So-called ‘unicorns’, venture capital-backed startups whose valuations have reached $1 billion or more, have transformed a whole corner of the direct secondaries market, making it a lot more competitive and reducing the investable universe for traditional buyers.
There were nearly 115 unicorns with a $409 billion cumulative valuation as of 24 June, according to a regularly updated tally kept by data provider CBInsights.
These companies are predominantly based in the US, China or India (about 10 are in Europe). Many are tech companies that were backed by early stage venture capital funds, and while now more mature they may not necessarily be headed for an IPO or trade sale anytime soon.
That historically would have been an ideal scenario for traditional direct secondaries buyers to provide liquidity for founders or employers and access venture-like returns without the same risks. But unicorns have traditional buyers running in the opposite direction.
This is because non-traditional buyers such as hedge funds and mutual funds have increasingly been attracted to unicorns, hoping to get into the next Facebook or Twitter before it goes public. Investing in a company while still private gives them easier access than during an initial public offering and at a lower valuation than if they were to participate in the IPO.
Fidelity Investments has invested in Pinterest’s latest round of funding in May, while Valiant Capital and Lone Pine Capital invested in Uber’s series E round in December. Such investors have much deeper pockets than traditional direct secondaries investors and whether they invest in direct secondaries or in more traditional financing rounds, it inevitably results in swollen valuations.
While increasing competition and valuations imply unicorn-related deals will lead to lower returns than what direct secondaries investments have historically produced, sources suggested the returns would still be higher than what mutual funds would achieve in many other asset classes, considering the low interest rate environment since the global financial crisis.
“Big institutional investors are happy to do [direct] secondaries, and right now, pricing on these are like public valuations,” said a traditional direct secondaries buyer. “There’s a lot of inflated late stage valuations.”
At least a dozen unicorns, including Airbnb, Pinterest and Snapchat, now have double-digit valuations. Uber is currently valued at $41 billion. In addition to inflated valuations, the minimum investment amount needed to secure a spot at the cap table of a ‘unicorn’ has also gone up; one analyst told me the minimum used to be about $1 million to $1.5 million, but now a hot company may request $5 million. This evolution has prompted even some large venture capital firms like Andreessen Horowitz to create special purpose vehicles that can invest much bigger amounts in companies than traditional direct secondaries investors ever could.
“Because of that, there’s no attractive returns there [for smaller, more traditional buyers],” the investor added. “You’re trying to beat hedge funds so you won’t get private equity returns. That market isn’t VC anymore.”
It’s not completely true as some large venture capital firms, like aforementioned Andreessen Horowitz, have adapted to this new dynamic in the market. But the changing landscape has the more traditional direct secondaries houses adapting strategy.
“Direct secondaries guys now have to get in a bit earlier,” the analyst told me. But that can be a difficult task as it may be too early for founders, employees and even early-stage venture capital investors to sell.
Buyers I spoke to, though, said the strategy for now is to steer clear of unicorns. The thinking being that some of the ‘unicorns’ will inevitably blow up, non-traditional direct secondaries investors will get hurt and retreat.
“The frenzy will die soon,” said one direct secondaries buyer. “After a few bad years, they’ll exit the market. We’ll see a correction in terms of valuation expectations.”
At that point, direct secondaries investors should be back to business as usual.
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