SECONDARIES III

The venture capital market is having an existential crisis.

With liquidity horizons lengthening, M&A activity significantly slowing and IPO markets in the US and Europe effectively frozen, a growing number of private venture-backed companies may be left isolated, anxious and uncertain as to when or if they will reach a liquidity event.

To borrow the title of a famed existentialist text, they may indeed feel as though they have No Exit.

But unlike the characters in the Jean-Paul Sartre play, a company's investors, founders and employees have more than one door at their disposal. And at least one of them – the market for venture capital secondaries – is wide open.

CATCHING UP
The venture market has historically lagged behind its buyout counterpart in terms of exit routes, which some argue has inherently stalled its growth.

“The private equity market has always had three exit mechanisms,” says Ken Sawyer, founder of San Francisco-based Saints Capital, a direct secondaries investor that, like many direct secondaries firms, got started at the height of the dotcom bubble.

Sawyer ticks off buyout firms' ability to take a company public, merge or sell to a strategic or corporate investor or sell their stake to a fellow buyout firm.

“The venture market, historically, has never had that third stool,” Sawyer says. “And in these periods of time, when the IPO market is in deep trouble or non-existent, you've only got one strategic exit, which is a corporate acquisition. And as we all understand, corporations' desire to take on additional debt and leverage themselves is somewhat constrained in this type of economic environment.”

But the so-called third exit option is growing exponentially, market participants agree.

“There's a tremendous amount of deal flow today,” says Gretchen Knoell, founder of San Francisco-based direct secondaries firm Lake Street Capital.

“I think historically it had a negative taint that if somebody was selling, it meant there was something wrong with the asset,” Knoell recalls. “We're now seeing that very high quality groups are selling – whether it's a portfolio or a single stake – because they have motivations that are unrelated to the asset.”

FRAGMENTATION
Gradually, venture firms are accepting the idea that they can sell portfolio items to a specialist secondaries buyer. But not all direct secondaries firms are created equal, market participants are quick to point out.

For one thing, there is a wide discrepancy in how direct secondaries firms are funded. Some have committed blind pool partnerships while others are funded through deal-by-deal arrangements, often obtaining funds from larger groups and established players in the partnership-focused secondaries market, like Coller Capital or HarbourVest Partners.

Capital sources matter greatly to vendors, as they can – and do – impact certainty of closure with buyers.

Even beyond sources of funding, strategies vary greatly.

Some groups, like longstanding US firms Paul Capital Partners and Venture Capital Fund of America, specialise in synthetic secondaries and/or purchasing portfolios of interests from institutional investors, but tend to avoid single asset deals.

Paul Capital's first synthetic secondaries deal, which basically involves sponsoring the spinout of a captive venture team and its portfolio, was in 1995, recalls general partner Bryan Sheets. As a result, Olivetti Ventures, an in-house group of a now-defunct computer manufacturer, became 4C Ventures.

“We took the team that was doing the venture capital investing for Olivetti out with a portfolio of assets around that time of about $56 million in trades,” he says.

Other direct secondaries firms specialise in single-asset, single-company transactions, sometimes colloquially referred to as “onesies”, like The Blackstone Group spinout Millennium Technology Ventures, or the UK's Azini Capital, which is backed by Greenpark Capital and Lexington Partners.

A typical transaction for Millennium, notes co-founder Sam Schwerin, is to do a series of onesies with founders and other shareholders of one company, as it did in mobile directory company Tellme. Between 2005 and early 2007, Millennium made 12 investments in Tellme, worth more than $12 million and involving a mix of debt, senior preferred stock, junior preferred stock and common stock.

Still other firms employ a mix of the above strategies, like New York-based W Capital.

“You have an explosive industry with a limited exit market. What it's led to is a strong need for an after market,” says W Capital's founder, David Wachter.

“It's the same trend that's taken place, though, in almost every single asset category,” he adds. “Meaning in the old days, everybody kept their loan portfolio. In the old days, everybody kept their equity LP interest portfolios. They kept their high yield loans.”

NEW ERA
Today, the road to realisations for US venture-backed companies and their employees is longer – something that can hurt employee retention levels, particularly in a contracting macroeconomic climate that's challenging consumers.

As of the second quarter of 2008, National Venture Capital Association (NVCA) statistics show the median age of a company from founding to IPO was 8.6 years – a 27-year high. Several years ago it might take a company only two years to build the momentum needed to go public.

Venture capitalists polled by the NVCA said a confluence of factors are contributing to the increased hold period, among them skittish investors, credit market dislocation and Sarbanes Oxley regulations.

Similar problems are being felt across the Atlantic, says Hugh Stewart, founder of the UK's Shackleton Ventures. Two-year old Shackleton has purchased two portfolios comprised largely of venture assets from 3i, as the global private equity firm moves up the scale in terms of transaction size.

“M&A has reduced and in some segments of the market is basically shut down. It's not shut down in technology but it's certainly quite a bit less active,” Stewart says.

He adds: “Over here, the Alternative Investment Market (AIM) was going like a train until the middle of last year and then came to a grinding halt. Now there are far too many companies on AIM, which means sub-critical mass.”

That means the market will remain closed for some time, just as is predicted in the US, he says.

In these periods of time, when the IOP market is in deep trouble or non-existent, you've only got one strategic exit, which is a corporate acquisition. And as we all understand, corporations' desire to take on additional debt and leverage themselves is somewhat constrained in this type of economic environment

Ken Sawyer

W Capital's Wachter explains the appeal of a secondaries solution. Say you lead a seven-year old Silicon Valley company with no plans to go public for several years: “You want to promote employee retention and one way to do that is to offer them the ability to sell down some of their options, exercise some of their options without having to wait for the IPO.”

The same applies to companies that have been forced to shelve IPO plans, says Hans Swildens, founder of San Francisco-based secondary investor Industry Ventures.

“A lot of those companies thought they were going to go public and filed IPOs and now have withdrawn them,” Swildens explains. “The manager teams, the investors in those companies expected an exit and now there's no exit. So that's caused them to look for alternatives for liquidity.”

SECONDARY SAVIOURS
“I didn't even know firms like this existed,” says Barry Libert, chairman of mzinga, a W Capital portfolio company in the social networking industry. “I had spoken to tons of [potential investors].”

A direct secondaries firm like W Capital that will take an active role in shaping a company and helping it develop new relationships and lead subsequent funding rounds can be extraordinarily useful for relieving tired, sometimes apathetic shareholders and creating a better organised capital structure, Libert adds.

“There are a lot of good companies out there with bad capital structures,” Libert says. “It doesn't mean the company is bad.”

The understanding and acceptance of direct secondary transactions, both at board and management levels, has greatly increased in the past few years – in much the same way the secondary market for LP fund interests has matured and become more mainstream.

“Everybody's very accepting of it now,” says Industry's Swildens. “Five years ago, people were not as accepting, or they just didn't know about it. Or it was their first experience with it [so they would say], ‘Wait, I've never seen this before, what's happening?’”

Those conversations rarely happen now, he adds.

SWELLING SELLERS
Venture secondaries are nothing new, points out Bruce Evans, managing director of US private equity and ventur e capital firm Summit Partners.

Secondaries have been a major component of Summit's strategy for 24 years, with its largest-ever gain resulting from a deal with the founders of fibre optic industry-related technology company E-TEK Dynamics, Evans notes. Summit's $108 million investment in the family-owned company, part of a 1997 recapatilisation, ballooned to $4.1 billion in value in 2000 when ETEK merged with JDS Uniphase in an $18.4 billion transaction.

While he says he doesn't notice a change in the number of people wanting to sell stock in private companies, he has noticed a change in the types of sellers.

“Formerly, it was the founder or a non-institutional investor seeking to sell their stake,” Evans says. “But as private equity funds have grown and it has become more difficult for venture firms to exit, we're acquiring stock from other professional investors when we do secondaries – not every time, not even the majority of the times, but more often.”

Lake Street's Knoell also observes that seller dynamics have shifted in the past five years or so.

In addition to seeing founders and senior management in need of liquidity, executives displaced in rollup acquisitions and GPs with funds nearing the ends of their 10-year lives are increasingly looking for liquidity, she notes.

“And there are also some GPs who, maybe the best company in their portfolio they still haven't gotten a distribution on,” Knoell says. “But they want to raise a new fund, so we'll buy a slice of that investment.”

That type of transaction, says Shackleton's Stewart, “creates some plusses for the fundraising story”.

MOTIVATIONS
An individual's versus an institution's need for liquidity are stimulated by different dynamics, says Millennium's Schwerin, whose firm does roughly the same number of deals with both types of sellers.

“For individuals, it's driven by the macro-economic [factors], the recession we're in, and for institutions, it's driven by the capital market seizure,” Schwerin explains.

Since January, he's seen a marked increase in the number of individual shareholders seeking buyers in a customised way.

“And that's different than just company A sells stock to company B – it's really about the way you go about a transaction, the fact that you're working with others in that same company and capital structure, so you're a trusted liquidity partner.”

There are a lot of good companies out there with bad capital structures. It doesn't mean the company is bad

Barry Libert

One of the ways Millennium is arriving at what it deems “total solutions” is offering some companies custom “white label” programmes. These effectively allow the portfolio company to give its employees cash and take all the credit, with the secondary firm doing heavy lifting in the background and then directly targeting other shareholders outside the company, such as former employees, in a traditional secondary investment way.

“So that means the company can set up its own policies. Let's say it wants to let its employees sell up to 10 percent of its stock. But the company gets the credit for that, not Millennium, so the employees are dealing with the company, not some outside investor,” Schwerin says.

The firm has done four such “white label” programmes so far, which tend to be in the $5 million to $15 million range.

A company with which they're currently in negotiations wants a $20 million programme, which will result in Millennium owning different pieces of its capital structure.

“We said we're happy to buy up to 20 percent of anybody's share, we think you should do 10 percent upfront and then let people get liquidity over the next two-and-a-half years because they think they'll exit in two-and-a-half years,” he explains. “So we've said fine: 10 percent now and then another 2 percent per six months for the next five six-month periods. So that's highly customised. That's not just one transaction, that's a total solution for an entire capital structure.”

The firm expects demand for such programmes to increase among companies interested in managing the process of tired shareholders seeking liquidity.

“Some people feel the company should be providing liquidity to its employees and some people feel like it might impact the motivation and so that's fine, we'll never push into a company,” Schwerin says. “We'll tend to offer it up as an idea and what we'll find is a lot of the seeds we planted in the fourth quarter of '07 – I think in the fourth quarter of '07 everyone was still a bit in denial – those seeds are really starting to grow today.”

Whatever the transaction type, and no matter which buyer is chosen, there is one thing that all sellers have in common. “They have the same motivation,” Swildens says. “They want cash.”