One of the biggest unknowns in venture these days is the value of private unicorns.
Will the capitalizations of these billion-dollar-plus companies hold up in the public market, if they are lucky enough to get there, or will they wither under public market scrutiny, with on-paper IRRs disappearing like early spring flowers?
The answer might be found here, in the secondary market, where trading has evolved in the past year to better reflect the dynamics of a public arena for buying and selling.
For many observers, the growing scale of the market gives it new credence.
“The market is functionally more like a market” now, said Hans Swildens, founder and chief executive of Industry Ventures. “I think that market of unicorns is going to perform a little bit like a public market, where you are going to see winners, losers and somewhere in between.”
This transformation shouldn’t come as a surprise. Activity in the secondary market has steadily increased over the past several years as illiquidity in venture led LPs, GPs and startup employees to look beyond traditional IPO and M&A exits for cash.
At first, secondary buyers felt they missed the unicorn price run up and eagerly jumped in. Now a greater skepticism has stirred crosscurrents, and discounts for companies, amid fears the up cycle may have run its course.
The market seems prepared for this role.
Market researchers estimate global secondary volume, including buyout, venture, distressed debt and real estate, is headed toward another record this year, rivaling the recent peak year of 2015. If combined, global deal making reaches the more than $40 billion that market monitors project, the venture share of the total could be an estimated $3 billion, or between 5 percent and 10 percent of the total, with about $2 billion targeting the U.S. market. It is a substantial sum likely to increase fluidity in the market for unicorns, even before adding in the trading of so-called direct secondaries, those shares from ex-employees and company founders.
Both the supply and demand sides of the equation are contributing to this expansion.
On the demand side, fundraising by secondary funds also is at a record pace this year, with $23.2 billion raised through mid-year, according to Preqin.
This suggests $1.2 billion or more of new money has started to chase venture secondaries, or about 5 percent, with close to $800 million targeting venture specifically in the North America market. Another 45 secondary funds are looking for money, with the aim of raising an additional $32.4 billion, Preqin reported. So an additional $1.6 billion or thereabouts could be on the way to venture, if fundraising efforts succeed.
With plenty of capital, new buyers are active. Hedge funds have returned to the market, such as Coatue, according to industry sources, and family offices, corporate venture arms, secondary firms, such as Lexington Partners, and special purpose funds targeting specific companies are ramping up their efforts. Sovereign wealth funds also are looking, and so is SoftBank Group, with its $100 billion Vision Fund, which could ultimately have a significant impact on the market and created waves in August with the news it was considering investments in Uber or Lyft.
With the cash has come with a structural transformation of the market. A large company in the secondary market used to have a valuation of $200 million to $300 million. Now capitalizations are in the billions and sometimes tens of billions, with greater resources needed to get deals done.
The supply side is fueling the market, as well. LPs with interest in selling are more numerous. In a second quarter survey, Preqin found 43 percent of firms considering secondary sales in the next 12 to 24 months are poised to unload venture assets, up from 35 percent in a similar study from 2016.
Secondary market fund managers have taken noticed. One reported fielding half a dozen potential sales opportunities a week.
“I think there are a lot of LP positions moving around,” said Larry Albukerk, a managing partner at EB Exchange. “There’s definitely a lot more money, and the buyers are writing much larger checks.”
Secondary pricing this year reflects the momentum. Greenhill reports that average high bids on venture offerings rose to 82 percent of net asset value in the first half of 2017, compared with 75 percent in 2015.
“That’s quite significant,” said Patrick Adefuye, a commercial manager of secondaries at Preqin. “If you’re a potential seller, you are going to be more willing to sell.”
It shows “there’s more money chasing deals, so there is more demand,” Adefuye said.
All this has created several concurrent trends. First and foremost, the market enthusiasm hasn’t translated this time into broad, across-the-spectrum demand for unicorns. Instead, greater skepticism has taken over, with a small group of top unicorns able to maintain pricing premiums of up to 5 percent, and others facing discounts of as much as 45 percent during the first half of the year, according to a study from NYPPEX.
A significant change in shareholder sentiment toward unicorns has taken place in the past 12 months resulting in lower offering prices, NYPPEX said.
Second, where buying interest has been surprisingly potent is with the growing inventory of newer vintage funds, which have come to the market at the expense of older, end-of-life assets, and with non-unicorn shares, as investors look for the next breakthrough companies. This activity is likely behind 2017’s shrinking overall discount.
Where the discounts have run deeper is with unicorns, especially those that haven’t re-priced with new rounds in the past year, and in particular with those that had up rounds in their previous financing.
This is mirrored in the secondary direct market, where more conservative price expectations from former employees and founders have led to an uptick in transaction volumes.
In other words, a dose of unicorn realism has set in.
“There is a little more scrutiny and caution,” said Howard Lee, a managing director at Founders Equity Partners. “I think there is a pull back in trading what you call unicorns.”
This pullback explains what some traders say has been an increase in the use of deal structure to buoy current pricing levels and offer guaranteed returns to buyers. By some estimates, as many as a third of LP-related transactions now rely on structured terms, maybe triple the percentage of 2015.
In some cases, these terms require sellers to put extra stock in escrow to guarantee buyers a minimum return should the shares fall in price. In other instances, structure has come in the form of a pledge from buyers to share the upside if shares bought at a discount perform better than anticipated. Still other deals have given buyers the flexibility to pay over time and forced sellers to place guaranteed IRRs on strips, where they sell a broad slice of a portfolio.
According to some market participants, structured deals have become more prevalent again after receding in the years following the great recession.
“The trend is very clearly going up,” said Samuel Schwerin, a managing partner at Millennium Technology Value Partners. “The way the bidders try to compete with one another is with structure.”
“There are a lot of these structured deals out there,” echoed Albukerk.
All this has made unicorn secondaries a more diverse, less homogenous market with investors playing the role of sorting out winners and losers.
The result is a short list of perhaps 30 unicorns that remain in high demand with access still difficult and pricing at a premium. But even some of the most heavily traded stocks – such Uber’s, Airbnb’s, SpaceX’s, Palantir’s and Lyft’s – see discounts from time to time.
Discounts also show up for such companies as Spotify, Instacart and Pinterest, traders say.
“The market is much more of a stock picker’s market than it was previously,” Swildens said. “I think it’s so big now it is its own market.”
The one caveat to its new role in pricing unicorns is portfolio balancing. In some cases, LPs are eager to sell part of a holding in a unicorn, willing to lock in profits even if it means accepting a lower price. At the same time, they hold onto a big chunk of remaining shares believing they could be worth more. Whether this distorts the market mechanism is hard to tell.
Still, in the past opportunistic sellers sold at high prices. Today there are diverse outcomes and greater reluctance, with late-stage funds doing fewer secondary financings and buyers willing to walk away from transactions.
“I think as a result, the pricing you’re able to get has a bigger discount now,” said Ken Sawyer, a managing director of Saints Capital. Yet “if you’re selective, I think you can do well.”
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