When a Limited Partner commits capital to a standard venture capital fund, that commitment is typically 10 – 12 years in length. The time from first capital invested until all capital returns are distributed back to the LPs can even stretch to 15 years, even in successful venture capital funds. Likewise, early founding employees in great venture-backed companies can often be part of a very valuable company on paper, but have no access to cash liquidity for 8-10 years or longer.
The result is that investors in venture funds, or venture funds invested in great companies, or employees and ex-employees of successful private companies will sometimes look for the ability to realize cash today for their shares even if they might be giving up greater returns later. The motivation to get liquidity today can range from a general need for cash to satisfy other commitments, to a fund that is at the end of its investment life and is required to liquidate holdings, to an individual wishing to buy their first house or invest in purchasing further stock options.
‘Secondary’ transactions involving venture capital funds or individual company investments have been around a long time at a small scale. It was not until the dramatic expansion of the amount of money dedicated to venture capital funds from 1995 – 2005 however that new institutional funds started to organize to focus on venture secondary investments. With the larger percentage of private equity dedicated to venture capital, a much larger set of opportunities became available and the dedicated venture secondary funds were born to satisfy the demand for liquidity.
A Secondary Venture Capital fund is a committed venture capital fund that focuses on providing liquidity to shareholders in great late-stage venture-backed companies or venture portfolios. This investment strategy allows shareholders to realize proceeds on an accelerated schedule and gives investment access to great later-stage companies that would otherwise be unavailable.
Opportunities for venture capital secondary funds to succeed today are increasing significantly and a few forces in the market in particular are accelerating the pace of change.
Institutional sources of invested capital such as pension funds and endowments are under tremendous pressure to deliver returns above and beyond the returns available from the stock market. With issues like ever-increasing healthcare expenses, the pending retirement of the baby boom generation and overly-optimistic pension programs, combined with historically low interest rates has this $64T of capital in the United States trying to find ways to improve investment returns or better IRR. To find better returns, the total capital dedicated to ‘alternative’ investments such as Venture Capital and private equity doubled between 2005 and 2013 and is continuing to grow. The alternative asset class as a whole now represents over $7T of capital commitments, or over 10% of total invested capital in the United States.
This desire for better returns has again caused an ever-increasing commitment to venture capital funds and an ever-increasing number of new private venture-backed companies to get founded and emerge as leaders in their markets. Fundamentally however, the underlying risks of investing in venture-backed companies has not changed (cyclicality, early-stage losses, and timeframe to liquidity). The IRR returns seen by institutional investors is determined by two factors: cash multiple return and time. You can improve the overall desirability of an investment by improving cash-on-cash return, or time, or both. The venture capital secondary path of exit for these investors can dramatically improve the element of time in the return equation. Instead of waiting until year 10 or 12 to realize an investment in a fund or individual company, these shareholders can realize an exit in year 8, thereby dramatically improving IRR performance.
Another driver of the opportunity today is public market volatility. If the public markets are surging for a significant period such as from 2010 – 2015, the opportunities for individual companies to get liquidity through a public offering or by getting acquired abound. When the public markets have a lot of uncertainty or distress, such as 2000 – 2004, 2008 – 2009, or potentially 2016 – 2020, the availability of public offerings or acquisitions as an exit goes down significantly. In 2015 there were 77 IPOs of venture-backed companies. Through the first half of 2016, only 7 venture-backed companies have been able to IPO constituting a dramatic change in the availability of liquidity to those investors or employees. When the potential for liquidity in the public market or through acquisition goes down, the opportunity for great investments on a secondary basis goes up. Sellers become more desperate for liquidity and distress fosters opportunity. Secondary funds can do quite well in any market cycle, but will have a significantly greater chance of success in a volatile market.