Niche No More: Navigating the Venture Capital LP Secondary Landscape

Introduction to Venture Capital LP Secondaries

In the broad landscape of venture and growth investment (VC) opportunities, VC limited partnership (LP) secondary investing has emerged as a compelling strategy, especially in the current economic environment. To start, it’s worth walking through the typical structure of a closed-end VC fund. VC fund managers (GPs) raise committed capital from limited partners (LPs) and call on this commitment over time to make investments. VC funds typically have a 10-year fund life, and during that time LPs have no liquidity option available to them and must wait for the GPs to distribute proceeds from the exits of underlying investments.  

VC LP secondary transactions offer flexibility and liquidity in an otherwise relatively illiquid asset class. These transactions occur when an existing investor in a VC fund sells their interest to another investor. LPs may look to sell an existing fund investment for many reasons - an institutional LP (a pension, endowment, or fund-of-funds) may be facing pressure for liquidity to make new commitments or have a need to rebalance their portfolio. “Non-traditional VCs” such as corporations, sovereign wealth funds, and hedge funds that entered the market in 2021 may be facing pressures to revert to their more traditional core strategies.  In these transactions the buyer assumes the position of the seller, taking over their capital commitment obligations and rights to future distributions. Being a buyer in these transactions can be complex and requires careful due diligence, as it involves assuming ownership of assets that are not publicly traded in a situation where the seller typically has an information advantage.

The rise in interest rates since 2021 in response to inflation has had a chilling effect on traditional exit avenues for VC-backed companies. Both IPO exit and M&A activity have declined materially since reaching record levels in 2021 – this lack of liquidity is resulting in significant supply in the VC LP secondary market from increasingly eager sellers which presents a compelling opportunity for the Nicola Venture Capital LP (NVCLP).

Venture Capital LP Secondaries Market Overview 

Secondary investing in private markets first emerged as early as the 1980s but began to experience strong growth in the early 2000s, with large, dedicated secondary investment firms like Coller Capital and Adams Street Partners being among the first significant entrants. Historically, dedicated secondary funds primarily focused on private equity LP interests and only reserved a small portion of their funds for VC secondaries. More recently a number of specialized VC secondary buyers have emerged and raised significant amounts of investor capital. In the early days of this market, there was some element of reputational risk associated with selling a fund position in the secondary market but today LP sales are commonplace and accepted as a valid alternative liquidity option. LP secondary volumes across private equity and venture capital reached record levels in 2021, before falling in 2022 and rebounding slightly in 2023. The decline from peak levels likely isn’t due to a lack of buyers and sellers, but a wide gap between buyers’ and sellers’ perception of value. As seller liquidity needs have grown more pressing and as GPs increasingly bring their valuations more in line with public market comparables, we are seeing this value perception gap narrow. The narrowing value perception gap, the significant amount of unrealized net asset value in existing venture funds, and the proliferation of dedicated VC secondary specialist funds are all likely to be tailwinds for sustained strong activity. 

Source: Jefferies Global Secondary Market Review, January 4, 2024

The Opportunity for the Nicola Venture Capital LP 

Increased Demand for Liquidity Driving Strong Supply:  There is a significant amount of investment value held in existing venture funds today and as we mentioned above, the pace of distributions from sales and IPOs has slowed materially. There are estimated to be over 1,300 venture-backed Unicorns (defined as private companies with a valuation over $1B) in VC portfolios today totalling over $4.6T in value on paper. Even if exit activity picks up, this backlog will take time to convert to distributions – in 2021, the most active year for exits ever recorded, 209 Unicorns went public or were sold(2). Dedicated VC secondary investor, Industry Ventures, also estimates that there is over $1.1T of unrealized net asset value in venture funds that are 2016 vintage and older. In place of distributions from traditional exits, LPs in older venture funds are seeking other liquidity avenues and the secondary market is a viable alternative.

Discounted Pricing: Secondary interests in venture funds often trade at a discount to their net asset value, presenting a unique opportunity for buyers to enter mature VC investments at attractive prices. Average discounts on secondaries in VC funds widened significantly in 2022/2023, a reflection of both seller desperation for liquidity and the gap between net asset values and market realities. Some secondary investors favour highly diversified portfolios comprising many underlying funds and a wide optical discount, but our focus is on smaller fund portfolios where we can use a bottoms-up approach to examine / stress test each of the underlying company valuations to validate net asset value and pricing.

Diversification: While committing capital to top-performing GPs remains a significant part of our strategy, these funds invest capital over several years, so it takes time to deploy cash in this manner. We continue to opportunistically look at direct investment opportunities, but we are keenly aware that diversification is particularly important in venture capital. Investing in LP secondaries allows us to invest more significant capital in a highly diversified manner across multiple fund vintages without waiting years for our capital to be deployed. 

Time to Liquidity: Purchasing stakes in more mature funds means that there will be minimal capital calls for the secondary buyer to meet, and the companies in the underlying funds are often of greater scale and margin maturity and are therefore theoretically closer to being IPO/exit ready. Compared with a new venture fund, which may take 5 years or more to start returning capital, we typically expect to see a more rapid return of capital from a secondary investment. Given the lack of activity in exit markets today, our assumptions for return of capital pacing on secondaries are highly conservative, and our focus is on acquiring fund positions comprised of high-quality underlying companies that can continue to grow in a capital-efficient manner, even in less favourable economic environments. We spend a significant amount of diligence time evaluating the quality of these underlying companies and the timing of the potential exit avenues available to them.  

A Focus on Quality 

While the venture LP secondary market offers compelling opportunities, it's not without its pitfalls: 

Lack of Transparency: The private nature of these investments can lead to a lack of transparency about the underlying assets' true value. LP-led secondary transactions are often completed with very little involvement from the underlying GPs, so buyers sometimes must rely on little information to reach a decision. Often a late-stage technology company will have multiple VC investors but one VC’s view on valuation only tells part of the story. When we conduct our diligence, we are focused on opportunities where we can use our network to backchannel for information on the largest assets in a portfolio, gathering datapoints and other insights on how the companies are performing and being valued by other investors. We focus only on opportunities where we have an information advantage.  

Transfer Rights: VC GP approval is required any time an LP is looking to sell their position in a fund. Often, some of the top VC GPs are highly restrictive on which secondary investors they will allow to purchase LP interests in their funds. They favour other existing LPs, or large, well-capitalized groups that they think may have the ability to make primary commitments to their future funds. While some deal flow comes to us directly from placement agents, in many cases this means that we need to work with a partner to access the highest quality opportunities. In 2023 we set up several such partnerships with secondary specialists with proprietary relationships, and with long-tenured venture fund-of-funds platforms – these firms have decades long relationships with VC fund managers and are considered “approved buyers” of many of the best LP secondary interests. These relationships also improve our ability to access information to properly underwrite an investment – but it is still important to do significant research of our own to validate what is presented to us.  

Valuation Complexities: Determining the fair value of illiquid assets in venture funds can be challenging and subjective. As mentioned above, these LP secondary interests are typically priced at a discount to net asset value. In today’s market we think of this discount as having two components – 1) a liquidity discount (the discount the buyer is willing to accept for cash today) and 2) in cases where NAV is overvalued or portfolio quality is mixed, a discount to more closely reflect true market value of the portfolio. If you purchase an LP secondary position with an especially wide headline discount, you might be purchasing assets that are overvalued and therefore you could expect net asset value to decline over time. We are focused on situations where net asset value closely reflects market realities, and where the discount is primarily the result of a seller being particularly motivated to seek early liquidity.  

Mixed Quality in Larger Portfolios: We are focused on investing in the LP interests of top quartile performing VC fund managers. Often LPs are looking to sell a large portfolio of fund investments all at once, and sometimes high-quality assets are stapled together with a long tail of lower quality assets that are difficult to underwrite. Our preference is to transact in situations where we are assessing only a handful of high-quality fund interests, each with a few material underlying companies with strong future growth prospects. 

Conclusion

The venture/growth LP secondary market represents a compelling investment frontier, especially in today's environment. However, like all investment opportunities, it requires due diligence, an understanding of its complexities, and an awareness of the associated risks. For investors looking to diversify their portfolios and potentially capitalize on the growth of private companies and current pricing dislocation, the venture LP secondary market demands consideration. As the market continues to evolve, staying informed and engaged will be key to unlocking its full potential. Whether you're a seasoned investor or new to the game, the venture LP secondary market is a space worth watching. 

Key Takeaways: 

• Venture LP secondaries provide liquidity in a market otherwise known for its long-term, illiquid investments. 
• Current economic factors, such as the slow pace of venture-backed company exits, have amplified the importance and attractiveness of these secondary markets for both buyers and sellers. 
• While offering the potential for attractive pricing, investors must navigate the valuation complexity and lack of transparency carefully – this requires a strong bench, deep due diligence and a robust network.  
• By understanding the structure, opportunities, and risks of the VC LP secondary market, investors can better position themselves to make informed decisions. This market is not just a place for financial maneuvering but a testament to the dynamic nature of investment strategies in the face of changing economic landscapes. LP secondaries are an important strategy for a diversified VC program and a key focus for NVCLP.