Previously, we unpacked the opportunity presented by emerging managers in VC, and introduced Recast Capital — a new platform investing in the next generation of venture investors.
This time, we deconstruct the opportunities to provide liquidity to micro VCs and emerging managers. Our analysis explores two questions:
- Is there an unmet need for liquidity by early stage micro VCs, emerging managers (EMs), and their Limited Partners (LPs)?
- What solutions could address those needs?
The Need for Liquidity in Early Stage Venture Capital
Over the past five years, an explosive demand for early stage capital has driven investor specialization across sub-stages, sectors, and geographies. A new asset class of managers has emerged — venture capital firms that manage sub-$100 million funds, also known as micro VCs. In 2012, only 100 micro VCs were active. By the end of 2019, over 900 micro VCs were in the market, marking a ~9x growth in just 7 years. In total, these micro VCs represent $25.6 billion in capital. Over half of this was raised in the last three years. Within this set, 78% are focused on seed stage investing and the median micro-VC fund was $50M in AUM.
The majority of EMs and Micro-VC have a long tail of non-institutional LPs. A 2019 RAISE LP survey noted that on average, two-thirds of commitments in a “Fund I” come from non-institutional sources like family offices or HNWIs. Many of these LPs may have invested into the asset class opportunistically, and in light of macroeconomic uncertainty need to fully or partially exit their positions to release them from non-core commitments or fulfil near term liquidity needs. Since the COVID-19 pandemic, this last concern has become increasingly acute for some LPs given the uncertain outlook, and risk/illiquidity exposure they have in other areas of their overall portfolios. However, creating liquidity can pose a challenge for EMs, who are less likely to benefit from the traditional secondary market as we explain later in this article.
Moreover, venture-backed companies are staying private longer, which elongates the liquidity cycle for early stage investors. The median amount of capital raised by US venture-backed companies pre-IPO has shot up from $30 million in 1999 to $117 million in 2017. The median company age at IPO has also grown from 4 years in 1999 to 11.5 years in 2019.
This growing lag in liquidity limits the ability for managers to recycle capital. Besides the obvious effect of reducing the amount of investable capital a manager can deploy, fee recycling is particularly significant for smaller funds as it enables amortization of management fees and fund expenses across a larger investable capital base.
Pre-seed and seed investors bear the brunt of increased illiquidity. As the earliest institutional investors, they have the longest to wait until a liquidity event, but also the lowest capacity for paying management fees and the least amount of dry powder to invest in subsequent rounds.
Potential Solutions for Providing Liquidity
Historically, providing liquidity to the venture market is difficult at all stages — let alone to EMs who seek to prove their ability to deliver outsized, cash-returns without distorting long-term objectives. The challenge stems from limited pricing transparency in early stage companies, high risk of startups, and the pro-cyclical nature of venture assets.
Also, as incumbent secondary players continue to amass AUM and more startups achieve unicorn status, deal sizes rise accordingly. Due to their structural makeup, it is often inefficient for these large funds to enter the small-to-medium segment of the private equity market. As a result, the majority of buyers focus on large buyouts and later stage portfolios. Last year, the average secondary transaction size was $53 million, driven by the large number of $500+ million transactions.
At the same time, venture capital has skyrocketed in terms of the number of funds, deal volume, investor specialization, and manager sophistication. Yet secondary trading still represents only a miniscule 2% of the total private equity market. As more EMs look to actively manage their portfolios, we believe there is room for known and innovative capital solutions that equally benefit GPs, LPs, and founders.
Buying a Single LP Position
Buying all or a portion of a single LP commitment. This could include both the funded and unfunded obligations. In some cases, fund secondaries are bundled with a commitment to a manager’s next fund — a deal sweetener known as a stapled commitment. Relieving an LP from its unfunded liabilities enables it to avoid forfeiture while allowing the manager to maintain the same fund size.
This transaction involves negotiating with a single LP to come to a fair value of their position. A standard portfolio pricing technique is to identify the companies that are the key fund value drivers, conduct a detailed bottoms up due diligence of those specific companies, evaluate the remaining underlying interests, and arrive at a price range that reflects either a discount or premium to net asset value (NAV).
Pre-covid, the trailing ten-year average high bid as a percentage of NAV ranged from 70-80% for venture and 80% to nearly par for buyout.
Buying a Percentage of All LP Positions
Similar to the above, but in this case the transaction involves buying a specific percentage of all LP commitments across the board. For example, purchasing 10% of all LP positions and essentially becoming a new LP that represents 10% of the fund. Usually requires more complex and lengthy negotiations than the prior option.
Traditionally, fund secondary activity is dwarfed by purchases of LBO portfolios. In 2019, LBO funds represented 75% of transaction volume, venture funds 9%, fund-of-funds 6%, debt funds 6%, and energy funds 4%.
Staking Pro Rata Rights
Funding all or a portion of the EMs pro rata rights in a particular company and working out a mutually beneficial economic arrangement. Common cases include:
- An EM that has exhausted reserves, but would like to continue supporting a fund winner in a later stage, follow-on round
- A new investor that wants to participate in an oversubscribed round, and the only way in is through a previous investor’s pro rata rights
In both cases, the economics can be highly beneficial for EMs. Not only can the transaction allow them to maintain rights and involvement in the company, but more importantly, carried interest in the pro rata stake can be split between the EM and the new investor. In this case, incentive alignment is fundamental to prevent adverse selection for the investor staking the EMs pro rata. Pro rata opportunities in top performing companies are more likely to be made available to investors that offer carry-incentivized deals rather than to those simply cruising for “free looks.”
Speed is important here. Investors must move fast so they do not slow down the closing timeline. This can be difficult for both smaller LPs such as family offices that lack information on the portfolio companies, a dedicated venture team, or even larger LPs such as pension funds that require a lengthy process to diligence an opportunity. Done correctly and at a regular cadence, pro rata investors can establish a programmatic relationship with the EM and build credibility for themselves as a value-add LP who is rewarded with priority access to deals.
Buying a Direct Stake in a Portfolio Company
A direct, secondary purchase of all or a portion of the preferred shares in a portfolio company that are held by the EM and/or their LPs. This is a classic secondary transaction that involves a new investor (e.g., a secondary fund or an LP looking for direct investment opportunities) reaching a mutually agreed upon price with the EM and/or LP. While these direct secondaries historically occur when managers sell into a higher priced round, it is also possible to leverage this solution in between financings. Doing so provides an opportunity to right-size company valuation to reflect growth since the last capital raise.
Keep in mind that although a direct secondary market already exists, most of today’s buyers skew strongly to large, mature transactions, due to the massive size of their funds and the difficulty associated with pricing early-stage companies. As such, there remains an unaddressed gap for EMs seeking to provide their LPs with early liquidity.
A loan, or senior equity with liquidation preference to the GP and all other LPs. This can be a creative solution to providing liquidity that avoids the burden of price negotiations. It can be executed at the portfolio level, for an individual LP, or for the GP. The key here is ensuring that underlying collateral is sufficient and that incentives remain aligned.
The Way Forward
Managers and LPs understand that there are signaling risks associated with early liquidity. Behavioral incentives are unique to the entire universe of EMs, and the above capital solutions are not one-size-fits-all. They must be precisely applied within the context of existing manager-to-LP and manager-to-founder relationships. However, one element that is the same across the board is the high level of uncertainty in the venture ecosystem, and the world as a whole.
“Though 2020 once promised to be a year of splashy IPOs and long-awaited liquidity for players across the ecosystem… [managers] are now feeling pressured to produce liquidity somewhere in their holdings.” TechCrunch, March 2020