This is a guest post by investor, Hans Swildens
One of the most misunderstood markets in venture capital is the secondary market. Even some top VCs and long-term institutional LPs who have been in the market for over 30 years have misconceptions.
I believe that this is because they have limited market visibility and a direct investment bias that doesn’t take into account the vast array of transaction types, legal structures and securities that trade in the market. Over the last five years more special situation transactions have emerged that involve investments in end of life funds, corporate venture divisions, and financial institution balance sheet restructurings, for example. It’s a very challenging segment to understand if you are not an active, fully engaged buyer.
Up until Facebook’s well-publicized secondary market activity, structures were not broadly known. Now it’s safe to say that everyone thinks they can access and buy secondary shares through a few high visibility brokers, including SecondMarket and Sharespost.
During 2011, even public BDC vehicles were created to buy pre-IPO shares in Facebook, Zynga, Groupon, and other high profile consumer internet companies. Now that many of these companies have gone public and their share prices are trading below both their IPO price and the prior private secondary market values, “what’s happening now?” is the question on everyone’s mind.
So what’s happening now?
In my view, the secondary market has grown to be a large and robust complement to the primary venture capital market. Secondary funds are more focused today on businesses that sell products and services to businesses rather than consumers. This may seem counterintuitive, however the secondary market to buy shares in Software as a Service (SaaS), healthcare, storage, communications and cleantech investments is in vogue and have just the right attributes for profitable investments.
Who is buying?
Buyers are mainly institutional today. Most of the buyers have a ten to fifteen-year track record in the market. Retail investors and high net worth investors have “left the building” as many got burned buying the aforementioned high profile consumer internet investments during 2011. BDCs are now having trouble raising additional capital as their investor base has lost money. The market has adjusted and reverted back to pre-2010 market dynamics where buyers expect to hold investments for three to seven years vs. flipping shares into an IPO for a quick return. We’ve recently seen hedge funds, investment banks and family offices put their efforts on ice.
How do you sell private company shares in this environment?
The market is dominated today by institutional buyers and a host of small funds that were started to try to fill the void. These funds consist primarily of long-term investors and require their managers to perform traditional due diligence processes for investing in private companies. Most require financial information, access to the company capitalization structure and financing documents, as is the case for my firm, Industry Ventures.
Some buyers may have already acquired shares in the company or have an existing relationship, therefore making their process much shorter to send prospective investors an offer letter. Other buyers may be invested in the company indirectly via a venture capital fund that sits on the board. In general, institutional buyers have most of the capital today in the market.
Why are we bullish about the secondary market?
We have seen over the last 10 years that the secondary market is not just for times of distress or excess. In fact, it is a strategic and vital investment area that supports the primary venture capital market with liquidity and special situation investments. From our firm’s perspective, long-term oriented, institutional investors understand the investment risks inherit in owning illiquid shares and also understand how to work with management teams and boards throughout an investment lifecycle. We believe we’re entering another cycle where our industry will again support the market so it will operate efficiently.
Hans Swildens is the founder and managing director of Industry Ventures and is on the investment committee of the firm’s secondary and partnership holdings. Since founding Industry Ventures, he has sourced and led the acquisition of over one hundred secondary investments in the venture capital industry. Earlier in his career, he cofounded and acted as President of Microline Software.