A limited partner at a public pension recently walked me through his private markets investment model. Despite having allocations to some of the top venture managers, he wasn’t thrilled with the asset class’s performance.
VC has not behaved at all as expected, he said. Funds were deployed too quickly. Valuations of portfolio companies ballooned to unrealistic levels. But his biggest grievance is that cash distributions from venture funds have been nowhere near as high as PE and growth equity funds.
Getting cash back has become so important that the pension plan decided not to recommit to several brand name firms who didn’t provide enough liquidity from their older funds.
The pressure to send money to LPs is driving some VCs to sell portfolio company stakes on the secondary markets, but they’re finding that buyers are interested only in the best assets. Meanwhile, less attractive companies are not generating much demand, even at big discounts.
Secondhand returns
Gone are the days when LPs were happy to back funds with strong paper returns. A measure known as distribution to paid-in capital (DPI), which refers to how much capital a manager returned relative to what was invested, has become more important than all other metrics during the downturn.
VC funds entering their peak distribution years have been lagging LP expectations. In recent quarters, vehicles that were started in 2016 through 2019 have been falling further and further behind the average DPI pace set by pre-2016 funds, according to PitchBook data.
With IPOs and M&A exits the lowest they’ve been in years, VCs are increasingly considering generating liquidity for their LPs by selling secondary stakes in their portfolio companies to other investors.
“The secondary market is growing significantly now,” said Devon Kirk, co-head at Portage, where she co-leads growth equity, structured equity and special situation investments. “We see a lot of seed investors looking for liquidity alongside a primary round.”
These investors had expected many companies to go public by now, but now it looks like it may be three or four more years until they can IPO. Meanwhile, as LPs push for DPI, selling a stake to new investors—even if it’s at a hefty discount to the company’s last valuation—is a no-brainer for many early-stage VCs that want to raise a fund in this market.
The trading of secondary stakes in startups is expected to increase as more firms are pushed by their LPs to generate liquidity.
Demand doldrums
Buyers of startup secondaries have a list of companies they would like to scoop up from existing investors. While it’s impossible to know exactly which startups are on it, one thing is near certain: The figure is much lower than more than 1,000 unicorns hoping for an exit.
In other words, investors have no interest in buying secondary stakes in a whole bunch of companies, even if current backers would sell them at a more than 90% discount.
“If a company raised capital at 100x annual recurring revenue [ARR] in 2021, then we don’t even bid,” a secondary institutional investor told me. With multiples now at 5x to 12x ARR, such companies may never grow into their previous valuations, the person said.
These steep valuation drops could snuff out the motivation of management teams. If their shares are trading at discounts that make their shares worthless, these executives may not want to work hard toward an exit.
That’s why secondary investors and existing shareholders are flocking to stakes of best-performing companies and those related to generative AI. But they’re shunning middling and bottom-of-the-pack businesses.
While trading volume has increased since the middle of last year on secondary platforms, activity is still limited to the top 50 to 100 names, according to Akrati Johari, chief growth officer of secondary marketplace Zanbato.
That’s not a great sign for various sellers, including Tiger Global Management. According to my reporting, it’s so eager to generate liquidity for its LPs that it opened its full portfolio to individual bids.
Tiger may struggle to attract buyers for many of its portfolio companies because those deals were done at such high multiples that some of those stakes may not be attractive, even at high discounts, two investors told me.
Yet Tiger also has certainly accumulated a small treasure trove of crown jewels among its portfolio of 300-plus private companies. I can’t wait to learn if—and at what price—the crossover investor will release them from its paws.
This article appeared as part of The Weekend Pitch newsletter. Subscribe to the newsletter here.
Featured image by Jenna O’Malley/PitchBook News
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