Twenty years ago, venture could look confidently down two paths to portfolio-company exits: public offerings and tech-company M&A.
Not so much anymore.
Sure, nice deals take place. Workday, Veeva Systems and Tableau Software did IPOs in recent years. Cisco and IBM keep buying.
But for the third year in a row, overall exits of venture-backed companies fell in the U.S. in 2017 and considerable assets remain bottled up in aging funds.
For the six vintage years 2005 to 2010 combined, which should be seeing substantial distributions, almost 97 cents of every invested dollar remains inside a fund, Cambridge Associates data shows.
But a solution might be on the way. New paths to liquidity in venture are opening up, and they could leave the industry looking quite a bit different.
First on the list: secondary-market transactions, which not long ago drew considerable attention when Softbank and others spent about $8 billion for Uber shares. Secondary deals are finally offering investors an attractive avenue to sell stakes.
An alternative path to partial liquidity also is showing up in private-equity-backed M&A, which has been on the rise. At the same time, other new buyers of portfolio companies have emerged from the ranks of non-tech companies that are concerned as business models in their industries change rapidly.
Looking ahead, initial coin offerings could provide an additional market-based mechanism for finding liquidity, if digital tokens can clear their trading hurdles. This may take several years.
Together, these new alternatives for liquidity promise to move the needle on returns. And they illustrate how a maturing industry requires, and evolves toward, financial flexibility.
“Venture capital is growing up,” said Venky Ganesan, a partner at Menlo Ventures. “We have tried to be the Peter Pan of asset classes by staying young. We are institutionalizing as an asset class.”
Such a turn of events could bring considerable benefits. With companies delaying IPOs amid a massive move from public to private ownership, new ways to harvest capital could enable a steadier stream of returns to LPs.
They also could enhance portfolio management and encourage risk reduction while facilitating the shift of a company’s investor base from early- to growth-stage backers.
Perhaps most important, the new paths to liquidity underscore how outdated the traditional exit model of the 1990s has become and begin to address the obsolete notion of a 10-year fund life with two-year extensions.
“I think we’re in another change-making period,” said David Blumberg, a managing partner at Blumberg Capital.
The most immediate of the new channels is secondary transactions, where early investors are finding opportunities to sell shares in large growth rounds, such as with WeWork, Flipkart and Uber, the current poster child of the trend.
“VCs aren’t going out and seeking secondary sales, but I think they are becoming more opportunistic about companies that are exciting to the market,” said Samuel Schwerin, a managing partner at Millennium Technology Value Partners. “This is a leading indicator.”
Attitudes appear to be changing, even if so far deals are relatively few in number. Established firms are increasingly open-minded, such as Benchmark and Menlo, which participated in the Uber deal. Portfolio management is a big reason why.
“It is important they take chips off the table along the way and send some of the gains back to their LPs,” says Kirsten Morin, co-head of global venture capital at Aberdeen Standard Investments. “[Secondary] sleeves in these massive financings could become one of those release valves.”
More reticent are angels and super angels because of the discounts they would have to accept.
“A lot of them have talked about it,” said Ken Sawyer, a managing director at Saints Capital. But when it comes to pricing, “the angels are still struggling with that.”
Financial management was clearly an element of Menlo’s decision in the Uber deal. The firm sold half its position and received a 93x return on its initial investment.
“All of us felt bullish about the company” and believed it would eventually trade north of $100 billion in value, Ganesan said. But after seven years, “it felt like a prudent thing to do. We had the flexibility to return a significant amount of capital to our LPs.”
With longer holding periods for portfolio companies, secondaries provide more exit choices, and that is better for investors, he said.
Risk reduction similarly was a motivation for Blumberg Capital. In a 2013 secondary deal the firm sold some shares in HootSuite for a 52x return. The transaction brought flexibility and didn’t require the company to be sold.
VCs get to tune their portfolios between growth and liquidity, he said.
Supply is another critical issue that will give momentum to the deals. With giant pots of late money floating about (such as SoftBank Vision Fund and Sequoia Capital’s anticipated growth fund), finding enough primary shares to satisfy ownership targets won’t always be possible. From this perspective, secondaries may be less an option and more a necessity.
Also telling is the interest hedge funds are showing toward late-stage companies. Demand for fast-growing private companies is strong.
“These hedge funds have almost blazed a path for the venture and institutional investors,” Schwerin said.
If deal volume ticks up, secondaries are almost certain to become huge difference makers for firms and funds. Secondary-market trading of private-company shares this year is expected to climb to about $27 billion. If early-stage investors were to participate in just 20 percent of the transactions, they could generate $5 billion, a substantial sum.
Private-equity acquisitions are providing another critical avenue to liquidity. In 2017 alone, PE buyers accounted for almost $7 billion of venture-backed exits with deal volume up by a third, according to PitchBook and the National Venture Capital Association.
PE buyouts aren’t new to the industry, but low interest rates and active PE fundraising have driven a recent surge and the activity is expected to continue. The stable, predictable revenue streams of maturing SaaS companies have become more attractive to buyers.
Proof of this interest is reflected in the multiples they offer, which are now similar to those from strategic buyers. Deal sizes have climbed, too. The median PE acquisition of a venture-backed SaaS company increased to $250 million, five times the figure in 2010, according to Tomasz Tunguz, a partner at Redpoint Ventures.
The benefits are easy to see.
For instance, in August when Providence Equity Partners invested about $200 million for a majority stake in Blumberg Capital’s DoubleVerify, the firm sold a third of its position for what was a “solid multiple,” Blumberg said. DoubleVerify’s technology is strong and “the company had performed extremely well, so we had a very nice gain on our investment.”
Another payday could be ahead.
PE deals, such as DoubleVerify’s, “make our portfolios less lumpy and make the holdings more versatile,” Blumberg said. “They meet the needs of a lot of participants.”
Blumberg expects to see more of them.
Another firm to take advantage is IVP. In 2014, Permira offered to pay for a controlling interest in portfolio company LegalZoom, which pulled its planned IPO.
IVP sold a third of its holdings and kept two-thirds, which amounts to about 11 percent of the company. Kleiner Perkins Caufield & Byers also is a holder.
“We really liked the business and thought it had great potential,” said IVP General Partner Steve Harrick.
IVP received a 2x to 2.5x multiple on the deal and has since benefited from a $50 million dividend. Harrick said he expects an eventual 5x return from the investment.
PE deals may not change the way venture investors think about deals, Harrick said. The key elements of assessing a company remain the same: its market opportunity, management, pricing power and competitive environment.
But they increase investor confidence that liquidity options will be available. This is especially true for slower-growing mid-tier software companies in good markets.
“You feel better about being able to get liquidity for your portfolio,” Harrick said. “I think it’s a permanent presence in the ecosystem.”
ICOs also could offer liquidity options, though not for a while. Tokens price every day, but float size and other challenges remain, including rewriting limited partnership agreements to permit ICO investments.
“At some point, it is going to become a mechanism through which those managers who are investing in blockchain technologies can monetize their positions,” Morin said.
Mark Radcliffe, a partner at DLA Piper, also is convinced the day will come. He estimates freely trading tokens may be a reality by the end of 2019.
“It’s too powerful a fundraising option to be shut down,” Radcliffe said. “I think we will see a trend toward the greater use of tokens by venture-backed companies.”
So far, a few firms have adjusted LP documents to permit investments without voting rights, which tokens don’t have. But this will change.
Perhaps the greatest hurdle will be the SEC, which has stood by its belief that a token is a security and therefore only licensed exchanges can trade them.
Clearly there are details to work out.
Photo of investor considering liquidity options by Allison Brown for VCJ. Images based on Brosko/iStock/Getty Images, Ivan_Mogilevchik/iStock/Getty Images and Evgeniya_Mokeeva /iStock/Getty Images.