The recent stock market correction and ongoing volatility signal that another cycle of increased secondaries volume may be imminent. It has been more than seven years since the industry has experienced defaults in any meaningful volume, and we are now starting to see an increase. We identify the market dynamics that lead to LP defaults and the criteria that GPs employ to fill in the gaps with appropriate, valuable investors.
How the LP secondaries market works
Transactions in the secondaries market for company shares and LP interests are much less public than in the primary venture market. When a VC invests in a company, both the company and the venture fund typically promote the investment via social media and a press release. Secondaries transactions are seldom announced, and one-off LP interest transfers are never publicised. It’s not surprising that general partners and their limited partners want to keep this activity quiet – an LP interest transfer resulting from a very practical reason could be misconstrued as a vote of no confidence by the LP or a signal of an LP’s poor financial health. Contrary to popular belief, almost every venture capital fund experiences LP transfers.
LP defaults on the rise and transfers
Just as a VC-backed company has investors, a venture fund has investors who sign limited partnership agreements that legally bind them to fund a commitment amount. Unlike VC-backed companies, limited partners don’t fund the entire commitment amount on day one. Typically, the general partner of a venture fund draws down capital over a three- to seven-year period as it needs to. LPAs usually state that if a limited partner does not fund a capital call, then the limited partner may be placed in default. When an LP default occurs, the general partner will seek to find a new limited partner to buy out the defaulting LP and take over the unfunded liabilities.
The secondaries market typically sees increased selling and transfer activity in venture funds after a public market correction or a liquidity crunch, such as the current energy market crisis. When investors lose large amounts of capital in the public market (for example, more than a 15 percent to 30 percent drop in the Nasdaq), individual and non-traditional limited partners in venture funds traditionally start to sell or reduce their stakes to reduce or eliminate their unfunded liabilities.
Suitable secondaries LPs
What type of new limited partner does a venture fund want? Assessing over 200 venture capital fund secondaries transfers where our firm acquired interests, we identified several criteria that venture capital managers use to find a new limited partner:
- A stable balance sheet and understanding of the asset class and company risk levels
- A long-term capital source with prior experience in the asset class
- An existing limited partner relationship with the desire to increase fund ownership
- Ability and pre-disposition to invest into new partnerships in the future
- Ability to help portfolio companies with value-added introductions, strategic advice, and direct co-investment dollars
- Straightforward internal processes
- A proven commitment to the asset class through both up- and down-cycles
- Diversified capital sources
- Prior experience with secondaries transactions
Quickly identifying appropriate LPs can help minimise the negative impact of defaults on venture capital funds and portfolio company management teams. Working with an experienced and trusted partner solves this problem, and allows the industry to function in a healthy way regardless of fluctuating market cycles.