Unlocking liquidity in a tight market: a guide for venture capital GPs
The IPO window, which accounted for the lion's share of venture capital exits in 2021, has narrowed significantly. This shift has left many investors seeking alternative avenues for liquidity in an increasingly challenging market.
In this article, we explore the current global market environment. The same principles apply to emerging markets, which require even more strategic thinking and creativity when approaching the topic of liquidity. GPs who can successfully navigate these challenges by exploring alternative exit strategies and effectively communicating with their LPs will be well-positioned for success.
Nodem’s team has significant experience across emerging markets and venture capital. Get in touch to discuss how best to navigate the complexities of secondary transactions. We have worked in VC and understand the challenge of balancing the need for liquidity with the desire to participate in the continued growth of their portfolio companies.
The VC landscape: from boom to uncertainty
The venture capital market is in flux. After reaching a crescendo in 2021, marked by record fundraising, sky-high valuations, and a flurry of exits, a sense of uncertainty has settled in.
While the total value of US-based VC funds alone remains near $1 trillion, the market dynamics have shifted significantly. The exuberance of 2021 has given way to a more cautious environment, prompting both investors and companies to adjust their strategies.
The fundraising landscape has become more challenging for startups. Priced funding rounds, once commonplace, have become less frequent as investors exercise greater caution. Down rounds, while still relatively uncommon, have become more prevalent, reflecting the recalibration of valuations in certain sectors. This shift has led to a greater emphasis on capital efficiency and strategic fundraising. Companies increasingly rely on alternative financing options, such as convertible notes and extensions, to bridge funding gaps and preserve runway.
As traditional exit routes become less reliable, venture capital stakeholders are exploring alternative paths to liquidity. Two strategies are gaining traction:
Venture buyouts: Once a niche exit strategy, buyouts have emerged as a viable option for venture-backed companies, particularly those with strong fundamentals but perhaps not yet ready for a public offering. This trend is driven by the growing appetite of private equity firms seeking to invest in promising technology companies.
Secondary sales: For larger, more mature companies, secondary sales provide a valuable mechanism for investors to achieve liquidity without relying on the public markets. These transactions allow existing investors to sell their shares to new investors, providing capital solutions and portfolio rebalancing opportunities.
The counterintuitive appeal of exiting in a buyer’s market
The slowdown in traditional venture capital exits, particularly IPOs, has led many to believe that holding onto assets is the optimal strategy. However, the current market presents a compelling case for considering exits, even at valuations below previous highs.
The record valuations achieved in 2020 and 2021, fueled by abundant capital and a growth-at-all-costs mentality, may have created inflated expectations. Exiting investments today, even at a discount to those peak valuations, can be a strategic advantage.
Time is a critical factor in venture capital returns. Holding onto an asset for an extended period, hoping for a return to peak valuations, may not always be the most prudent approach. The opportunity cost of capital and the potential for further market adjustments should be carefully considered.
An Industry Ventures analysis showed that for a hypothetical 5-year-old investment held at a 4x return to an investor’s original cost basis, selling today at a 50% discount would generate a better return on a time-weighted basis than holding the position for another five years, assuming a NAV exit.
Unlocking liquidity, capturing opportunities
Exiting investments in the current market can provide several benefits:
Crystallizing Returns: Securing returns today, even at a discount, can generate immediate liquidity and enhance DPI for LPs.
Redeploying Capital: The current market presents attractive investment opportunities with more favourable valuations and investor-friendly terms.
Mitigating Risk: Exiting positions can reduce exposure to potentially overvalued assets and the risk of further market corrections.
While exits may be more challenging to come by, they are not impossible. By embracing alternative liquidity solutions and adopting a flexible approach, investors can navigate the current market dynamics and position themselves for long-term success.
Venture secondaries: from niche strategy to mainstream solution
The venture capital secondary market has undergone a remarkable transformation, evolving from a niche liquidity tool to a well-traveled path for investors seeking to optimise their portfolios and access liquidity.
Over the past two decades, secondaries have gained significant traction, driven by the growing complexity of the venture ecosystem and the increasing demand for flexible liquidity solutions.
Transfer assets to a new vehicle
Asset Sale
Fund in liquidation sells all the final assets to reduce operational expenses. Transfer assets to the buyer—no new vehicle.
Continuation Vehicle
Transfer assets to a new vehicle with a reset of economics/incentives. LPs can choose to cash out or roll stakes into the new vehicle.
Strip Sale
A continuation vehicle where the fund sells a portion of all or some assets. GP manages the existing fund and new vehicle. LPs keep the upside.
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Keep assets in the same vehicle
LPA Change
Amended the LPA to lengthen the fund's life or reset the economic alignment. Requires a minimum level of LP consent.
LP Tender / Co-Sale
The new investor buys LP interests from existing investors.
Preferred LP Commitment
LP provides new capital with a preferred return for management or distribution to LPs. Requires special LPA amendments to create a separate LP class.
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For investors holding high-growth, later-stage assets, the secondary market offers a compelling alternative to traditional exit routes. The institutionalisation of the secondary market has led to a surge in specialised buyers, providing sellers with a wider range of options and greater negotiating leverage.
General Partners have embraced secondaries as a valuable tool for managing their portfolios and meeting LP expectations. Secondaries offer GPs a mechanism to:
Unlock liquidity: Generate distributions and enhance DPI, even in challenging market conditions.
Optimize portfolios: Rebalance holdings and manage exposure to specific companies, sectors, or vintages.
Align with LPs: Demonstrate proactive portfolio management and address LP concerns about liquidity and returns.
Venture Buyouts: Another Strategic Path for Growing Businesses
In today's dynamic market, where liquidity is prized and traditional exit timelines are extended, venture buyouts have emerged as a compelling pathway for growing businesses, particularly those seeking capital and strategic guidance. While buyouts have historically been viewed as a last resort, they are increasingly becoming a strategic choice for founders and investors seeking to maximise value and control their own destiny.
Several factors contribute to the appeal of venture buyouts:
Access to capital and expertise: Buyout firms provide capital, operational expertise, and industry connections to help companies scale and navigate challenging markets.
Founder and investor alignment: Buyout structures often allow founders and existing investors to retain equity and participate in future upside, fostering a sense of shared ownership and commitment.
Attractive returns in a challenging market: Lower middle-market software buyout deals have historically generated strong returns for investors, even in economic downturns.
Focus on long-term growth: Unlike some strategic acquirers who may prioritize integration or cost synergies, buyout firms often focus on long-term growth and value creation.
Potential for secondary exits: Companies acquired by buyout firms often have multiple pathways to liquidity, including subsequent acquisitions or even IPOs.
Concluding words
The venture capital market is cyclical, characterized by robust growth and retrenchment periods. In this environment, venture capital General Partners (GPs) who can successfully navigate liquidity challenges and leverage strategic partnerships will be well-positioned for long-term success.
Interested in more educational content? Read about Venture Orphans here.
Sources
“Q3 2023 Pitchbook-NVCA Venture Monitor”. Pitchbook Data. October 2023.
“2023 Global Fund Performance Report as of Q4 2022 with Preliminary Q1 2023 Data”. Pitchbook Data. August 2023.
“Q3 2023 US VC Valuations Report”. Pitchbook Data. November 2023.
Pitchbook Data 2008-2023
“McKinsey Global Private Markets Review: Private markets turn down the volume”. McKinsey & Company. March 2023
DealEdge Data from 2007 – December 31, 2022.
