Venture Capital Secondaries: the newest inevitability

Venture capital’s tremendous growth make secondaries an option for those prepared for their unique characteristics

The secondary market presents a different route for LPs to gain exposure to venture capital. Essentially, a secondary is the purchase of an investment – direct or fund – from one investor to another. Should a manager want to change their portfolio or access liquidity, they can sell the investment to another party. 

Secondaries themselves are nothing new. The strategy is decades old in private equity (PE), and in 2020 the PE secondaries market received a lot of attention (Fig. 1). That year, aggregate capital raised for PE secondaries hit a record high of $78.6bn, over three times the $23.1bn raised in 2019 as some of the big names in secondaries – Lexington Partners, Coller Capital, and Ardian  – hit the market at the same time. There was also a bump in capital raised in 2017, when the three firms listed above closed that year. The market experienced a less obvious but in some ways more significant jump in the past three years as the number of funds increased from 27 in 2019 to 40 in 2020 and 46 in 2021. This is due in part to buyers and sellers maintaining a cautious, yet committed, approach during early COVID-19. As the PE secondaries market grows and thrives, more specialist strategies are likely to emerge.

Room to expand
Until recently, most venture capital funds were too small to warrant the attention of the big secondaries players. VC’s expansion over the last decade, however, has now created sufficient scale. 

There are several reasons why a vibrant secondaries market would be a welcome addition to the VC ecosystem. First, for LPs secondaries present an opportunity to gain some stability in a naturally turbulent investment. VC is about innovation, so involves untested business models, evolving technology, and varying ability to scale. In short, it has higher risks with higher rewards particularly in the earlier stages, and secondaries would give LPs exposure to a more developed set of portfolio companies. For GPs, the innovative nature of these investments mean that it can take longer for investments to exit, so secondaries players could provide some flexibility to extend hold periods that is not possible within a standard 10-12 year limited partnership structure. 

What opportunities do VC secondaries offer?
In addition to flexibility within portfolio management and access to liquidity for the seller, VC secondary investing presents buyers with four distinct advantages. The first is a fast-track to rate of return growth, with LPs that purchase a secondary able to mitigate or even skip the negative return period inherent in early-stage investments (the J-curve). 

VC secondaries also provide more insight into which companies show promise. Through detailed due diligence LPs can take a more formed view as to which companies will deliver, with the distribution of returns from the companies in a more established portfolio almost certain to be lower than in a new one. 

Third, VC secondaries offer LPs diversification. Venture capital investments often focus on niche sectors or have a specific regional focus, allowing investors to be more intentional about their exposures.

Finally, this strategy could allow GPs to stay with investments for longer. This was the rationale given for Sequoia's move to create an evergreen VC fund, but recycling LPs through the secondary market would allow GPs to enjoy growth for longer in the event of an IPO or trade sale financed with shares. 
 

GPs grow in scale
Ardian, a veteran secondary investor, started raising secondary funds in 1999, and has noticeably increased the size of its funds over the years. Earlier this year, the Paris-headquartered fund manager launched its largest secondary fund to date, ASF IX, targeting $15bn. And it is not alone. Lexington Partners is another major player, having raised its first secondary fund in 1996, and it has already launched two new secondaries funds this year.

The emergence of VC secondaries is an exciting opportunity for LPs looking to get into the growing asset class. Venture capital’s development has come as little surprise to those watching the industry, but the option of secondaries puts a new spin on an old game. LPs will undoubtedly be intrigued by how this new dynamic will impact the VC space.