Second quartile deal solutions

Hugh Stewart examines 'a case study from the business school of hard knocks' that shows why secondary firms are well suited to help GPs provide follow-on capital.

Times are tough for the weary managers of recession-ravaged portfolios. Some deals done in the early part of the decade now look less promising with cash flow problems to manage and the prospect of arranging survival money. But perhaps there is a happy ending.

Venturus Buste, an experienced venture capitalist, trudged wearily through the wet and stormy November night, tossing around in his mind what to do about ChangetheWorld Technology Limited, a classic tech deal from the early noughties.

The firm had invested €25 million across three rounds (one planned, that was a joke) and installed a new CEO, but the company was still losing money and was now pitching for a fourth round. It was growing, slowly. No mean feat in a recession and, with a following wind, it might do €2 million in revenues this year. “Maybe we could exit at €5m if we’re lucky and can get it to break even,” mused Venturus. “I guess I’ll have to write yet another paper for Monday’s investment committee and go through the usual grilling with nobody really wanting to support, but equally nobody wanting to kill it because we’re in the midst of fundraising. It really is no fun managing a typical 2nd or 3rd quartile deal that’s on the cusp of running out of cash.”


What made it worse for Venturus was that his glamorous colleague Ventura Boome was also working on a paper – for ShinyNewScheme Limited, a new investment into what looked like a really promising company. It boasted an experienced third-time management team who were investing serious money, a clearly defined market, proven customer proposition, good range of potential acquirers etc, etc. It looked like a classic Top Quartile deal which should sail through the investment committee.

That was the problem with managing the second and third quartile deals in the portfolio – presenting proposals to put survival money into rusty old deals is no fun compared with doing shiny new deals. Venturus felt very much like the poor relation. The other problem is that what he’d really like to do with ChangetheWorld would be too radical – put a line through the loans, stick all the legals into the shredder, especially those incomprehensible pages on liquidation preferences, and start afresh with a properly incentivised management team. That would crucify the valuation, though, and there would be the usual discussion about what we’re getting for giving up the loan, even though we own 99 percent of the economic value anyway. It would never fly.

One can see why the secondary guys make these deals work. They have none of the constraints that the primary investor has. No doubt their returns from the same set of assets are much better than if they’d been kept in the original portfolio. Maybe therefore the answer is to package up some of these deals and, rather than taking 100 percent cash and getting rid of it, take some cash and some paper in a new LP alongside a secondary investor. “I might just put in a call to the secondary guy I met the other day,” thought Venturus.

Hugh Stewart is the managing partner of direct venture secondaries firm Shackleton Ventures.