The tip of the iceberg

VC-focused secondaries seems like a niche market, but don’t be fooled: there is more to it than meets the eye.

This week venture capital-focused secondaries player Industry Ventures closed its latest fundraising programme, raising around $400 million across two vehicles. This followed soon after the firm amassed $700 million for its eighth dedicated secondaries fund and a sidecar vehicle.

Industry Ventures’ closings are a milestone for VC secondaries and the firm itself; its $700 million haul is thought to be the largest ever for the strategy.

Hard data on the size of the VC secondaries market is difficult to come by. While there are a number of specialists around the world raising VC-focused secondaries funds – normally sized in the low hundreds of millions – sources say that the capital raised is a disproportionally small fraction of the primary capital raised for venture.

So with around $47 billion raised in primary venture capital in 2015, why aren’t we seeing more capital raised for dedicated VC secondaries funds? After all, when VCFA Group raised the first ever secondaries fund, stakes in venture funds were one of its key targets.

For one thing, VC secondaries are apparently trickier to execute than conventional private equity deals. Calculating valuations is harder. Much harder. While the potential upside is greater, VC fund stakes are a lot more difficult to value because of the lack of established financial performance data. The start-ups are usually in innovative sectors and may have no publicly traded comparison. Venture-backed companies often can’t provide figures on profitability, EBITDA and cashflow like buyout target firms.

“They’re often still loss-making and cashflow consumptive,” a managing partner at a tech-focused secondaries firm told me. Because valuations are so subjective and complicated, discounts tend to be greater because of the risk, he said.

Of course, valuations in buyout strategies are somewhat subjective too, but in venture, where an asset could be a failure or a unicorn, the stakes are much higher. And even if you get the valuations right, timelines for realisations are less clear.

“It could take three or four years, or it could take 12 to 15 years,” one source said.
Second, legal and administrative hurdles often block deals. The best assets are most to likely be subject to pre-emption provisions such as right of first refusal clauses, which means they have to be offered back to existing investors in either the fund or portfolio company first – a headache for both LP and direct secondaries buyers.

Sven Lidén, Adveq’s chief executive, told me RoFL clauses are less common on buyout funds but very common for VC funds.

“On top of that, the GP needs to provide consent to any given transfer,” Lidén said.

While most buyout funds are quite relaxed and provide consent to most buyers, some highly oversubscribed funds – and in particular VC funds – tend to interfere a lot in the transfer process.”

Finally, it’s more common just to extend a fund. The nature of venture investing means investors know they might not see exits for successful companies within the standard 10-year fund life. With average life of VC funds extending to around 14 years, there is less need to liquidate and hence less dealflow for secondaries funds, I’m told.

One important distinction is that VC fund stake deals aren’t always done from dedicated funds focusing on the strategy. Large secondaries firms including Lexington Partners, HarbourVest Partners and Pantheon all invest in VC secondaries through their main funds, a detail that isn’t captured in fundraising statistics.

Last year VC fund stakes accounted for 27 percent of secondaries trades worked on by Greenhill Cogent, the second largest strategy by number of funds behind buyout. It’s clear venture stakes are swapping hands, just not through dedicated funds.

Sources are reluctant to give me even a ballpark figure on the size of the total VC secondaries market and point out that when you include secondary trading in venture-backed companies, the figure is almost unknowably massive. This giant market – potentially larger than private equity secondaries, one source tells me – is certainly on the radar of secondaries buyers of all shapes and sizes.

Why else aren’t we seeing more dedicated VC secondaries funds? Let me know: adam.l@peimedia.com