Q&A: What VC professionals think about alternative exits and liquidity

Kevin Scott,
Managing Director, VC Relationship Management, Silicon Valley Bank

Fiona Brophy,
Partner and Co-Chair, Emerging Companies & VC Practice, Perkins Coie

Ryan Logue,
Head of Business Development & Innovation, Private Markets, Solium
 

The following excerpt has been edited for length and clarity.

PitchBook: Is the increased involvement of private equity in VC a trend or more of a new norm?

Kevin: I initially was going to characterize this as a strong trend, but I think it's actually more of a new norm. I think there'll be some tempering of it as cycles change and I've got a couple thoughts: The first one being why I think it's not an absolute new norm, which is what we've seen in this 10-year bull market is a huge denominator effect with the investors, the LPs and in private equity and venture. They've had much more of their endowments or their balance sheet to allocate to private equity and to ventures, which is much more money pouring into private equity. I do think that as the bull market tapers off at some point they'll settle down a little bit. 

But, there are a couple of other factors that counterbalance that, which make me think it's a bit closer to a new norm. The first one is about technology, which used to be thought of as a vertical—as a segment of the economy where you might have government, manufacturing or consumer goods. Today, I think that's completely different. We look at technology as a horizontal that underpins every sector of the economy and if it's not every sector yet, it will be. 

There's so much more opportunity for tech as an investment for private equity to go into. Another factor that is pushing us closer to a new norm is that in the past, private equity did not come in to technology deals because they were too small. With private equity funds much larger than venture funds, they need a much larger investment threshold with companies staying private much longer. We've all seen that these unicorn rounds are going north of hundreds of billions of dollars and there's actually room for private equity investors to put in a significant part of their fund. Another thing that really contributes to the strong trend/new norm is that business models of the tech companies have matured. So, the private equity folks really like stable cash flow, EBITDA they can predict and with the advent of the SaaS business model they found something that they really like. And, they can invest with confidence into those types of business models which really didn't exist before this last cycle. 

PitchBook: Regarding private equity involvement, we've seen a deployment of a wide swath of strategies. Could you help us understand more about the merits to some of these strategies that are being deployed into venture capital?

Fiona: My practice is primarily focused on the VC industry, but we do see private equity players interjecting themselves in a couple of different ways. Private equity is an asset class that's very versatile and very diverse and it's turning out to be able to fill in gaps where VC firms aren't necessarily stepping in. PE is looking for ways to deploy all of this capital and one area that we're seeing certain funds focus on is more of a traditional PE type investment where they're looking for more distressed assets where they can come in, infuse capital and turn it around.  That's sort of coinciding with a phenomenon with VC-backed companies where they are often having an easier time raising early money, but then are expected to show traction by the time they get to that Series B, Series C round.

At the same time, there is a shift in the VC industry where the clear winners are attracting a whole lot of that later venture money, but those companies that maybe haven't emerged as the clear winner in their particular space are having more trouble raising money in that Series B or Series C. And, a number of these companies are software SaaS-type enterprise businesses that fit nicely into a PE model because they've got market share and recurring revenues. So, where VC firms are seeing a flattening out and maybe looking at a potential exit because they want to focus their efforts on the clear winners, we're seeing PE firms come in with a buyout scenario and providing money for an exit. And in a lot of cases, the firms are coming in at higher valuations than a strategic buyer would—particularly in auction scenarios. 

I think another area is PE firms joining in on later-stage mega rounds. And you know, companies are staying private a lot longer for a variety of reasons: the cost of going public, the governance issues, the regulatory pressures of being a public company. PE is definitely filling out these mega rounds. You know, I think they're capturing what was historically the bump in valuations that came through accessing the public markets, PE has moved in to try and capture that uptick in valuation by investing in these later-stage mega rounds. 

PitchBook: Secondaries are an increasing part of the VC space. What are the relative pros and cons to this strategy?

Ryan: The private company secondary market has really exploded over the past decade or so. When I first started working on these transactions in 2010, we really had a handful of companies that were seeing secondary activity. And similarly, we had a handful of funds that were doing investments in more than one name in the secondary space. So, what's happening today is we're seeing more funds—and certainly much larger funds—across the whole private company ecosystem. So, while there are more secondary-only funds than there used to be, I would say they still make up a relatively small percentage of the overall secondary market. 

The biggest participants in the market are the same groups doing these massive 100-million-dollar+ primary rounds. So, you have investors looking to put all this capital to work and it's often difficult for these companies that have already taken in a lot of venture capital because they may not need $200 million to go directly to their balance sheet. They want to avoid dilution, so they will look at the opportunity and believe they can accomplish two things at once—get all the capital they need from the investor, but also use part of it to go directly to the employees and some early investors to give them a chance to take something off the table and really reduce some of the pressure for an eventual exit. So, that's becoming an increasingly common strategy. 

The vast majority of secondary transactions that are organized by companies actually happen on the back of a primary. And it's becoming increasingly common for every company to look at the strategy and they will often do more than one transaction while they're still private where they increase the amount they allow people to sell, but certainly increase the number of people that are in the sale over time as a way to reward people for staying with the company and just generally as a way to keep people engaged and seeing the value of their stock. 

PitchBook: As a percentage of exits, corporate M&A has decreased steadily over the past 10 years—do you see this trend continuing or are we supposed to see a change in the near term?

Kevin: I think it will improve, but I think it will broadly continue. We have a fairly major effort around understanding corporate M&A, corporate venture investing, and corporate I.T. initiatives here at Silicon Valley Bank. We do spend a lot of time studying this and talking to the corporates. Two things that may contribute or may have contributed to the decline: One, it's a zero-sum game, so if you have private equity taking a much more aggressive investment, then that's largely coming at the expense of the corporate M&A teams. Private equity frankly is more aggressive, more nimble and they can get to the punch much faster.

And then with the high valuations of corporates, they can afford to wait. And with those high valuations, private companies have a lot of cash on their balance sheet, so they're not as pressured into M&A as it may have been in the past. But the other angle that I think may be more relevant and we see this very strongly, is that the corporate venture activities has skyrocketed; It's doubled in the last five years from around 15 or 16 billion to post 40 billion dollars. And having spent a number of years doing you know corporate M&A integration, I can say it's much less risky and much more fun to make an investment in a company as opposed to buying it and having to integrate it. And I think corporations are learning they can take advantage of a lot of what they're looking for, trying to get access to technology, access to friends, supplant some of their R&D by making an investment, but not necessarily go all the way and make the acquisition. So, I do think we have a slight shift because of those two or three factors, but when things slowdown, companies may have fewer options for financing so you'll see the corporations come back in and use their balance sheets to make full acquisitions.  

PitchBook: Are investors concerned about liquidity and what alternative forms of liquidity are available to companies in today's market?

Ryan: I would say in general everyone is concerned about liquidity at all times in every decision they're making. The top things you hear when talking to investors, whether they're making a secondary investment or investing long-term in a company are, ‘What are my goals? And, what are my eventual plans?'
 
Every fund has a life. Some of the capital in the market is what they like to call evergreen and they have a long-term view, but at the end of the day everyone wants to understand what the plan is and that was focused on liquidity. An interesting change that's happened in the market is how VCs are achieving liquidity. Liquidity used to revolve around M&A or an IPO, but today I'd say it's a very different landscape. Founders are taking a little bit off the table while they're still private. It relieves the pressure to rush to the exit door and allows large investors to sell to a SoftBank or another late-stage VC fund that wants pre-IPO exposure. Some of the very early seed-stage funds, especially ones that have only raised one or two funds, almost view that as their IPO opportunity. They get to return the fund and then go out and raise more cash in the market. 

We're seeing some of the secondary activity occur as early as after a series B round and what that's mainly focused on is keeping the founders laser-focused on building a huge company. If you're a VC investor, your goal is to have a billion dollar plus company. You're not looking for singles and doubles, you want home runs and so they're allowing these founders to take a little bit off the table, relieve those short-term pressures like buying a house, paying off loans or whatever it may be that would rush a founder into selling a company before they're ready. This allows them to take the long view and build a company that's going to matter and produce the largest returns. 

It looks like the total secondary market for VC-backed private companies should be well over $15 billion, which is certainly a huge improvement over what we've seen over the years. It's an incredibly large growth market for both investors and people on the sell side that are thinking of this as a viable alternative to waiting for a sale or an IPO. And, these transactions in general come in all shapes and sizes, but it's really altered the way people are thinking about liquidity. You hear a lot about the dual track in IPOs, and we've seen companies even put in filings, but have their eye on a sale while in confidential filing. We've also seen companies take a third approach, where they view this as a chance to get the company ready to see what the interest is—but some of them are taking private investment rounds and then doing secondary on the back of that to relieve any of the shareholder pressure that might build up while they were anticipating that IPO. It gives founders and executives a chance to have multiple options on the table and not feel like they're pressured into doing anything. And I think that's one of the reasons why you see so many people raising the large rounds while the money is available. They want to be in the driver's seat. They want to make the decision when it's right to exit for both them and the company. 

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