Venture Capital Secondaries: Exits for Yesterday and Tomorrow

We wanted to follow up on our earlier insights, “Unlocking opportunities: The rise of VC secondaries in democratizing venture capital,” with some recent observations from our conversations with players in the market. 

As cash distributions from VC investments continue to decline, venture capital funds face increasing pressure to find exits and realize returns for their investors. Venture IPOs and M&A activity have been few and far in between in recent times, and investors are keenly focused on DPI ratios, which have fallen notably over the past few years.

Innovation-driven paradigm shifts 

While global economic conditions have not proven favorable to VC investors and managers alike, there has been an ongoing paradigm shift driven by innovation itself. The shift by VCs from an era of mobile technology and internet-related opportunities to AI, battery technology and electric vehicles, raises uncertainty as to whether VC will still be able to provide the “unicorn” rates of returns that have made venture investments attractive to more risk-tolerant investors.  

While apps and internet-related products were quickly monetizable upon deployment over the last decade, many of those markets are now saturated with mobile games, social media apps and content creator platforms. VC investors looking at AI and battery technology are straddling the line between venture capital investments (typically requiring smaller amounts of seed funding with shorter exit horizons and higher return) and infrastructure investments (typically requiring more capital and more time to develop into marketable products and services and yielding steady but lower returns). 

In tandem with VC’s pursuit of these new, more capital-intensive opportunities, the dearth of exits from existing positions has put pressure on many VC funds’ fundraising efforts. It also has resulted in some LPs seeking liquidity through a secondary sale rather than waiting for distributions, as such investors are under increasing pressure to not only realize returns but also to replenish their capital for future deployment. 

All of these factors have driven growth in the VC secondaries industry. Many LPs have turned to secondary sales to rebalance their portfolios and, with attractive pricing, a number of secondary buyers have raised dedicated VC secondaries funds to focus on these opportunities.  Other buyers are attracted by the opportunity to gain exposure to VC funds they couldn’t otherwise access.

The growth in VC secondaries is not limited to sales of VC fund interests, however. VC managers are increasingly looking to GP-led restructurings and tender offers as a potential solution to provide liquidity for their investors, despite secondaries having historically been uncommon in the VC industry. 

The impact of industry shifts on secondary transactions

Relating this to the change in focus by VC investors, the assets transacted in secondary sales often originate from the previous wave of VC investments. This includes some of the most frequently traded start-ups in secondary sales and purchases this year. These businesses are relatively recent yet fairly established, with some considering them as "unicorns". Their status as later-stage VC investments helps in reaching a more accurate valuation and provides a higher degree of certainty on returns for investors.

The path forwards for VC exits?

Since the pandemic, the general trend was that secondary purchases of VC assets were increasingly transacted below reported net asset values.  While this trend appears to be continuing at least as of the first half of this year, the pricing gaps and discounts have generally narrowed compared to recent years.

In many respects, secondary transactions are the natural and obvious path forward for VC exits.  While it is probably less likely that VC investments will be traded on the secondary market at the same volume as private equity investments any time soon, the shift towards VC investing in more infrastructure-esque assets can foreseeably fuel the drive for even more VC secondaries, as today’s early stage investors placing their bets in battery technology, electric vehicles, AI, and the like will eventually need to find liquidity for this new breed of longer-hold VC investments that may not provide the more traditional venture risk/return profile.

What is certain is that many investors have set aside any lingering hesitation with respect to secondary transactions and are embracing GP-led restructurings and tender offers as another useful tool in their arsenals.  Given the early-stage nature of VC investments, it is foreseeable that secondary transactions of VC assets may become part of the industry norm for VC exits, including where buyers and sellers agree on a premium over net asset value rather than to a discount. 

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