What the IPO crisis means for Venture Capital
I have always found the VC world to be interesting; GP’s are the enablers of technological innovation. VC funds act as the bridge between entrepreneurs and investors, or between the spaceship and the fuel. And throughout the last 50 years, they have done a spectacular job; funding world-changing innovations like Apple, Microsoft, Google, Amazon and more. They even funded defiant and ballsy concepts like PayPal, Uber and AirBnB. Since GP’s are the ones funding these disruptive projects, you would think that they themselves would be constantly exploring ways to innovate their own field — but this is far from the case.
Before WWII, investing in startups or young businesses was limited to ultra high net worth individuals and family offices, such as the Rockefellers and the Wallenbergs. Until in 1957, Georges Doriot, also known as the father of VC founded the ARDC fund — a fund raised to invest in small businesses ran by former WWII soldiers. ARDC became the first fund to raise capital from sources other than wealthy families, (although it had several notable investment successes as well). In 1958, the Small Business Act was passed in the U.S., which lead to the accessibility and popularization of VC funds. Than in the 1980s, the internet gained tractions and startups like Digital Equipment Corporation, Apple Inc., Genentech started to make some noise — which lead to the development of the VC industry as we know it today. In 2012, Barack Obama introduced the JOBS act, enabling retail and accredited investors to invest in alternative assets. This enabled emerging businesses to meet their funding requirements on the private market, while avoiding the burdensome and expensive IPO process.
Even though VC has enabled world-changing technology, there has been very little change in the Venture Capital structure itself. The same waterfall structure used in 1957, usually along the lines of a “20% carried interest with a 7–10 year lock-up period and a 2% management fee” is still used today. Not only that, the entire process, including: suscription, LP management, distribution and, most importantly, secondary market transactions; are still paper-based and performed manually.
“A VC partnership is a 10-year blind-pool — a long relationship in which investors have limited ability to exit, and no clarity of outcomes.” Mahendra Ramsinghani
One of the main reasons why there has been little change in VC structure is because many GP’s appreciate the obscurity and cumbersomeness. The obscurity allows them to operate with less accountability to investors and the cumbersomeness of selling LP interests on the secondary market creates friction for the LP’s, who would like to sell. This leads to LP being less enticed to perform secondary market transactions and hold their interests until the end of the commitment. This is great for GP’s because they do not have to worry as much about LP’s selling their interests on the secondary market, even though they might need to restructure their portfolio or need the capital for another investment opportunity.
Now, you may ask yourself, why aren’t fund sponsors more concerned about this situation? The answer is twofold: investments in VC or P-E funds only compromise between 1%-3% of their total investment portfolio and these are very high risk investments or an alternative investment.
But this is rapidly changing. Leading companies, such as AirBnB, Robinhood, Pinterest and more are now deciding to stay private for a lot longer. The amount of IPO’s decreased by 50% throughout the last 20 years, meaning that top investment opportunities for institutional investors are no longer found on the stock market but through private placements. The best way for accredited investors to access these exciting investment opportunity is through VC funds. As a result, pension funds, academic endowments and family offices are now allocating a larger portion of their budgets to investments in VC and P-E funds.
Meaning, that since a more significant portion of institutional investors’ portfolio is now placed into private placement funds, LP’s are now starting to pay closer attention to the obscurity and cumbersomeness of investing in VC funds and are now beginning to demand transparency and efficiency.
Previously companies would IPO within 5–7 years. Now, the most common means of returns for a VC fund is when a portfolio company gets acquired; which takes a lot longer than an IPO, ranging from 10–12+ years. As a result, GP’s are now setting longer lock-up periods and reserving the rights for more extensions.
This is why the private placement space will radically change. Not only are institutional investors allocating a larger portion of their budgets to VC funds but the lifecycle of these investments are now twice as long. Meaning that, eventually LP’s will no longer tolerate the inefficiency and cumbersomeness of the current VC structure, since they are now more invested and that the lock-up period is a significantly longer. Longer lock-up period also increase the likelihood of situations where LP’s need to liquidate their interests. These reasons include, restructuring their portfolio, conflict of interests or lack of liquid capital.
These changes will ultimately lead to the secondary market for LP interests growing exponentially.
Problem being: the P-E secondary market is not built for this kind of scale. It is manual, paper-heavy, reliant on redundant intermediaries (such as clearinghouses and escrows), can cost up to 5% of the asset’s value and take several months to settle.
Next: Why Digitalize Secondary P-E Transactions? (Stay Tuned)