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Navigating a mature direct secondaries market

With strong deal flow and high pricing expectations, demand for direct secondaries is robust, but the market also tends to reflect a disconnect to the fundamentals, according to Hans Swildens, chief executive and founder of Industry Ventures.

With strong deal flow and high pricing expectations, demand for direct secondaries is robust, but the market also tends to reflect a disconnect to the fundamentals, according to Hans Swildens, chief executive and founder of Industry Ventures.

How has the venture capital secondaries market evolved in recent years?

We believe that we are in a robust secondary market environment for venture capital investments and that the market is already mature. Interestingly and in contrast to the buyout market where you are taking control positions into companies, a large part of the venture secondary market today is direct secondaries, which consist of buying a minority equity position from an existing shareholder directly into a venture-backed business. On the indirect side, there is also a great amount of activity in the purchase and secondary sale of limited partner stakes.

What are some of the challenges in investing in direct secondaries especially as opposed to buyouts?

When comparing secondary transactions in venture to those in buyout, you realise that there are some similarities but also some major differences. One of the biggest differences and main mistakes investors make is the notion of applying buyout investment processes to the venture market.

At a high level, the deal structuring and transaction management involved in venture is akin to that in buyout, however the due diligence and valuation processes at the company and underlying investment level are completely different. Specifically, most venture capital investments are valued using a heavy bent on qualitative diligence processes, just given the stage of investment and lack of tangible data and metrics. This mostly involves understanding the underlying technology, market, growth drivers, customers, competitive landscape and the eventual exit of the investment, either mergers and acquisitions or initial public offerings.

In contrast, buyout investments tend to be more mature in nature, have tangible metrics to track against and also have a third avenue of exit which includes selling to another buyout fund.

Generally, we like to tell people that half of what we do involves qualitative diligence with the other half being quantitative, as the financial analysis really only tells half the story in venture.

How would you characterise the current market for direct secondaries in terms of deal flow and pricing?

We see historically high amounts of deal flow in the market with pricing expectation commensurately as high. Investors are looking for growth and are willing to pay forward for it, sometimes reflecting a disconnect to the fundamentals.

How has competition evolved over the years in the venture capital secondaries market?

When we started investing, we only had two real competitors, which happened to be two pure play direct secondary firms. Nowadays, we have many competitors across the market depending on the deal type and structure. In the direct secondaries market, we’re working more with the venture funds that financed the business while mutual funds and hedge funds are competing for deal flow in the “unicorn” market. On the LP and tail-end side of the market, we have different competitors which tend to be the more traditional LP secondary funds or fund of funds. Our competitive landscape has changed dramatically over the years as the market has matured.

On the fund side, what types of LPs are the main sellers of stakes?

Seller needs have been constant over the years but the mix of seller type has changed due to macro-economic and capital market factors. Today we have a large volume of angel investors, employee and founder shares in our investment pipeline as valuations are high and companies are staying private longer.

We also have more tail-end venture fund deals in our pipeline as investors look to liquidate older portfolios. Corporate sellers exist but not in the same number as a few years ago. More corporate venture funds are being created today than sold. Hedge funds are active buyers in the market today when five years ago they were active sellers. Financial institutions are selling but not as much as compared to four years ago. The secondary seller mix moves around over time, but the need for liquidity is constant in the market. We operate in a very illiquid market.