Venture-backed IPOs: Holding out for returns?

Venture firms’ distribution strategies vary widely. But one thing many venture firms have in common is that they don’t necessarily distribute publicly-quoted stock at the earliest possible opportunity. On the contrary: many venture firms retain ownership in portfolio companies for many months or even years after the initial lock-up period has expired.

For instance, Matrix Partners was still holding a 10.8% stake in Netezza Corporation when it was acquired by IBM for $1.7 billion in November 2010, more than three years after the company made its debut on the Nasdaq stock exchange. Similarly, Sequoia Capital was widely reported to have held on to a substantial position in publicly traded Isilon Systems when it was acquired by EMC Corporation for $2.25 billion in December 2010, four years after it listed on Nasdaq.


Efficient markets?

LPs generally take a very dim view of this practice. They believe that it exposes managers to unnecessary risks, which are not offset by a corresponding improvement in returns. Many also object to paying management fees and carried interest to GPs for ‘managing’ public stock. In fact, some investors believe that GPs deliberately hold publicly-quoted stock in order to maximise value creation for themselves – at the expense of their LPs.

The Efficient Markets Hypothesis would appear to support LPs’ objections. If public markets are efficient, it shouldn’t be possible for GPs to generate abnormal returns on their public investments – and therefore it would be in LPs’ best interests for GPs to either liquidate or distribute publicly-quoted stock when the lock-up period expires.

Equally, if public markets are efficient, LPs should be able to generate the same returns post lock-up as the GP by holding the investments directly – but lock in 100 percent of the gains (rather than just 80 percent, the amount that would accrue to LPs if the investment was still being held by a fund that charged a 20 percent carried interest).

However, GPs believe that in some instances, they can create economic value by holding stock post lock-up both for their LPs and for themselves. As board directors and industry experts, they argue, they have access to information that puts them in a better position to decide when to realise or distribute publicly-quoted stock. They are keen to point out that carried interest aligns their interests with those of their LPs. And they clearly recognise that it is a risky practice, which suggests that they wouldn’t do it unless they felt confident of creating value.

Many GPs also highlight the fact that an overwhelming majority of LPs automatically liquidate publicly-quoted stock on receipt – so in general, it is not in their best interests to distribute stock at the earliest opportunity.


Absolute discretion

Last year, Vencap undertook a survey of twelve top-tier venture firms to gauge GPs’ attitudes towards holding publicly-quoted stock after the expiration of the lock-up period.

The survey confirmed the discretion that GPs maintain over distribution policies: nine of the twelve firms said they did not have any defined policy specifying the timeframe within which they should seek to dispose of their public holdings. The remaining three firms did appear to have in-house guidelines – but none of the firms surveyed provided LPs with any kind of guarantee as to when they would receive stock in publicly-held companies or the cash proceeds from its sale.

The survey also confirmed GPs’ apparent willingness to hold public stock, with ten of the twelve firms acknowledging that they would retain ownership in publicly-quoted portfolio companies post lock-up if they thought they could create value by delaying realisation. None of the firms aimed to liquidate stock at or close to the expiration of the initial lock-up period. Three firms aimed to sell or distribute stock within 12 months of the lock-up expiry; five firms stated that they typically held stock for an average of 12-24 months; two firms indicated that they regularly held stock for two to four years post lock-up and one firm even admitted that it often held publicly quoted stock for more than four years.

What was perhaps most interesting, however, was that while the GPs almost unanimously believed that holding stock post lock-up was in the best interests of their LPs, only one of the twelve firms surveyed had actually analysed the economic impact of this practice.

We then ran an empirical analysis on data obtained from twelve venture funds raised by a total of nine established venture firms between 1998 and 2001, the aim being to quantify the economic impact of GPs’ holding publicly-quoted stock post lock-up.

The empirical analysis confirmed the survey findings, with the twelve funds analysed holding publicly-quoted stock in a total of 32 discrete companies for an average of 1.8 years post the expiration of their lock-up periods. The maximum length of time a public stock was held post lock-up was 6 years.

Nine of the twelve funds surveyed generated an absolute gain by holding publicly-quoted stock after the expiration of the lock-up period. Three funds generated more than $200 million in additional proceeds and one firm was able to return more than a third of its entire fund by employing this practice.

However, not all the funds made a profit by holding public stock. Whilst one firm generated a gain of $226.8 million by holding one stock for 2.4 years post lock-up, another held a single stock for 3.8 years and posted a loss of $76.1 million. This underlines the risk inherent in the practice.


Not so risky

Whilst it is interesting to consider absolute gains and losses, it is of course much more pertinent to look at risk-adjusted returns. The Efficient Markets Hypothesis states that GPs should not be able to generate abnormal returns on publicly-quoted investments and, as a result, it would be in the LPs’ best interests for the GP to distribute publicly-quoted stock in a timely manner. But the findings do not support this claim.

Risk-adjusting the returns to account for movements in the public markets over the period that the stocks were held, on average the GPs in the study were able to generate a positive abnormal return of 27 percent by holding publicly-quoted stock post lock-up. Discounting the instances in which the lead GP stepped down from the board of directors at the IPO (and therefore in theory no longer had access to privileged information), the positive abnormal return increases to 41 percent.

This suggests that, contrary to popular belief, GPs may be able to add economic value by holding publicly-quoted stock post lock-up. So it may well be in LPs’ best interests for GPs to maintain discretion over the timing of stock distributions. n


Michelle Ashworth is Director of Fund Investments at VenCap International, an independent investment advisory firm focused on top-tier venture capital funds in the US, Europe, China and India