In Search of Liquidity: Navigating Today’s Illiquid Market as a GP
Is Liquidity Drying Up?
Recent years have generated record levels of liquidity for US venture capital stakeholders. With over $1 trillion of cumulative exit value, 2020 and 2021 produced more liquidity than the prior 7 years combined.
However, the environment for venture capital liquidity has fundamentally changed since the highs of 2020 and 2021. The cumulative value of US venture IPOs, which in 2021 accounted for 85% of overall VC exit value, has fallen 95.9% through September 30, 2023.1 Despite a small number of companies reportedly testing the waters of the IPO market again, public listings are still not a viable option for a broad swath of the venture landscape today.
Where, then, do venture stakeholders turn for liquidity in such a stagnant market? In our 2018 whitepaper, we predicted the growing importance and prevalence of buyouts as an exit pathway for venture-backed companies. This trend has largely played out, with more than three times as many buyout exits as public listings as of Q3, 2023.1 These buyouts are predominately smaller exits to tech-specialist funds or sponsor-backed strategics, who in today’s more challenging climate are often the right partners to help smaller businesses navigate unfamiliar waters.
For larger, scaled businesses, secondary sales continue to serve as an attractive alternative for investors who may otherwise have to wait for the IPO window to widen for “organic” liquidity, which may only be viable in a more normalized market.
The bull market mentality of 2020 and 2021 has shifted to one where GPs need to prioritize portfolio management and generate DPI. In this article, we will explore how General Partners can navigate the potential benefits and pitfalls of seeking liquidity in an illiquid environment, across a variety of structures and against the backdrop of a uniquely challenging market.
Today’s Venture Capital Market
2021 was a high point for venture capital – record amounts of capital raised, record valuations, record liquidity through SPACs, IPOs and M&A, and record “hype”. VC funds raised more capital between 2020 and 2022 than they did in the prior seven years, with average fund sizes more than doubling. Today, there is nearly $1 trillion of remaining value across US-based VC funds.1
However, the market today looks quite different and has been marred by uncertainty. Many venture-backed companies have yet to raise capital via a priced round since the market correction began in early 2022. With the total number of down rounds more than doubling in 2023 (YTD as of 9/30/23),3 companies that are in the financial position to delay their next funding rounds may be wise to do so. For those that need additional cash but don’t want to be subject to a priced round, convertible notes and extensions have become the norm, with companies and investors alike kicking the proverbial can down the road.
Material revaluations of venture fund NAVs have been slow to take place across the VC fund landscape and have not been as universal as investors might expect. Venture capital fund NAVs only saw a reduction of -21.4% in 2022 after expanding by 49.9% in 2021, and off the heels of a historic, decade-long bull market for the asset class.2
Perhaps unsurprisingly, LPs have been slower to commit to new venture funds in recent quarters. It’s now taking longer, on average, to raise a new fund across all sizes and stages of the VC ecosystem than ever before. It’s a particularly challenging market for younger firms, with the lowest number of first-time funds successfully closing in over a decade and the least amount of capital raised for new funds since 2013.1
Distributions slowed substantially in 2022, with VC funds calling twice as much capital as they distributed.1 At the current pace of distributions, it would take 20 years for the current cumulative NAV across venture capital funds to be fully distributed. We believe that the combination of record inflows to the asset class in recent years with what has become an anemic environment for distributions has contributed to a historically challenging market to raise capital.
In a market where LPs are becoming fatigued with the high ratio of capital calls to distributions, General Partners may increasingly need to think creatively about how to generate liquidity in order to maintain LP appetite for upcoming funds.
Why Sell in an Illiquid Market?
Against the backdrop of a dramatic slowdown in “organic” venture liquidity, it may not be unreasonable to assume that, for many venture-backed companies, traditional exits are likely to take much longer to materialize. Perhaps counterintuitively, selling today at a discount to current holding values may not be a losing game.
Furthermore, if net asset values derived from financing rounds that took place in 2020 and 2021 are, in fact, inflated values that certain businesses may take years to grow into, liquidating shareholders may be surprised that exiting today at substantial discounts to those values may ultimately be accretive to their IRR.
For the 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.
We believe that selling in today’s unique market environment, where attractive opportunities to redeploy capital are seemingly abundant, may be the best way to both generate DPI and defend against IRR erosion. Despite the lower values that sellers will see at exit, savvy investors will benefit from the incremental dry powder at their disposal to redeploy into attractive opportunities.
According to Pitchbook, there is more demand relative to the available supply of capital today than there has been in 7 years. We see this trend playing out firsthand through our own investments, with a shift towards investor-friendly terms and more rational valuations. This shift is most pronounced for top companies that would have garnered headline-inspiring financing rounds in 2021 – average top decile late-stage pre-money valuations, the segment of business garnering the highest absolute valuations in primary financing rounds, are down 56% since 2021. IPO performance has seen a similarly dramatic decline in valuation, particularly relative to the last round of venture funding, as evidenced by recent listings from Instacart and Klayvio.
From an LP’s perspective, the value of cash proceeds today cannot just be measured by current return metrics but should rather be evaluated based on potential future value if deployed during what may be an extraordinary period for the asset class. For GPs, providing liquidity to their LPs may serve as a strong catalyst to drive demand for their own funds.
While exits are harder to come by in this market, we believe that there are two key alternative forms of liquidity that VC fund managers should be evaluating today.
secondaries – once a niche liquidity generator, now an exit path well traveled
Since we started Industry Ventures over 23 years ago, as one of the first secondary buyers exclusively focused on the venture market, secondaries have become an increasingly sought-after path to liquidity for a variety of stakeholders in the ecosystem.
For investors who hold higher growth, later-stage assets, the venture secondary market may serve as an attractive liquidity pathway. With the institutionalization of the venture secondary market over the last decade, sellers today have more options than ever before in navigating their pursuit of liquidity.
For General Partners in particular, the venture secondary market has become an important tool for portfolio management that has proven to be resilient and accessible across a variety of market environments. In our recent article, Managing Liquidity through General Partner-Led Secondaries, we explored a number of the recent innovations in the venture secondary market available to venture GPs. The below summary offers a broad overview of the current spectrum of liquidity solutions available to GPs.
The venture secondary market has evolved as a reaction to the increasingly complex needs of venture capital stakeholders. GPs will often face a variety of different scenarios that may drive them to seek liquidity in the secondary market over the course of a fund’s lifecycle.
While secondaries have become one of the most widely pursued solutions for GPs managing out “end of life” funds, we expect the appeal of the secondary exit to grow meaningfully with limited near-term prospects for other forms of liquidity. For funds that are within the “Goldilocks zone” for distributions (typically years 7-12), the dramatic slowdown in liquidity pacing for the asset class may mean that even top-performing funds may no longer be able to expect a steady cadence of exits. With increased LP scrutiny on DPI metrics, GPs may need to look to the secondary market to generate meaningful enough levels of liquidity to maintain LP demand. In many instances, the cost of liquidity today may be justified in order to prevent meaningful IRR erosion as the market normalizes.
The menu of options available to venture GPs today is more robust than ever, with a sizeable and growing cohort of specialist buyers focused on the asset class. Many buyers, however, focus exclusively on the subset of larger, and often higher-growth, businesses within the venture landscape. However, for smaller businesses with more subdued growth profiles, but attractive cash flow characteristics, another alternative exit has emerged – the Venture Buyout.
buyouts – the most attRACTIVE option for smaller or plateauing businesSES
Over the past decade, venture-backed companies have increasingly turned to buyout funds as an exit pathway, but often only after exhausting other options. While buyout funds have established themselves as a permanent and crucial buyer set for venture-backed companies, market sentiment still has some catching up to do.
In today’s environment, where DPI is paramount and liquidity is scarce, we believe that buyouts are the single most attractive exit pathway for founders and investors of smaller or slower-growing venture-backed businesses. Not only because of the interest that they can garner today from what has proven to be a very resilient base of buyers, but also because of the future value that these buyers can generate.
As exit pathways narrow and investment activity slows, smaller venture-backed companies that haven’t reached escape velocity, find themselves with a limited set of options. These options include raising capital through a down or flat round, exploring strategic acquisition opportunities, or considering a sale to a buyout fund.
While raising a down or flat round extends a company’s lifespan and offers renewed hope, data suggests that it may not be the most prudent decision for investors. Over the last 15 years, 22% of companies that opted for down or flat rounds have gone out of business, 8% haven’t found liquidity, and just 5% have gone public. The remaining 65% have been acquired by strategics, buyout firms, or sponsor-backed strategics.4
Instead of bridging to a potential strategic acquisition or unlikely IPO, we believe that smaller and slower-growth businesses should explore their exit options today.
Although strategic acquisitions have historically been the most common exit pathway, buyouts have steadily grown throughout the last decade, reaching an unprecedented high in 2022, accounting for 22% of all exits, and exceeded public listings by three times in 2023.1
This activity is largely driven by both the appetite for software and the increasing volume of dry powder in the buyout ecosystem. From 2021 to 2022, the amount of capital available to buyout GPs expressed as a multiple of annual deployment jumped from a historically low 0.9 times to 1.4 times, marking the highest ratio since 2013.5
Another key factor is the proliferation of buyout activity in the small-cap market. While strategics need to see a business reach critical mass before becoming an acquisition target, buyout firms in the lower-middle market are now targeting businesses with less than $10 million in revenue as platform investments. Even smaller businesses can be bolted-on or rolled-up into these platforms as well, making private equity an increasingly attractive exit opportunity for smaller companies that no longer garner interest from venture investors.
The other, and perhaps most appealing, benefit of private equity is the opportunity for founders and even investors to retain their equity in the go-forward business. Unlike most acquisitions, where existing shareholders are converted to junior share classes and stripped of many of their rights, buyout firms often allow existing shareholders to rollover equity while maintaining their current share class. This dynamic helps to align financial interests and allow existing shareholders to retain a “second bite at the apple”. For venture GPs who are seeking partial liquidity but believe in the upside of the company, rolling a portion of the investment alongside a buyout fund can be an elegant path to achieve both near-term DPI and upside value. This rollover equity also has the potential to deliver substantial value, with lower middle-market software buyout deals returning a median 2.5x MOIC and 24.97% IRR over the past 15 years.6
While today’s correction looks very different from prior “crashes”, venture GPs who successfully navigate today’s unprecedented market will find themselves well-positioned for the next cycle. Venture GPs will need to prioritize portfolio management, and Industry Ventures can be a creative partner to help facilitate liquidity.
Industry Ventures has been a pioneer in both the venture secondary and small tech buyout markets since their infancies. We have been a leader in the venture secondary market for over two decades, investing across and innovating around numerous secondary structures, including GP-led transactions, LP interest purchases, portfolio acquisitions, direct cap table transfers, corporate spinouts, and many other structures.
We see many GPs looking to generate liquidity for their LPs but who also see potential continued upside in their portfolio companies that they wish to capture. Both our Secondary and Tech Buyout strategies have pioneered different solutions that can accomplish both objectives simultaneously.
Portfolio companies with less revenue scale that are at or near break-even may be well-suited for a buyout exit. As an early mover in the Venture Buyout segment and a Limited Partner in many of the leading small Tech Buyout-focused funds, we can serve as a helpful guide for VCs looking to navigate the Tech Buyout landscape.
In an environment where venture liquidity has ground to a halt, fundraising has become extremely difficult, and LPs are increasingly scrutinizing DPI metrics, we believe that these represent two of the most compelling, and perhaps only, reliable exit pathways today.