Secondaries Primer Part 2: Why sell?
In Part 1 of this series on secondaries, I covered the basics and history of the secondary market. In this post, I’d like to dive deeper into the motivations for selling prior to a liquidity event and seemingly forgo further upside.
The most common motivation behind secondary sales is the desire for liquidity. Historically, sellers have been individuals and institutions who sold at a steep discount due to distressed circumstances. The secondary market rose to prominence following the dot com crash as investors wanted out of underperforming investments and needed to generate cash to cover other losses.
Today, while the desire for liquidity remains at the heart of most secondary transactions, sellers are often not selling from positions of distress. If you recall from Part 1, venture investments (either directly into a startup or into a venture fund) have long time horizons to exit and those time horizons have only lengthened in recent years. This longer holding period and higher valuations are causing shareholders to consider selling on the secondary market due to large paper gains that they cannot access rather than selling because they are distressed.
Below I lay out different possible sellers on the secondary market and their likely motivations for doing so.
Founders & early employees
Founders and many early employees who had been granted stock are likely fully vested well before a company goes public these days. Even though these employees could be sitting on stock that is worth tens of millions of dollars, they may not be able to afford to buy a house, pay down their debt, or save for their kids college tuition because they have no way to access that wealth. Often times these early employees took a below market salary in exchange for large potential upside and now want to cash in on some of that. In other words, they are paper rich but cash poor. Secondary sales authorized by the company alleviate some of this pressure by allowing early employees to take some chips off the table.
Employee tender offers are becoming more common for the following reasons:
- Provides financial stability and allows founders and employees to do things such as buy their first house, pay down debt, pay for kids schooling, etc.
- Diversify their holdings. Most, if not all of their net worth is likely tied up in this company, especially the founder. Taking some money off the table and reinvesting it in other areas greatly reduces personal risk.
Angels
Angels are typically the earliest investors in a startup and by the time a company has become successful, they have likely already been invested for a significant period of time. Individuals have different liquidity needs than professional investors. While motivations for liquidity vary widely among this group of investors, potential reasons could include a desire to buy a new house or car, pay for their kids or grandchildren’s college tuition, or simply want to keep investing in more startups and need some liquidity to do so. This means that many angels are likely happy to sell part or all their position to realize a gain rather than hold onto the stock until an IPO.
In addition to different liquidity needs, most angels do not face the same return profile targets as VCs (unless they are professional angels and as such, behave much more like typical VCs). Smaller multiples on a single investment might not move the needle for a venture fund but could be a great outcome for an angel investor. Angels also do not have outside investors with target return expectations or fees they have to clear to make money. Finally, because they are often the first money in, their cost basis is lower than most institutional investors. As a result, a smaller outcome can be very meaningful for an angel but not for a traditional VC. It makes sense that many angels are more than satisfied to lock in returns now rather than continue to ride out an investment even if the upside is bigger.
Family Offices
While there is a wide range of sophistication among Family Offices, generally speaking, this group of investors might not have the same level of commitment to illiquid asset classes that institutional LPs often do. This group is also more likely to have shorter investment time horizons, be more susceptible to macro conditions, and have higher level of liquidity needs. Sometimes investing in startups or VC funds falls out of favor with the decision makers and they would prefer to reduce their exposure to this asset class in order to invest in something else. As a result, a Family Office might be willing to liquidate their stake in company or fund well before the investment has fully run its course.
General Partners (aka VCs)
General Partners are increasingly turning to the secondary venture market to sell both strong and weaker performing investments. Some investors use the secondary market to sell off the “tail-end” of an existing fund that has reached the end of its ten-year term. In addition, early stage investors might use the secondary market to sell investments (or a portion of their investments) in order to lock in investment gains and distribute capital back to their investors. Fred Wilson had a great post on exactly why it’s often prudent to take some chips off the table.
In addition to smart portfolio management, the secondary market can be a great tool for GPs to use when considering raising their next fund. Selling some stock and distributing capital back to LPs improves the fund’s performance numbers and puts cash back into the hands of LPs who can then reinvest a portion of that money back into venture funds, thus making it easier for GPs to raise subsequent funds. Furthermore, some secondary funds have a hybrid model in which they will buy out an existing LP in a current fund and then commit to investing in the next fund. Because of this, GPs can partner with those who are likely to be more long-term oriented allocators and lock in commitments for their next fund.
Altogether, the secondary market allows General Partners to:
- Lock in returns given market conditions or portfolio performance
- Generate realized gains to distribute capital back to their LPs
- Wind down an older vintage fund
- Refocus time and energy on newer companies and investment areas
- Relieve pressure from LPs who are seeking liquidity
Institutional LPs
One key development in recent years that is driving more Limited Partners (or LPs for short) is the desire to take an increasingly active approach to managing their private equity portfolios. As a result, many have begun to use secondary sales as a portfolio management tool to obtain liquidity or rebalance their portfolio at various times in the investment cycle. This trend is likely to continue and intensify over the next few years, as LPs re-shape their holdings in response to economic conditions and focus more of their commitments on a core group of preferred managers.
The secondary market gives Institutional LPs the ability to:
- Lock-in gains from a high performing investment
- Achieve full or partial liquidity to generate cash for other uses
- Eliminate or reduce liability from further capital call requirements
- Rebalance their portfolio, address any risk management concerns, and ensure sufficient diversification with regards to vintage, geography, sector, stage, etc…
- Generate tax gains and losses
- Re-focus on core GP relationships
- Execute an investment strategy change or asset allocation change
- Adhere to regulatory changes and obligations. For example, new regulatory regimes for banks and insurance companies such as Basel III and Solvency II, have prompted significant secondary selling in the last few years.
- Divestiture of tail end funds
As you can see, while the motivations vary greatly among the various players, each has valid and logical reasons for selling a portion or all of their position prior to an IPO. As companies remain private longer and valuations continue to increase prior to IPO, I suspect we will see the secondary market be used more often as a tool to find liquidity for various parties.
