VC secondaries: Trading unicorns

Kalaari Capital was one of the first two institutional investors in Snapdeal, committing $12 million to the Indian e-commerce marketplace alongside Nexus Venture Partners in 2011. Over the next five years, the company raised round after round, reaching a reported valuation of $6.5 billion in early 2016. Kalaari is said to have taken some money off the table as new investors piled in.

Last year, the VC firm sought another, broader liquidity event: it wanted to return capital to LPs in one of its more mature funds by restructuring the vehicle and bringing in new investors, according to sources familiar with the situation. Snapdeal was the plumb asset in the portfolio.

However, at the start of 2017, reports began to swirl about a cash crunch, job cuts, slashed marketing expenditure, and plummeting sales. SoftBank, Snapdeal’s largest investor, agitated for a trade sale to direct rival Flipkart. The process has yet to be completed but it would value the business at around $1 billion, despite reported unhappiness over the terms among Kalaari, Nexus and other shareholders.

It takes a while for sellers to adjust their prices; they find it hard to accept that these companies are not worth $9 billion – Tim Flower

Once uncertainty emerged over the true valuation of Snapdeal – Kalaari had marked the position to a much higher level than $1 billion, says an investor who passed on the deal due to concerns that it represented too big a bet on one company – the fund restructuring failed to materialize. The situation amounts to an extreme example of how volatility can play havoc in Asia’s VC secondary market.

“Buying into unicorns can be hard because it’s often difficult to get the information you need. Looking at just the overall market positioning of a company, you may not be able to judge how attractive it is. You need an angle as a secondary buyer. If you can find the right information – information that others don’t have – these can be attractive investments” says Lucian Wu, a managing director at HQ Capital.

Lumpy market

This will likely be a record year for venture capital secondaries in the region, although deal flow remains lumpy. The standout investment is the $600 million purchase of LP stakes in a string of IDG funds covering China, India and Vietnam by HarbourVest Partners-led consortium. It is the largest-ever transaction in Asia’s VC space, but it was driven by unique circumstances. Specifically, China-focused IDG Capital participated in the acquisition of International Data Group and ended up taking ownership of minority interests the company held in funds managed by independent managers in its network.

Perhaps more instructive in terms of overall trends is Sequoia Capital India’s $180 million sale of stakes in eight portfolio companies to Madison India Capital, which was supported by Lexington Partners. This tactic of stripping several direct positions out of a portfolio – rather than pursuing a full fund restructuring, which requires broad LP approval on pricing – is increasingly popular. DST Global, for example, completed a similar transaction primarily involving Asia-based portfolio companies.

But secondary investors say they are seeing more of everything in the market, from tail-end fund restructurings to single positions in unicorns. “We have seen an enormous amount of interest in the last 18-24 months. It’s taking up a lot of our pipeline,” says Tim Flower, a managing director at HarbourVest. He declined to comment on the IDG transaction.

Some of this activity is valuation-driven. Paul Robine, CEO of TR Capital, notes that valuations were so volatile in 2016 it resulted in large spreads between bids and offers from one quarter to another. Since the start of this year, discounts to net asset value have stabilized and more transactions are closing.

Of the three main secondary transaction types – traditional LP positions, fund restructurings, and direct interests in portfolio companies – he sees the most potential in the latter two for venture capital, observing that the pricing for LP positions is still relatively high. TR completed one restructuring at the end of last year involving India Innovation Fund; it came about because the Indian institutional investors that backed the vehicle were unwilling to re-up, so the GP decided to withdraw.

VC secondaries are challenging because they are a very different animal to private equity. Companies are characterized by multi-class share structures, follow-on rounds, longer holding periods, and less proven business models.

Uncertainty over pricing can be addressed by the timing of entry – HQ’s Wu says that by year eight of the fund life, “the losers are already written down or written off and the remainers are more like growth equity plays” – but companies that are richly valued and unproven present problems.

Good and bad

For example, Chinese mobile phone manufacturer Xiaomi last raised equity funding in late 2014 at a valuation of $45 billion, making it the world’s most valuable start-up for a short period of time. Industry sources say stakes are available at valuations of $20 billion or below, but some are adamant they wouldn’t buy at any price because it is impossible to properly assess what the company is worth.

There is greater certainty over companies like Chinese ride-hailing platform Didi Chuxing, which completed an equity funding round as recently as May and regularly appears on the secondary market as single positions or in portfolio transactions. Flipkart is also seen as a relatively safer bet: it completed a down round in April, but at least that delivered a specific valuation; in addition, the company has agreed to buy eBay’s India business and is expected to pick up Snapdeal.

In contrast, Xiaomi has managed to avoid an equity down round by raising capital through the debt markets, leveraging its substantial assets and cash flow. While there are scenarios under which it might recapture some of its former value, several investors place the company in the category of unicorns they try to drop from portfolio deals if possible.

It is therefore unsurprising that, while valuations may have stabilized, far more deals are shopped by prospective sellers than ever get close to transacting. In addition to early-stage VC investors that cannot wait any longer for portfolio companies to go public, there are plenty of hedge funds and high net worth individuals trying to offload single or multiple late-stage investments in unicorns. Their pricing expectations are often far-removed from what anyone is willing to pay.

“It takes a while for sellers to adjust their prices; they find it hard to accept that these companies are not worth $9 billion. You can structure a deal so it is almost like the discount bleeds out over time in terms of how the economics are shared rather than crystallize it at the outset. But even with a structured solution, there would be some kind of discount. That’s why lots of deals fail,” says HarbourVest’s Flower.

There are various ways in which structuring can be used to close the gap between buyers and sellers. One option is for the secondary investor to place a portfolio of direct positions into a new vehicle in which it holds 80% but receives 100% of distributions until an agreed minimum return is reached. In return, the investor agrees on a narrower-than-desired discount. Similarly, the investor could compromise on the discount but stagger the timing of payments to the seller, thereby improving the IRR.

It is also possible for investors to secure an element of downside protection through the redemption provisions attached to some of these positions, particularly for later-stage investments. However, HQ’s Wu warns that redemptions should not be considered part of a base case investment scenario because they are unlikely to generate substantial returns and there are often questions about enforcement.

“You have to look at what the GP has done before. Have they been successful in generating distributions by leveraging those redemption clauses? Do the underlying founders have the means and intention to honor those clauses? It’s the ‘soft’ part of the equation. When you focus on the smaller end of the market you can be quite granular,” says Wu.

Irreversible trend

As long as the exit environment remains uncertain, venture capital secondary deals will become more prevalent in Asia. It is the inevitable consequence of GPs needing to cash in on the paper gains they’ve made on investments as funds near the end of their lives. James Lu, a partner at law firm Cooley, observes that whenever a unicorn has a new funding round, early-stage investors are increasingly aggressive in lobbying the company to include secondary shares in the offering.

And as the pressure mounts, more assets will become available at attractive prices. “The discounts on prime names, for VC or growth capital, tend to be small at the moment. For large discounts and potentially better returns, you need to go to more mid-market names,” says TR’s Robine. “But these prime names will have to sell at some point, and we are quite excited about this. It is a waiting game.”

However, there remain some concerns that an unusually large amount of secondary money is entering the venture capital space, with insufficient thought given to the risks. On one hand, several investors suggest that, based on the number of deals being shopped around, it would be easy to deploy an entire $3 billion Asia secondary fund in VC assets. On the other, based on the requested valuations, GPs taking a genuine bottom-up approach to pricing wouldn’t get much done.

“We are trying to size things appropriately and we are cognizant of the risk,” adds Doug Coulter, a partner with LGT Capital Partners. “It seems that the smart people are the ones selling right now, although this doesn’t mean you can’t participate in select deals where you are buying very high quality assets.”

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• Topics
• Secondaries
• Greater China
• South Asia
• Venture
• Technology
• China
• India
• HarbourVest Partners
• HQ Capital
• LGT Capital Partners
• TR Capital
• Secondaries