Secondaries Primer Part 3: Why Buy?
In my previous two posts, I covered the history of the secondary market and motivations for selling. In this third installment, I would like to dig into the investment rationale for purchasing stock or LP positions in funds on the secondary market rather than investing directly in a primary.
Before digging into why secondaries might be a compelling investment, let’s go over who the likely investors are. There are four main groups of investors I will cover:
Existing investors
One of the most common purchasers of secondary shares are existing investors within the company already. While some early investors may be looking for liquidity and willing to sell, there are often other investors on the cap table that are willing to buy. Existing investors know the company well, they likely have information or at least a good sense on the progress the company is making. If the company is doing well, then some investors might want to increase their stake in a company.
Many times, these transactions are kept confidential and the public never learns of them. However, there are some notable public instances of secondary investments paying off handsomely. Chris Sacca, an early investor in Twitter, was so bullish on the company that he famously raised additional capital to keep purchasing secondary shares. By the time Twitter went public, he was the second largest shareholder and most of that was done via secondaries.
More recently, Thrive Capital invested a total of $150m into GitHub. Of that $150m, $120m came via secondary purchases. When GitHub was acquired by Microsoft for $7.5 billion, it was the largest return to date for Thrive Capital.
New Investors
An emerging trend is the inclusion of secondary transactions alongside a primary investments by new investors. The most famous example was Softbank’s $10bn investment into Uber in 2017. Of the $10 billion Softbank invested, only $1 billion went into the company as a primary while the remaining $9 billion was used to buy out employees and early investors.
One reason for the proliferation of secondaries in late stage deal structures is to allow the new investor to hit ownership targets. Some investors might have an ownership target they want to achieve such as 15% or 20%. However, the company might not want to incur that much dilution, so the term sheets might include a primary investment into the company that gets the new investors partially to their ownership target and then use a secondary tender offer that allows the new investor to purchase up to the remaining percentage.
Another reason new investors and companies might agree to this structure is it allows the new investors to invest at a blended down entry price but still allow the company to maintain a lofty valuation. For example, if a new investor invests half their capital into a $1bn valuation and then the other half in secondaries with a 20% discount, their blended price paid is actually $900m. However, because the investment into the company was at $1 billion, the company can still report that higher valuation to the public.
Secondary Focused Funds
Initially a niche strategy, dedicated secondary funds have started to become much more mainstream. The first secondary fund, launched in 1982 by VCFA, was a $6m fund. Today, secondary firms have grown much larger as evidenced by Lexington Partners’ new $12 billion fund. As venture funds have increased in size and private companies have increased in valuation over the years, it’s no surprise that secondary funds have grown in order to keep up with the market. Other big players include firms such as Harbourvest, Coller Capital, and Industry Ventures.
Individual Investors, Family Offices and SPVs
In many cases, there are private individuals or Family Offices that are looking to buy shares on the secondary market. Sometimes a group of private angel investors pool their capital and form an LLC, often referred to as an SPV (special purpose vehicle) for the sole purpose of buying secondary shares. These investment vehicles have become more common in recent years.
In addition to looking for financial returns, this group of investors often times enjoys the cache of having invested in a hot company before it hits the public markets. High flying consumer facing companies often attract this group of investors because their brand is well known. Facebook saw a lot of this activity in the years leading up to its IPO (more on Facebook’s impact on the evolution of the secondary market in a later post).
Why Invest into Secondaries?
Now that we have established who the likely investors into secondaries might be, lets dig into the why. Secondary investments, when structured and priced properly, offer investors a very attractive risk/return profile. The reasons for this include the ability to buy at a discount, shorter holding periods, more consistent returns, and J Curve minimization.
Discount to Current Valuation
One of the primary appeals of secondary transactions is that they often times come at a discount to the current valuation. If you recall from my previous post, the principal motivation driving secondary sales isn’t to maximize value, it’s the desire for liquidity. As a result, most sellers are willing to trade at a discount to the current value in exchange for access to capital.
There are a number of factors that come into play when determining pricing for secondaries. The first is a familiar concept from Econ 101: supply and demand. If there is a hot company that lots of investors want access to but there is limited available supply, the price will go up. Some high-profile companies that recently went public had secondary transactions leading up to the IPO that were actually trading at a premium to the last round’s valuation. However, this is not the norm and with the exception of a few companies, most of the time, secondary investors are able to buy at a 20% - 40% discount.
Another key component of pricing is the anticipated time to exit. The longer the expected time to IPO the steeper the discount tends to be. A third factor is the performance of the company. Companies that grow quickly tend to have higher pricing while companies that might have failed to hit their numbers or have had bad press tend to trade at larger discounts. One key to keep in mind in all of this is the potential for rather significant information asymmetry between the buyer and seller (more on that in a later post). Finally, the company’s last price per share (and hence valuation) in its most recent financing round tends to anchor a lot of these negotiations.
Relatively Short Holding Period
Another attractive feature of secondary investments is a much shorter holding period than traditional venture capital investments. Whereas venture investors are investing early in a company’s lifecycle, secondary investors are investing much later, often times even after large growth equity rounds. Today, the average age of a company at IPO is 12 years and fund commitments are typically at least 10–12 years. In contrast, secondary investors expect exits within 4 years and often times the actual hold period is less than that.
Later stage investing typically results in lower multiples. However, despite these lower multiples, due to the shortened time horizon, it’s not uncommon for secondary investments to result in higher IRRs than venture or growth equity investments.
More Consistent Returns
Because direct secondaries are investments into more mature, later stage companies, there is less risk than early stage investing. When compared to growth stage investors, because secondary investors usually pay a lower price compared to the most recent growth equity investors, their returns can be better.
This effect is even more pronounced when buying into an existing portfolio. Standard investments into a VC fund consist of investing in a blind pool vehicle, meaning the LPs are committing capital before knowing which companies will be invested in. In contrast, secondary buyouts of venture funds are backward looking because these investors know exactly what companies are in the portfolio because the portfolio is already fully (or nearly fully) constructed. This allows secondary investors to not only value the assets much more accurately, but secondary investors can target specific companies or vintages of venture funds to which they want exposure. Timing of vintages can often be just as important as which manager to invest in. Similar to building a collection of fine wines, secondary investors can pick and choose the best vintages of venture funds.
As a result of these dynamics, secondaries may not achieve outlier multiples that some VC investments do, but they do tend to have more stable returns. Taken as a whole, higher IRRs and lower risk means secondary investments have high Sharpe Ratios compared to other asset classes meaning secondary investments provide an excellent return profile per unit of risk.
J Curve Minimization
If you plot out returns throughout the lifecycle of a venture fund, most funds follow what is known as the “J Curve.” Unlike public markets where there are daily price changes, private market stocks are typically only marked up upon the next round of financing. Therefore, it could be many months or years until an investment sees appreciation on paper. During this time, investments are held at cost, but fees are collected and accumulated during this period. Returns, net of fees, are therefore negative early on in fund lifecycle.
In addition, within a portfolio, the worst performing companies tend to fail early while winners take longer to generate returns. As a result, funds are typically forced to incur losses before realizing the majority of the gains. This write down to zero of some early non-performing assets accentuates the negative returns early in the funds lifecycle.
However, over time, as some of the investments begin to perform and grow, returns (realized and unrealized) should eventually overtake the losses and fees. It’s only after a few years that a traditional venture fund typically starts to generate positive return and IRR numbers.
Secondary funds, on the other hand, can reduce or even eliminate this J Curve phenomenon. Because secondary investors buy at a discount, the performance metrics are often positive from the start, even when taking fees into account. Another consideration is that secondary funds typically have lower fees compared to traditional venture funds thus the hurdle to get to positive performance is lower.
As previously discussed, secondary investments consist of companies that are more mature, less likely to go under, and are able to be priced more accurately. As a result, secondary investments lose money far less often than primary investments. This drastic reduction of loss rate associated with secondary investments further mitigates the J Curve effect.
Finally, if buying into an existing portfolio, majority of fees are likely to have already been paid earlier in the fund’s lifecycle, so the fee commitment of the new investor is minimized. All of this means secondary funds might start in the black from the very beginning and do not experience the same J Curve as most venture investments do.
Secondary investments aren’t made with the aim of large return multiples that primary venture investments are typically looking for. Whereas early stage investors can make 100x or more on the best investments, secondary investors are more likely to return 1.5–3x on average. However, the flip side of that is where early stage VC investments can take on average 10–12 years to exit, secondary investors have a much shorter holding period, more consistent returns, and typically higher IRRs.
