VC Returns Have Trailed Stocks. Are Secondary Markets the Answer?

Venture investors are looking for better returns and more liquidity options, especially as big tech is grabbing a lot of the inherent value in AI.

Traditional approaches don't seem to be working, which is why secondary markets are becoming more attractive to VCs and limited partners. JL

Steven Rosenbush reports in the Wall Street Journal:

Venture capital lagged behind its benchmark over the most recent 15, 10, five, three and one-year periods. Even the strongest firms are looking beyond venture’s focus on seed and early-stage paydays collected when startups go public or get acquired for big numbers. Limited partners are pushing venture to deliver greater liquidity, providing cash that isn’t obtained at a discount to the value of their holdings. They would also like funds to boost their returns to a level that justifies their fees. Venture secondary funds can have shorter liquidity timelines because they are investing in more mature companies and don’t require an IPO-or-bust mentality. Venture capital’s share of the secondary market has been 14% this year, up from 5% in 2020

Venture-capital firms traditionally have been bit players in the secondary markets, but that is changing as some funds look to boost disappointing liquidity, distributions and returns for investors.

It is unclear the extent to which selling startup shares through private sales is a better strategy than waiting for the initial public offering market to open up or other opportunities to cash out, however.

The sector delivered a return of negative 1.55% in the second quarter of this year, according to preliminary data from investment firm Cambridge Associates. That lags behind the S&P 500 index and the Nasdaq Composite Index.

Some pension funds, university endowments and other limited partners are pushing venture capital to deliver greater liquidity, providing cash that isn’t obtained at a discount to the fundamental value of their holdings. They would also like many funds to boost their returns to a level that more clearly justifies their fees.

The second-quarter performance might sound bad, but it actually isn’t so uncommon for the broad VC market, in which returns are highly dispersed with only a minority of persistently strong funds.

VC did generate a return of 18.96% over the last 25 years, compared with 10.44% for a benchmark, Cambridge Associates calculates. That is a value add of 8.52 percentage points.

But that spread shrinks to a mere five basis points when you look at the last 20 years, and venture as a whole lagged behind its benchmark over the most recent 15, 10, five, three and one-year periods, Cambridge Associates said.

 

In this environment, even the strongest firms are looking beyond venture capital’s archetypal focus on seed and early-stage rounds, with paydays collected when portfolio startups go public or get acquired for big numbers.

Venture capital “is in many respects a zero-sum game at each financing stage,” said Scott Kupor, an investing partner focused on growth-stage companies at Andreessen Horowitz and the managing partner of a16z Perennial, which functions as a multifamily office.

In contrast to the public markets, venture capital has limited opportunities to buy shares in a company.

“If we both like Apple, we can go buy Apple on any given day. But there’s typically only one venture firm that will be able to lead the series, be the first investment in Airbnb or Facebook,” Kupor said.

An alternative approach got a boost in 2018, when Ravi Viswanathan left venture capital giant NEA to form the venture secondaries investment firm NewView Capital. He raised $1.35 billion to acquire NEA’s positions in 31 growth-stage companies including Duolingo and Uber. NewView, which fully invested the first $1.35 billion and has already exited a number of companies, has raised multiple funds since 2018 and now has about $3 billion under management.

Venture founders don’t want their capital to be taken over by investors with a trading mindset. But venture secondary funds can have shorter liquidity timelines because they are investing in more mature companies, have a more active focus on liquidity, and have a portfolio construction that doesn’t require an IPO-or-bust mentality.

“Because they can control when to exit their companies, private-equity firms have always actively managed their portfolios. VCs have been more passive about liquidity because they are minority investors,” Viswanathan said. “As VCs look for other exit paths, we espouse the idea that venture should embrace more sponsor-to-sponsor transactions, where VCs sell their positions to other VCs.”

Venture capital’s share of the secondary market has been 14% this year, up from 5% in 2020, according to a NewView presentation.

“One of the healthier things we have noticed now is a renewed focus on fund management—including distributions, which is where secondaries can play a key role,” Viswanathan added. Efforts to boost VC fund performance can be measured by metrics such as the ratio of distributions to paid-in capital.

The so-called DPI ratio has declined since 2021 because the IPO window has been mostly closed and there has been regulatory restraint on some mergers and acquisitions. 

The secondary market presents challenges of its own, said Steven Neil Kaplan, a professor of entrepreneurship and finance at the University of Chicago Booth School of Business.

Such transactions can be difficult to value and are likely to be executed at a discount, according to Kaplan.

“Right now, DPI is tough to come by,” he said. “Although not so easy to do, it seems like the best strategy is to be patient, at least until next year.”