Over the last 10 years, more liquidity options have become available to entrepreneurs and investors than ever before. As a secondaries fund focused on venture capital since 2002, Vintage Investment Partners has seen the maturation of the secondaries market, both in terms of secondaries of limited partnership interests in funds, as well as secondaries directs in companies – both of which are more commonplace.
For example, many large institutional investors use secondaries sales of LP interests to free up capital and rebalance their portfolios by selling older funds in order to invest in ones that are currently raising. It is also now fairly common for direct investors and shareholders to seek liquidity to align their interests with those of the start-up; for US-based unicorns this has become so commonplace that it almost acts like a public market.
However, there is one area of the secondaries market within venture that is less well known: the low-funded secondaries deal.
Low-funded secondaries: a brief primer
Typical secondaries buyers of LP interests in venture funds will only buy commitments where a substantial part of the capital has been called, or at least the majority. The main reason is that once a venture fund is called, say 50 percent, it has basically completed all of its initial investments and the remaining capital will go to follow-on investments in the current portfolio companies (and fees of course). As a result, a secondaries buyer is not buying into a “blind pool” and can make at least some assessment on the quality and potential of the underlying portfolio.
However, what happens if the fund is called only 30 percent, or even 15 percent, and what about 5 percent or less? At that point it may be only one to three years into the life of the fund and the portfolio is still in the process of being built. As a result, few if any secondaries buyers are willing to buy into a portfolio at such a stage.
For the investor who wants to sell, this lack of buyers can create a huge issue. It can be an extreme case where they cannot meet capital calls and will be defaulted, and their paid-in capital up to that point will be written off (putting aside the legal and reputational issues of not meeting capital calls). There could also be a more benign case where they might be forced to sell due to regulatory or portfolio rebalancing issues, which might create a situation where the default is… to default.
It clearly also puts the fund in a difficult spot. If the LP can no longer meet their calls, the GP suddenly has a hole in its capital availability, which could affect its original and future planning around investments.
While it may seem like an uncommon occurrence – an LP seeking liquidity so early in the life of the fund – Vintage has been doing such transactions for over a decade both during market ups and downs. In fact, we have done low-funded secondaries where investors have had to back out of commitments in the first year of a fund and even prior to a first call.
What to look for in a low-funded secondaries opportunity
Clearly, given that in a low-funded secondaries deal the portfolio may only be in the early stages of being built, the assessment of the deal is based more on the conviction around the fund manager. As a result, potential buyers with a fund of funds strategy are likely more suited for such deals. In fact, here at Vintage we will look at these opportunities from the lens of our fund of funds strategy versus our secondaries strategy. Nonetheless, even having a few portfolio companies can be extremely helpful to get a sense of whether the manager is staying on strategy and to assess the quality of the entrepreneurs and co-investors.
This also gels well with what a GP should be looking for in a buyer. While the buyer universe for low-funded units is more limited, a GP should still be very discerning as to who will buy the unit, given it is still early in the fund’s life and again more like a primary commitment to a fund.
As a result, a GP should look at the buyer as they would any other potential primary LP who could be with them through future funds. Specifically, is the group an experienced primary fund investor? Do they have the ability to stay with us? Do they have a track record of investing through cycles? And even more so, can this be a value-add LP? In fact, the GP should look at the sale as an opportunity to strengthen the LP base by replacing a problematic LP with an engaged and helpful one… and better sooner than later.
To provide a little more colour on low-funded secondaries, I will briefly describe two low-funded transactions that include elements of deals we have completed, including the motivations and deal terms. Given that these transactions look more like a primary fund commitment, Vintage did these investments via our VC fund of funds and not our secondary funds.
Case 1: LP bankruptcy
A large institution had a $10 million commitment to a fund and had paid in roughly 30 percent. The institution was going through a bankruptcy and was looking to get out from under its obligations, which in the case of this investment was $7 million in future capital to be paid in. Vintage was very familiar with the fund, its history, partners, and so on. And although it was still early in the life of the fund, there had been a number of investments already completed that we could assess. The fund was also very familiar with us. Although we had not been an LP in prior funds, but they knew we knew the team and portfolio and could transact quickly – especially given subsequent calls that were going to be made in the near term and the meaningful size of the commitment (and outstanding capital) relative to the fund size. Given the deal dynamics, the seller was most interested in getting out from under the unfunded obligation, so what we did was a structured deal with the seller whereby we would pay the commitment going forward and split some proceeds with the seller after a minimum guaranteed return.
Case 2: Quasi-key-person event
An institution had recently committed to a GP’s second fund and shortly after, with the fund called roughly 15 percent, one of the partners – who was their main relationship – left for personal reasons. While this did not trigger an actual key person event according to the agreements, the LP was not comfortable continuing. In addition, there was an immediate 10 percent call that was open that needed to be funded. Vintage was already an LP in the fund via our fund of funds, knew the team well. We also felt it was one of the leading VC funds based on its prior fund and the due diligence we had completed not long before for the primary commitment. As a result, we offered to pay the seller their amount invested and take on the unfunded commitment going forward, including the 10 percent immediate call. For the GP, again, this was a very smooth solution, as we were already GPs who knew the fund and team well and could execute quickly.
Abe Finkelstein is a general partner at Vintage Investment Partners, an Israel-based investment firm offering secondary solutions for GPs, in addition to several funds of funds and direct investment funds.