VC secondaries: How early?

The technology boom has benefited VC firms that got in early and have seen the valuations of their portfolio companies rise with each consecutive funding round. For secondary investors looking to pick up assets or fund interests on the other side, the experience has been more mixed.

"We have passed on portfolios in the last couple of years because we couldn't get comfortable with valuations," says Doug Coulter, partner at LGT Capital Partners. "There is a good chance portfolios are marked up, maybe on the basis of later rounds and euphoria, so you may in fact be paying higher than fair value. With secondaries, a lot of it is about the price you are paying, but it is also about the quality of the assets you are buying. One of the problems with VC is it's much harder to assess asset quality."

Indeed, the pricing for venture capital fund positions is at its highest in eight years. Greenhill Cogent noted in its report on secondary activity in the first half of 2015 that in many cases pricing is "benefiting from large unrealized gains subsequent to the record date due to IPOs and up-rounds of financing at valuation levels that are significantly higher than the most recently reported carrying values."

It is more like looking at the situation from a growth perspective, not a Series A or B where you might just have a business plan and might be taking revenue risk - Lucian Wu

At the same time, investors are still willing to pay more for buyout funds. During the first six months of 2015, the average high bid for buyout funds was 95% of net asset value. For venture, it was 82%. The disparity is in keeping with historical trends and reflects the comparatively greater risk that naturally comes with venture capital. It also impacts how different investors prefer to address the VC secondaries opportunity.

"You are looking at buying VC fund interests versus buyout or growth funds where the outcome by nature is going to be more dispersed, warranting deeper discounts," Lucian Wu, managing director at HQ Capital, says of the pricing data. "But this shouldn't be generalized to apply necessarily in direct situations where the assets are more concentrated and you have deeper access to the underlying companies."

Digging deep

To many, direct positions in tech companies are preferable to LP interests because they simplify an already complicated process. Assessing a venture capital secondary proposition requires a somewhat different skill set to private equity. Companies are characterized by multi-class share structures, follow-on rounds, longer holding periods, and less proven business models. It may be relatively easy to draw a conclusion on one asset, but an entire portfolio presents more of a challenge.

"The process is a few months of due diligence with detailed visits on the ground of underlying portfolio companies," says Paul Robine, managing partner and CEO at TR Capital. "A lot of large secondary funds will think only in terms of discounts. They may not have the time to perform months of due diligence because they are in very intermediated situations."

Of the 25 secondary transactions TR has completed across its two funds, seven were venture capital deals, either single assets or portfolios. The payoff for the extensive due diligence is a potentially higher return than in private equity (perhaps a net multiple of more than 2x versus 1.5x) partly due to the steeper discounts available for fund positions.

The risk factor - identifying the handful of winners in a portfolio that also contains its fair share of mediocrity and write-offs - can be ameliorated by the timing of entry. Coming in at year five or six, there is more transparency than in year two or three.

While HQ Capital is generally more attracted to single-asset VC secondary deals, the fund positions it considers tend to involve later-stage portfolios with companies that offer greater visibility on revenue and EBTIDA. "It is more like looking at the situation from a growth perspective, not a Series A or B where you might just have a business plan and might be taking revenue risk," Wu explains.

Even if an investor gets comfortable with a venture capital portfolio, there is no guarantee it will come at the right price. This is usually the biggest obstacle in any secondaries deal, but the difficulty is arguably magnified in venture capital because, as LGT's Coulter puts it, the asset class "is in part about hope and expectation." While the seller emphasizes rapid growth and exciting stories, the buyer needs to step back and make a bottom-up valuation call. It may be that neither approach is a good fit.

Valuation could also be a point of contention with the entrepreneurs who control the underlying portfolio companies. "While they are not impacted financially, entrepreneurs would prefer a higher valuation," says Prashant Mehta, a partner at Indian VC firm Lightbox. "They don't want to be sold at below a certain valuation because they might be looking to raise new rounds of capital."

Industry pipeline

Lightbox was created last year when KPCB and Sherpalo Ventures ended their India joint venture, and the local management team spun out. Several secondary specialists supported the acquisition of the existing portfolio, while a separate group of LPs provided $100 million for new investments. It was followed by the sale of Canaan Partners' India VC portfolio to J.P. Morgan Asset Management. In both cases, the LP base was relatively small and motivated to sell, which helped facilitate the transactions.

The general expectation is that more venture capital secondary assets will become available: at one end of the scale, certain tech companies are raising capital at ever-higher valuations and some existing backers might want to take their money of the table; at the other, a lot of VC funds are sitting on portfolios primed for IPO exits that have yet to materialize.

In addition to India, TR's Robine sees potential in China, particularly among financial institutions that are selling assets for regulatory reasons and among corporations that are offloading VC units due to financial or strategic pressure. "When we started eight years ago this was not the case, but in the past 12 months we have seen an increasing number of Chinese sellers," he says.

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• Topics
• Secondaries
• Secondaries
• Venture
• Secondaries
• TR Capital
• China
• India
• LGT Capital Partners
• HQ Capital