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A number of firms across the globe are betting on buying up secondary stakes in venture capital funds. Jumpstart speaks to Michael Joseph, Co-CEO and MD of Ion Pacific, to learn more.
Investors who want to get in on a startup without waiting for a new fundraise often purchase a stake from existing shareholders, in what’s known as a secondary transaction. SoftBank’s purchase of 15% of Uber is one such example. But the next major opportunity in tech investing, according to a small but growing group of investors, is buying stakes in venture capital funds – offering investors the opportunity to invest in dozens of companies in a portfolio by purchasing the original investor’s stake.
In private equity and venture capital, a fund’s investors, called limited partners (LPs), may at some point want to withdraw their cash. The only way to do so is to sell their stake in the fund to another investor – usually at a discount to what the stake is actually worth, because it’s difficult to find a buyer otherwise. The two stakeholders in such a transaction benefit in different ways: the original investor gains some liquidity, and the new investor acquires an asset at a significantly discounted price.
Secondaries have existed in private equity for decades – in fact, there are funds dedicated to buying up capital commitments from other investors at steep discounts, known as “funds of funds.” In venture capital, however, the opportunity is newer and just beginning to pick up traffic. According to Michael Joseph, Co-CEO and Managing Director of secondary investing fund Ion Pacific, this is because in the last decade, VC has finally become large enough as an asset class to drive demand for liquidity.
“Over the past five or ten years, when we’ve seen this massive increase in dollars allocated to [VC], that need for liquidity has grown,” Joseph says. In a given year, he says, 10% of the participants in the asset class may want liquidity. If the asset class is only worth US$100 million, that translates to just $10 million of potential liquidity – not a big market opportunity for funds like his.
“But fast forward to when that market is now a billion dollars – which, by the way, it’s now a trillion – but in a billion-dollar market, all of a sudden, it’s a $100 million opportunity,” he says. To punctuate his point, according to Crunchbase, global venture capital investment reached $1.7 billion per working day in February 2021.
For Joseph, investing in LP secondaries isn’t so much a ‘next big thing’ as it is a foregone conclusion – it just makes sense. In VC, the technology is often disruptive, the business models unproven, and the ability to scale an absolute wild card. Investing in a VC fund four or five years into its lifetime, he says, provides unparalleled visibility that can allow an investor to gain a much more nuanced understanding of their investment exposure.
“If I’ve done my work correctly, I’ve taken out a lot of that binary risk,” Joseph says. “A lot of those value drivers, a lot of those companies that are worth something in that portfolio at that point, have already shown themselves.”
Growth drivers for secondary LP transactions
Purchasing LP stakes was uncommon in venture capital for a number of reasons. For one, the asset class wasn’t large enough – but that’s clearly changed.
Secondly, fund lifetimes used to be long enough to see at least one or two portfolio companies exit, but years have now been added to that timeline. Analyst and author Ian Hathaway found that the mean time to exit by acquisition in 2019 was 6.3 years, up from 4.6 years in 2005. Similarly, time to IPO increased from 4.8 years in 2005 to 6.6 years in 2019. This means that LP money is locked up in VC funds for increasingly longer periods of time, potentially affecting their investment schedules and liquidity.
And thirdly, selling an LP stake was a lose-lose-win situation: the initial LP would have to sell at a brutal discount, the VC firm would take a reputational hit for its LP pulling out, and only the incoming LP would win, coming away with what was essentially a subsidized investment.
As far as selling at a discount goes, not much has changed – most funds like Ion Pacific make a point to invest at a 30-35% discount. But changes in the first two factors have contributed to a realization that despite all the capital inflows into VC, the market remains extremely illiquid.
LPs generally tend to be high-net-worth individuals, family offices, and the like, who often have major interests in traditional industries like real estate. They may want to withdraw their money from the fund to pursue traditional business opportunities, or may simply want to withdraw from the fund because it hasn’t delivered returns in line with expected timelines. Secondary funds like Ion Pacific offer a way out for these investors.
Opportunity in secondary VC is high; risk is low
Timing is key to unlocking opportunities in secondary VC markets. Though the asset class has grown, it’s still much smaller than private equity.
“These individual trades aren’t $100 to $200 million each, like they often are in private equity – they’re going to be a lot smaller,” Joseph says. “However, the opportunity is a lot bigger, because there’s so little money that’s focused on providing liquidity.”
London-headquartered VC firm Draper Esprit, which is unique among firms of its type for being a publicly-listed company, also looks at such trades as one of its many investing options. In 2017, Draper Esprit purchased the two opening funds of seed-stage investor Seedcamp from the fund’s LPs for EUR 20 million (US$25.2 million), thus allowing it to acquire a stake in multiple startups, including fintech giant TransferWise.
Draper Esprit later sold that stake in TransferWise in 2020 for EUR 19.8 million (US$24 million) as part of a massive ‘direct’ secondary sale of shares in which early investors and employees made out with $319 million. In other words, the VC firm had purchased a stake in TransferWise and a number of other companies for EUR 20 million in 2017, and made almost that amount back through exiting just one of those companies in 2020.
Though the rewards can be enormous, purchasing another investor’s LP stake can be a daunting prospect from a buyer’s perspective. Entering a fund at a later stage, when the fund has already invested most of its money, means that the prospective investor needs to conduct due diligence on all the companies in the firm’s portfolio before deciding whether to buy the secondary stake.
However, by virtue of this very due diligence, it makes sense to enter VC funds at a late stage. Investors will have a much clearer picture of the potential risks and rewards of investing and will most likely be able to purchase the stake at a significant discount.
“For secondary fund managers that are buying those stakes – like us – if we’re willing and able to do the work […] we get to come in and see how the fund has performed over the past four years, look at each individual company, make our own assessment on what the value of that company is, and go ahead and buy that stake at a 30 to 35% discount. It may be a fantastic deal for us,” Joseph says.
The other benefit to this strategy is diversification. Many funds invest in a certain startup niche – like The Venture Reality Fund, which invests in VR and AR – or a certain geographical region, like 500 Startups’ Thailand-focused fund, 500 TukTuks.
“Each one of those managers is likely doing something a bit different, with a different focus on industry, geography, or stage,” Joseph says. “So I – by accident – get all of this diversification, which really smooths out my returns versus a traditional venture investor, [whose returns are dependent on] boom and bust.”
Ion Pacific’s criteria for closing a deal relies on whether the fund has any “value drivers” in its portfolio – three to five star companies that are picking up traction and show potential for immense growth.
“We’re identifying what we think are the value drivers – those three to five ‘all stars,'” Joseph explains. “Now, if we haven’t been able to identify any value drivers, needless to say, it’s not a deal that we’re going to go forward with, right? They should have value drivers at that point. And if they do, we’re interested in pushing forward. If not, nothing to do here, move on.”
Joseph is careful to emphasize that Ion Pacific views itself as a “creative capital [provider] of liquidity in the VC ecosystem,” and apart from buying LP stakes, has at times offered deals that are closer in structure to venture debt. This has usually happened when the LP doesn’t necessarily want to relinquish their stake, but nevertheless needs liquidity for other business operations. Ion Pacific loans the investor money, with their stake in the VC fund as collateral.
LPs want exposure to technology
Secondary VC investing is in its nascency, and obstacles still remain as far as compliance and reputational risk go. For a VC fund, having an LP sell their stake means being stuck between a rock and a hard place. Word is sure to spread that their investor wanted to get out of the fund, driving speculation as to why. At the same time, if they don’t let the LP go, they could gain an unsavory reputation as a firm that doesn’t take their LPs’ goals into account.
Yet, there is potential for this perception to change as more companies get into the business of injecting liquidity into venture capital, eventually perhaps normalizing it. And as far as Joseph’s belief in this investing model goes, the proof is in the pudding – or rather, in the limited partners.
“If we look at what happened in private equity in the secondary market, why it existed, why it was interesting for LPs,” Joseph says, “it is a easy and short step – not even a leap, not even a jump – to realize that this asset class of secondaries and VC is going to get massive.”
Tech, he says, is just too big of an opportunity to ignore. Where LPs like family offices would have previously shied away from venture and invested in safer bets like private equity, they now understand that technology companies can represent enormous gains.
“Why the LPs would come into a fund like ours is because they want exposure to the tech story,” Joseph says. “They want exposure to VC, they want outsized returns, but at the same time, they don’t want to lose money.”
Secondary VC investing, despite its problems, makes sense on many levels. It offers visibility, diversification, and exposure to a broad range of assets. Most importantly, though, it fulfils a growing demand for liquidity. And as any investor will agree, filling the market gap for an in-demand product is just good business.
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