Dave McClure, Founding Partner Practical Venture Capital and Ben Narasin, Founding Partner Tenacity Venture Capital: Secondary Markets

Dave McClure, Founding Partner Practical Venture Capital

Ben Narasin, Founding Partner Tenacity Venture Capital

Secondary Markets

Dave: I would start with saying that Secondaries are a pretty big and broad category. So there’s not just one thing that we’re talking about here, except that they’re all private companies. So there’s been quite a lot of activity in the private equity world for secondary for over 20 years, probably even longer than that. In venture capital, it’s also been around for quite a while, but most of the activity in the secondary market in venture capital has been at the company level. Maybe in the last five to 10 years, we started to see more activity at the fund level, and that’s kind of the area that we specialize in but, you know, broadly speaking, I would say there’s a lot of money invested in the venture capital market overall, trillions of dollars. However, the activity in the secondary market in venture capital is probably only maybe around $100 billion dollars plus or minus. So quite a bit less than 5%, maybe even more like 2% to 3%.

I think the big difference from investing in the primary market, which is where venture capitalists are doing rounds and investing in private companies, is probably they’re getting access to quite a bit of information from the founders and management teams of the companies to invest in. In the secondary market, that’s sometimes the case, but not always the case. And so at least on a lot of marketplaces for secondary investments (and there are many of those.) So Forge, which is a public company, EquityZen, which is a company that we invested in at 500 Startups, maybe about 10 years ago, Hive, and EquityBee, and several others. And there’s a reasonable amount of activity on those platforms, but usually it’s just the companies that are listed there. It’s not like going to a public market where you see a bunch of quarterly reports and financials that are publicly available. In most cases, quarterly financials are not provided with those listings. You might be able to get some information about top line revenue or growth, but that’s usually only if you are able to talk to the founders and get that information, which isn’t typical for most retail investors, and sometimes it’s not available at all, or at least not shared outside the company and the privately held investors who are involved in those rounds. So that’s one big difference, I would say.

Ben: I think it’s often something that’s misunderstood. I remember back in the day, Dave, you’ll remember this, when syndicates first started, there was one guy that ran more syndicates than anybody? And syndicates are, in essence, the ability for outsiders to invest in private shares or secondaries, in essence, through the primary investor. And he would send out an update from his knowledge of what was happening in those companies. And I remember he told me once he got this very detailed set of pieces of advice and feedback from one of his investors (pages and pages long) and he hit reply and said, that’s not how this works! Because ultimately, you are buying a share! I’ve done SPVs for Secondaries, I’ve sold some secondary shares, all in all it’s super rare for me, I tend to be a buy and hold guy. Ultimately you are entirely dependent on the provider of those shares to share any information with you at all, which they may or may not do. And so your expectation should be you’re going along for the ride and you’re going to have to wait it out and you’re probably going to be in the dark.

Public and Private Companies

Ben: Well, I think Databricks recently raised an enormous round with a lot of secondary in it and they raised debt. Now, sometimes when companies raise enough debt, they will register with the SEC and do filings. But when I read up on it, it appeared to me that they’re not doing that. So sometimes you get a loophole in a super late stage company to get those pieces of information but I would go back to my point that you’re going along for the ride you know or you may be making a bad decision. You’ve gotta wait till the wheel stops, when the ball lands on a number and along the way you can’t do anything about it except forced sell and people like that have created a lot of liquidity. You do have the ability to see the current bid, ask for the most part and potentially sell. You may not be able to sell in a way you want to, but at least you can get liquidity if you know you can hit a market price. Sometimes that market price, you have to think about this a little bit depending on the demand level.

Ben: ICOs or pink sheet stocks back in the day, sort of trade by appointment. These are bespoke transactions and people should be wary of the fact that just because there’s a market like Forge, doesn’t mean that this is a highly liquid market. It is literally one individual selling to one individual and if there’s not somebody on one side of that transaction that’s willing to engage, you’re not gonna make a sale! Maybe somebody wants to sell but the buyer wants to pay half of what they’re offering? So you know you’re highly highly sensitive to how hot that thing is at the moment and if you get it right it can be phenomenal! I actually think secondary markets are an extremely good way to get into great companies, but you’ve got to have some insight on those companies of your own to have a belief in why you’re going to stay there the entire time.

Secondary Markets versus Venture Capital

Ben: I was invited by a VC, with whom I used to play poker. I invited some VCs and they were of two minds. They were the ones that love poker because poker is, by the way, the single best teacher of venture investing that I’m aware of out there, other than actually doing venture investing. And others were like, Man, I gamble all day long. I don’t need to also do it at night so it’s just a funny dichotomy of approaches. Venture is not entirely gambling thats certainly true because there is some liquidity. It’s just when I say you need to be willing to stick it out if you’re not going to wait till the end, you’re gonna be stuck with a huge premium that you will end up paying because of the liquidity. Dave you can tell me if you experience something different? But unless you’re in one of the top top firms you have no idea whether there’s going to be a market in the security you bought a week from now, a day from now or a year from now.

Dave: I don’t necessarily want to agree or disagree with Ben. I just want to step back for a second and sort of describe the playing field, because I think we’re talking about one very specific component of Secondaries. I believe Ben is describing the experience of buying a Company Secondary, which is a bet on an individual private company, typically from a retail investor perspective, where they don’t have access to the founders or the investors in the company. I believe Ben is describing the experience of buying a Company Secondary, which is a bet on an individual private company, typically from a retail investor perspective, where they don’t have access to the founders or the investors in the company. And that probably is the most common experience for a lot of folks. But that’s not the entirety of the Secondary Market. And that’s certainly pretty different from how, again, the Private Equity Secondary market works. And it’s also different if you’re investing at the Fund level versus the Company level in Venture Capital Secondaries. But Ben is correct that you know you’re probably limited on the information that’s available and need to draw a distinction between public markets and Ventures and that’s certainly different.  But even in Venture Capital from the primary market where people are leading and investing in rounds, usually there’s quite a bit of exchange of information there. And that may not be the case here, when you’re buying Secondary interests in a company or a Fund. You’re essentially buying usually from the existing investor who was there. Sometimes you might be buying common shares from an employer founder company, or you could be buying preferred shares from an early investor in the company?  And so Ben’s correct, that you are really dependent upon access to information, usually from the person from whom you’re buying, but hopefully you might get access to the company information directly.

Dave: And that’s where is it’s a little bit different maybe for us?  We tend to view ourselves as a little bit more experienced investors than just the average retail investor in Secondaries. We raise money and we operate, similar to the primary market, at least we’re trying to identify information about the company or the fund, either from the management of the company, if we’re buying secondary shares in a company. Or from the general partners who are running a Venture Capital fund. And that’s where we spend most of our time is usually buying LP and GP interest limited partner and general partner interests in small funds. Sorry if that’s a lot of information, but I guess I was just wanting to try and set that playing field a little bit. So I wouldn’t say it’s gambling. I would say that you are operating on sometimes limited information and that doesn’t mean that it’s gambling. It just means that you might have less information than you do in a typical private primary transaction in the Venture Capital market, which is itself less information than you would have in investing in a public company. You might suggest that Venture Capital is also gambling in some ways. and don’t agree with that assessment.

Ben: But you know ultimately Venture done well (and one of my favorite quotes a buddy of mine said to me once is: Venture Capital is a great way to get rich really, really, slowly!

Dave: Or never?

Ben: I had a few LPs ask me to be very specific about liquidity in the terms. And I told them it was a 10 year window. They thought it might be sooner? I told them fast liquidity and Seed in Venture meant things didn’t go well! The good stuff takes a decade. So if you want to get true Venture outcomes, Venture returns, that’s how long it takes, as I’m going in at seed! Now Dave was right, I was talking about individual company Secondaries, which tend to be done at later stages where you have a shorter window before you get the potential for liquidity through M&A or IPO. And so, you have a different profile there. You can set your own expectations, although companies are staying private so much longer. I don’t know if it’s realistic for you to have a belief. I think Dave might be able to get access to companies and founders. I think Joe Schmoe on the street, there’s zero chance that’s going to happen. No one is going to want to talk to some random person that bought some shares on a Secondary market. Now, the other thing he brought up that I think is really interesting is Secondaries in funds. And I’ve never done that, but it is an intriguing thing because sometimes then you’re really in it for the long haul. As you have no right of rescission, you have to wait for liquidity out of the fund. But people rebalance. And so, as an example, we’ve had multiple times over the 18 years I’ve been doing this, where markets have gotten upside down: where LPs  (let’s pretend for a second – this would not be a good strategy). But let’s pretend for a second an LP said, I want 50% of my investments to be in venture capital and 50% to be in public stocks. Then the public stocks tank by a third. All of a sudden, their allocation is more like 70-30, and they’ve got to try to fix that, which is very, very hard. And one of the only ways you can is to sell off those LP stakes because the VCs aren’t taking them back. So there are sometimes opportunities based on another person’s set of realities or maybe poor planning or poor asset allocation to buy into funds you would definitely not be able to get into otherwise.

Ben: But I think those are going to be far more bespoke transactions and there are very large organizations who do a very good job of doing that. Some of the largest LPs in the world have huge Secondary funds. And I once heard that over the last 10 years, Secondary funds have been the highest performers. I don’t know if that’s true because I haven’t seen the data, but it makes sense to me because if you go back to what I was saying, there were only two people that I ever found that played in the secondary market in terms of buying stakes in Venture funds.

Companies Choosing to Stay Private Now?

Ben: I’m sure Dave has also had a long window to see this, but what has happened is you’ve had a massive increase in the amount of capital chasing Private Equity/Venture Capital style deals over the last decade specifically. Starting with Fidelity and T-ROWE coming into the market and then later all kinds of hedge funds and everybody from Tiger and SoftBank and so on. So these entrepreneurs are being given the opportunity to take capital at the same size and often bigger than they would have achieved through an IPO without any of the filings and legal headaches and reporting requirements. Now, I personally think it weakens the company not to get to that point. I think there’s a value in the maturing process of going through an IPO. I think there’s value up and down the organization and to all the constituencies. I took a company public. It was not as bad as people made it out to be! Now, that was a while ago! But here’s the thing, every Venture deal ever done in an exciting company, the buyers are overpaying.

Ben: It’s a question of how long the price they paid will remain the overpaying price? So if you have an entrepreneur that doesn’t want to sell, the only way you can get them to sell is to offer them a premium. So if you’ve got a company that could have gone public and someone says, Well, I’ll just give you a billion dollars at a price similar to that or even higher, it’s very, very hard to resist. I would argue in many ways, it’s just founder bribery. So I’m not sure that gets fixed because the amount of money in the system is not going down? Its just everything from sovereign wealth. There’s a stunning amount of capital. And last point, it’s chasing a finite number of exceptionally high quality deals. And whenever you have more demand than you have supply, price always goes up.

Dave: Well, I might disagree with that characterization a little bit, because I think you’re describing the environment prior to Q2 of 2022. And certainly there has been an incredible expansion of private capital in all times of alternative asset markets,  and specifically in Venture Capital, probably between the period of  2008, 2009 up until 2021 and early 22. In the last three years, however, there has not been as much capital, with the exception perhaps in AI companies and a few other categories. The overall amount of venture capital being deployed in, let’s say, non-AI companies probably has been cut in half over the last couple of years. And there’s been hardly any IPOs in the last two or three years. So while I generally agree with some of the things that Ben was saying, (and companies take usually about 10 years to go public) and Venture Capital funds probably take about 15 years to fully liquidate, (sometimes even longer.) So the prior problem, I think, or the prior opportunity, let’s say, was that there was a ton of capital chasing deals. And so companies were taking the opportunity to stay private, since the terms for private capital were usually less intrusive, let’s say, than public companies where people have to set up whole organizations to report on their financials to the public markets. But in the last three years, I would say that’s not really been the case.

Dave: There’s a lot of companies that would love to go public, assuming the markets are ready for them to go public. Maybe we’ll see that this year? But I think the issue again with the opportunity here is that there’s been a lack of exits and liquidity over the last three years. And there’s a ton of people who are invested in Venture Capital, both funds and companies, who are looking for liquidity for a variety of reasons. And so there is a big opportunity, I think, for Secondary buyers to come in and get assets at a discount value. Now, that may not always be the case. And there’s quite a lot of people who bought  overvalued unicorns, particularly in that period of 2020 to 21. And those companies’ valuations in the public markets got cut by more than half, sometimes two thirds and in private markets, probably also by at least 50% or more. But now I think we’re seeing the reverse of that where there’s a lot of great companies out there that could be had for pretty substantial discounts. And if you’re willing to help someone out with giving them liquidity today for those assets, you could possibly get those at quite a big discount to true value. And you may have to hold for three, four, five years or possibly even longer. But you’re not holding as long as a traditional investor would from the very beginning, if you were investing in companies at an early stage or investing in funds at the beginning.

Dave: And so we have this strategy we call ‘skip the J curve’. What that’s really about is the early five years of a fund where they’re deploying capital and usually expenses and running the fund and investing in those companies are upfront expenses and the growth in those companies tends to be delayed until they get to later stages. So you typically see this curve, which is the value of your investments going down. in the first few years and then later catching up and hopefully if things go well, really starting to perform in the last three to five years of a fund’s life, (which might really be after six, seven, eight or more years. But if you think about the opportunity to cut that holding period in half, let’s say you were going to someone who was invested in those companies and you bought shares from them, maybe when that company’s at a series C round or later?  Maybe they’re doing 30, 50 million in revenue and up. Maybe they’re valued at quarter billion to half a billion, maybe even low single digit billions. You might be closer to their IPO or closer to when those companies get to exit. And so you wouldn’t be waiting 10 to 15 years for a fund or 10 years for an IPO. You might only be waiting three to five years for liquidity. And you might be able to capture your known growth when those companies are a little less risky and more stable. So that’s really the opportunity that we see in investing in Secondaries.  Particularly, we see that opportunity in funds, which as Ben was saying, is even rarer for people to get out of funds because basically an opportunity has to be given to the general partner to approve that sale. And so as a buyer, you have to be acceptable to the guy who’s running the fund to replace the LP position that you’re buying out. But again, you can get those opportunities at fairly substantial discounts to value, particularly where those sellers are maybe not as large. And this is where I was talking about my own book a little bit as we found that there’s a really big opportunity in buying smaller positions, mostly in smaller funds. And we’re not buying a piece of Sequoia or Founders Fund or interest in Harwich, when buying from a large institutional investor, we’re generally buying out smaller individual investors, maybe family offices or corporate investors in smaller VC funds. And that trend started happening in the US maybe 15, 20 years ago with this explosion of micro VC funds and around the world in the last five to 10 years. And I think a lot of people who invested in those funds, didn’t really understand the holding period, again as Ben was suggesting, which can be quite, quite long! And so there’s a big opportunity to buy out some of these smaller investors in funds at a real opportunity and discount to value.

Ben: I admire Dave for being willing to do all the work because the opportunity exists. That’s clear, but I just want to caution Dave, (you can push back on this if you want?) because I don’t know the scope of listeners here, but there were thousands and thousands of “Emerging Managers” created over the last half a dozen years. And most of them bluntly suck and they’re going to die. They’re not going to be able to raise funds!

Dave: That’s accurate and also true of not just “Emerging Managers”, but all VCs!

Ben: No. And don’t even get me started on the fee whores that drive up massive funds that will never return that might start with a letter A or might end with a letter Z. But at the end of the day, the point I want to make here is that even a blind dog occasionally finds a bone. So some of the “Emerging Managers” will stumble into a phenomenal deal!

Dave: Even a broken clock is right twice a day, my friend!

Ben: Exactly. You know, blind squirrel, all that stuff. So, you know, what’ll happen, here’s my point. You’ve got thousands of RG managers! Some of them will stumble into a phenomenal deal. It’ll be literally the only deal they have that’s worth anything. They won’t be able to raise Fund II. They’ll  wonder why am I doing this? And they’ll want to get that thing out and get it liquid and get some money back to their LPs and make whatever Carry they can. So the challenge, of course, is you’ve got thousands of managers to deal with. Now if you can get views of the Cap Tables, then maybe you can track them down and it is interesting they’re late stage investors of all sorts. As a seed investor it is not uncommon for me to be approached by somebody doing a new round particularly at a later time like B, C or D and saying ‘Hey why don’t we buy out your shares now?’ But we don’t typically do that because as I said I want to stick it out to the end. That’s where the big, big opportunity is but it is not uncommon. I was going to use the word lesser funds, but that’s probably unfair. Smaller funds, less engaged funds, more mercenary funds to say: ‘Hey, why don’t I take my 10X right now? I don’t need to wait around for 100X.’ So you know I think that opportunity is awesome for somebody that’s super connected and willing to do a stunning amount of work. But for those that wanna try to do this armchair quarterback thing, wow, almost impossible! One other quick point as a closer, on the late IPO side, I would agree with Dave that there’s less, but it isn’t just AI. I mean, you’ve got Databricks, I’m an investor in Rippling, which did a tender at 13 and a half billion, that was all Secondary to the employees. You do have fewer companies that are doing it, but you certainly have a lot of capital that wants it, when it’s the right asset. I don’t even know if Rippling was massively oversubscribed at $13 and a half billion. Now, you know three years ago, secondary shares were selling for $2 billion.

Dave: Yeah, I don’t think that’s necessarily the places where there are opportunities?

Ben: So there’s upside there. Databricks most recently around $62 billion. I think it was probably four years ago it was $6 billion. So there is opportunity. It’s just, man, it’s a lot of work! And I think you’ve got to have a point of view and do the work and get the access. And I sometimes wonder how much somebody that’s not physically here working with these people, day to day and knowing them is going to get access to that?