlantic is currently exploring an IPO. We expect to see a handful of prominent venture capital firms go public over the next decade.

As Industry Ventures looks forward into the next decade, we believe the VC secondaries market is at an inflection point both in terms of transaction volume and market participant sophistication. In the near-term, with the IPO markets closed and macroeconomic uncertainty impacting prices across asset classes, institutional portfolios are wrestling with the strongest denominator effect since 1969. As a result, we expect shareholders behind the growing backlog of 1,300+ venture-backed unicorns to overwhelm the alternative liquidity options, and in particular the secondary markets. Deals sizes will swell, access will become increasing limited, complexity will continue to grow and unconventional deal structures will arise. As the VC secondaries market evolves and further matures through the next decade, investors will need to look forward, rather than in the rear-view mirror and relying on yesterday’s playbook.