Secondaries in LP Stakes
I’ve been asked a lot about trading LP-interest secondaries recently. Most LPs need liquidity, and while a lot of venture companies have recently been over-valued, there is a point of view that secondaries are trading so cheap that it makes up for the inflated marks.
In my view, the liquidity problem for those who need cash is bigger than the problem of over-valued companies. Because of this, secondaries should trade at a deep enough discount that they are worth buying.
I’ve always thought secondary markets should be a bigger part of the venture landscape. Founders, VCs and LPs all need liquidity from time to time and 10+ years serves as a very long hold time. Think about where you will be in 10 years! Holy moly. These things take a long time.
So when LPs ask me if now is a good time to buy into secondary markets, I often say the following:
If there has ever been a good time it’s now, but there are a lot of reasons secondaries in venture haven’t been easy, and will probably stay hard.
(1) Credit:
VC portfolios only get credit for their top few deals and almost no credit for the rest. Why? Smaller companies often don’t have enough data to underwrite with pricing precision, and they are so small they may not be worth underwriting at all.
Example: $100m portfolio of 30 companies, and a 10% LP in the fund wants to sell their position. It’s currently marked at 3x (great!) so the position is worth $30M (ignoring fees/carry for simplification). They want to sell this stake to a secondary buyer:
The top 3 positions probably make up 2/3 of the value. This means the other ~27 positions are worth $10m (or $370k each). Assume each deal is going to be bought for $.50, but is actually worth $.8 because of the market pullback. That’s $.30 of spread = $111k of profits. A secondary fund may be making 15% carry, so that’s $16k of income to the GP. The cost of a good employee probably exceeds that per month! It’s just unaffordable to underwrite those deals for a GP.
Because of this dynamic, it’s hard to sell an entire portfolio without getting $0 credit for most of the book.
(2) Reporting:
Getting information on the way in is difficult. VCs feel an obligation (as they should) to keep the information of their portfolio companies private. So usually there needs to be some willingness for a founder to be supportive to their GPs need to effectuate a transaction. Or, even crazier, they need to be supportive of some LP of some GP (who they probably have never met) to sell. Which I’ve never actually seen happen. So instead, LPs use highly imperfect, and usually delayed information (cost basis, current mark, and maybe high level numbers like revenue and burn) to market a position.
Getting the information after the transaction is even harder. The primary LP who sold the secondary state was at least getting commentary from the GP about how the deal was going. There isn’t a guarantee the new buyer of the LP stake will keep getting ongoing information. Getting information on a startup’s performance is famously difficult and founders are often lacking in their reporting, VC funds are often opaque, and the further you get, the worse it gets.
(3) Accountability:
I think this one is the most overlooked. In a normal venture capital deal diligence process, there is often a level of trust on both sides. If there is something wrong with a business, there is a higher likelihood that management will work with investors to address and represent the issue during an investment process. As a founder, it’s very awkward for a VC to come into a deal and then find out about something really horrible in the first board meeting. There are always some negative surprises (and positive ones too) that weren’t caught in DD. But rarely is there something truly existential or terminal. Why? Because the founder knows they’re going to have to be in business with that venture capital firm for the next 5-7 years. There is a level of accountability because they know that the investor is going to find out eventually if they are on the board, and that they are going to have to keep interacting with that board member for a long time thereafter.
That accountability doesn’t exist in private equity or buyout deals, because in those deals they are large and can afford teams of associates, VPs, consultants, operating partners etc to examine every single part of the business. This is a level of DD WAY outstripping what is available in secondaries.
So even though the same level of trust doesn’t exist, it doesn’t need to, because of the level of primary DD buyers can do.
In secondaries, you lack accountability, AND you lack the ability to do the DD that makes up for it.
In practice, this means that companies who have started to see a slowdown of growth, or know they may face some regulatory headwind, or who know management may be having its own issues often sell secondaries at their last valuation, knowing something is materially wrong with them. This doesn’t always happen (and shouldn’t happen), but it happens often enough that it’s a problem. As an LP, if you could only sell your over-valued positions, and not your under-valued positions, and there was no consequence if the buyer of the asset lost money, wouldn’t you just sell the deals you didn’t want? And if the buyer doesn’t get to do primary diligence, how would they know?
(4) Negative Selection Bias:
LPs want to sell their worst stuff, and keep their best stuff. Self explanatory.
(5) Liquidity:
It is very difficult to control the sale of a position. Venture capitalists have historically proven they are not good at getting out of their winners at the right time, and while being an LP doesn’t give you the power to get out, it does provide the power of influence that a secondary buyer doesn’t have.
(6) Governance:
There is usually very little ability to own enough of a business to influence any level of power or decision making that a primary buyer has. That governance is baked into the valuation of the company and a secondary buyer has to accept that price without much governance. At that point, the tradeoff becomes less attractive relative to public markets with better liquidity and arguably, better ability to influence management.
While each of these can be overcome, when grouped together, they make for a very difficult business model. If there has ever been a time to do secondaries in venture, now is the time, but these challenges are big parts as to why the market has never gotten as big as I assumed it one day would.
Figuring out how to create alignment and accountability are the top two items I flag to our friends and investors who are starting to get into the market.
This is a personal blog collaboration. All views and opinions expressed are those of the authors and do not necessarily reflect the views or opinions of any organizations the authors may be affiliated with. This website and the information contained herein is not intended to be a source of advice with respect to the material presented, and the information contained in this website does not constitute investment, tax, or legal advice. We make no representations as to the accuracy, completeness, correctness, suitability, or validity of any information on this site.