This article is sponsored by PJT Partners
Venture, while a relatively niche part of secondaries, has fared similarly to the rest of the market over the last 12 to 18 months: while allocations have grown quickly and returns have increased quicker than expected, liquidity has not necessarily followed suit. This has put a dampener on exits, and has left many GPs facing new and unexpected challenges.
Richard Chow, a managing director in the private capital solutions team at global investment banking advisory firm PJT Partners, explains how these liquidity challenges are impacting more specifically venture and growth secondaries, gives his take on the role that the IPO market is playing in the current macro environment, and why long-term thinking is crucial for fund managers hoping to ride out the current economic turbulence.
How would you describe the current scale of the venture and growth secondaries market?
One buyer in the market said to me recently that he was spending half his time in venture and growth. This is hugely reflective of how undercapitalised the market is. That buyer has a history of successful closes in venture secondaries deals and is seeing a huge uptick in supply.
The size of the programmes dedicated to venture secondaries has not grown to keep pace with primary capital formation.
What has been challenging for secondaries firms is that venture returns behave in a way that’s counter to what most secondaries investors are seeking. The basic tenets of good secondaries underwriting – namely, predictable near-term cashflow with modest growth where return attribution comes from a diversified pool of assets – get turned on their heads when it comes to venture.
What unique challenges come with venture and growth investing in the context of secondaries underwriting?
One of the key challenges when underwriting early-stage companies has been the lack of predictive accuracy of their financial forecasting. In any given year, those businesses could be 100 percent ahead of forecast or they could underperform by 40 percent, because you are working with small numbers and revenues tend to move in step functions rather than straight lines when dealing with immature businesses.
Forecasting the timing of exits is also challenging for a number of reasons. First, venture firms tend to invest as part of syndicates and as minority investors with limited investor rights to force an exit. So, exit timing is dependent not only on company management, but also on getting agreement from all the syndicate members on the exit terms. For secondaries buyers, it’s really hard to predict whether a company is going to exit in two years or 10 years.
Finally, many of the blue-chip, hard-to-access managers in venture and growth make it difficult to transfer their LP positions, with some managers flatly refusing to consent to transfers. While one can be sympathetic to the GP’s desire to curate its investor base, it puts enormous pressure on the partnership with limited partners if the GP refuses to support a secondaries transaction, particularly when LPs are overallocated to the asset class and need a way to release capital to continue committing to the new funds.
What is driving LP appetite for venture secondaries?
While fundraising pace and the volume of capital invested in venture and growth assets has increased, the return of capital has not kept up, which is disrupting the flywheel that has driven LPs to allocate capital into the venture market. We’ve also seen LPs being compelled to invest in adjacencies with highly successful fund managers, in region or stage-specific funds, which has led to a proliferation of fund rosters that need to be trimmed.
From the GP’s perspective, we saw GPs taking liquidity through share distributions of their public positions, and the rally in the NASDAQ and Russell indices have helped support those share sales. However, the IPO funnel that investors look to for subsequent liquidity has not yet been replenished. There remains a big question over when that IPO window is going to open.
How are GPs adjusting their strategies to suit the current environment?
For LPs and GPs alike, capital was deployed into venture opportunities under a very different economic environment than what exists today. Unable to access traditional exit environments, GPs are likely going to have to hold the assets for longer, but that hasn’t changed the partnership terms through which the fund was invested, which assumed economic ‘normalcy’ with a certain investment period and harvest period.
The secondaries market provides a reset mechanism for LPs to exit, but it also provides GPs with the ability to attract other forms of capital, with potentially a different return and investment horizon. And, in that respect, the secondaries market is not a last resort compared with an IPO exit, but rather is a flexible instrument for GPs and LPs to wield when faced with new economic realities.
What have been some of the most significant features of recent transactions?
On the one hand, the bid-ask spread has narrowed, where the GPs have proactively revalued their assets to be closer in line with publicly traded comparables. This, broadly speaking, has helped improve transactability. We’ve also seen the distribution pace recover in funds holding material public positions, so that liquidity has helped portfolio pricing as well.
A few success factors that we’ve found include being intentional about the assets we’re trying to sell, having appropriate price expectations, and understanding the implications for the seller when it comes to pro forma portfolio construction.
On the first point, we have found marketing a wide menu of assets to sell won’t lead to more price discovery or seller optionality. Buyers simply gravitate to assets where there is high conviction or asset familiarity. And that ultimately leads to more fall-down risk because the seller objective of exiting a broader basket of assets isn’t achieved.
Secondly, we think it’s vitally important for sellers to take a longer-term view on how a sale will de-risk their portfolio and view the crystallisation over the entire life cycle of the investment.
Lastly, we think it’s important for LPs to consider the impact of selling or not selling. So much capital was deployed during 2019-21, but those companies aren’t going to be ready to exit for many years.
LPs should also be critically assessing the return profile of the remaining unfunded commitments to those funds, and where additional support capital will come from if those funds are already fully called.
What is the longer-term outlook for the venture and growth secondaries space?
Venture has always been part of the private markets, with notably big winners and losers. On a primary basis, investment themes around climate and AI, for example, continue to draw a lot of investor support. Here, we know it takes time for winners to mature and reach their full potential.
Just look at Athenahealth, which was started in 1997, and was arguably one of the most successful companies to emerge from the dotcom era. That company didn’t go public until 2007, so it took 10 years to provide liquidity to its original venture investors. It was then taken private in 2018 by Elliott Management and Veritas Capital, and last year was acquired by Bain Capital and Hellman & Friedman for $17 billion. In essence, these ‘secondaries trades’ that provided liquidity for private and public investors still required the success story to be written over the course of two decades.
Right now, we are counselling many LPs to be realistic about their liquidity profiles. On the one hand, if the liquidity door reopens and they can see liquidity coming back, then all is forgiven. If that doesn’t happen, there is a chance they will have to work through these funds and assets for an extended stretch of time.
One can hope that a lot more capital will be raised for venture secondaries. That is a strategic discussion at the top of the house at many secondaries funds because the supply of these growth investments isn’t going to decrease anytime soon.
Interestingly, in buyouts, we have seen much more discussion around GP-led transactions. That hasn’t been the case on the venture side because of the challenges discussed previously around driving the exit cases and the difficulty in predicting the outlier winners in venture portfolios. Still, rest assured: secondaries buyers are going to become more accepting of those types of solutions.