Back to Insights

Limited Partner Secondaries and Signals of Defaults

Blog Post

The recent stock market correction and ongoing volatility signal that another cycle of increased secondary volume driven by Limited Partner (“LP”) sales may be imminent.  It has been over seven years since the industry has experienced defaults in any meaningful volume, and we are now starting to see an increase in this activity.  This primer identifies the market dynamics that lead to LP defaults and the criteria that GPs employ to fill in the gaps with appropriate, valuable investors.

How the LP Secondary Market Works

Transactions in the secondary market for company shares and limited partnership interests are much less public than in the primary venture market.  When a VC invests in a company, both the company and the venture fund typically promote the investment via social media and a press release.  Secondary transactions seldom get announced, and one-off LP interest transfers are never publicized by venture capital funds.  It’s not surprising that general partners and their respective limited partners want to keep this activity quiet – an LP interest transfer resulting from a very practical reason could unnecessarily be misconstrued as a vote of no confidence by the LP or a signal of an LP’s poor financial health. Contrary to popular belief, almost every venture capital fund experiences LP transfers.

LP Defaults on the Rise and Transfers

Like a VC-backed company has investors, a venture fund has investors (i.e. the Limited Partners or “LPs”) who sign Limited Partnership Agreements (“LPAs”) that legally bind them to fund a certain amount of money (i.e. commitment amount).  Unlike VC-backed companies, limited partners do not fund the entire commitment amount on day one.   Typically, the general partner of a venture fund draws down capital over a three to seven year period on an as-needed basis.  LPAs usually state that if a limited partner does not fund a capital call (i.e. a request for part of the commitment amount as part of an investment in the portfolio), then the limited partner may be placed in default.  When an LP default occurs, the general partner will seek to find a new limited partner to buy out the defaulting LP and take over the unfunded liabilities.

The secondary market typically experiences increased selling and transfer activity in venture funds after a public market correction or a liquidity crunch (i.e. the current energy market crisis).  When investors lose large amounts of capital in the public market (e.g. more than a -15 to -30% correction in the NASDAQ), individual and non-traditional limited partners in venture funds traditionally start to sell or reduce their stakes to reduce or eliminate their unfunded liabilities (i.e. future capital calls).

Suitable Secondary LPs

What type of new limited partner does a venture fund want? Assessing over 200 venture capital fund secondary transfers where our firm acquired interests, we identified several criteria that venture capital managers use to find a new limited partner:

  1. A stable balance sheet and understanding of the asset class and company risk levels
  2. A  long-term capital source with prior experience in the asset class
  3. An existing limited partner relationship with the desire to increase fund ownership
  4. Ability and pre-disposition to invest into new partnerships in the future
  5. Ability to help portfolio companies with value-added introductions, strategic advice, and direct co-investment dollars
  6. Straightforward internal processes
  7. A proven commitment to the asset class through both up- and down-cycles
  8. Diversified capital sources (i.e. not only invested in one area)
  9. Prior experience with secondary transactions

Quickly identifying appropriate LPs can help minimize the inevitable negative impact of defaults on venture capital funds and portfolio company management teams.  Working with an experienced and trusted partner solves this problem, and allows the industry to function in a healthy way regardless of fluctuating market cycles.

As featured in Secondaries Investor (Subscription) on 2/8/16

The views set forth herein are solely those of the author and do not necessarily reflect the views of Industry Ventures. The information and views expressed are generic in nature, and is not an offer to sell or the solicitation of an offer to purchase interests in any investments or services. Certain information contained in this article may constitute “forward-looking statements.” Any projections or other estimates contained herein, including estimates of returns or performance, are “forward looking statements” and are based upon certain assumptions that may change. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. There can be no assurance that the forward-looking statements made herein will prove to be accurate, and issuance of such forward-looking statements should not be regarded as a representation by Industry Ventures, or any other person, that the objective and plans of Industry Ventures will be achieved. All forward-looking statements made herein are based on information presently available to the management of Industry Ventures and Industry Ventures does not undertake to update any forward-looking statement that may be made from time to time by or on behalf of Industry Ventures.

This material does not constitute financial, investment, tax or legal advice (or an offer of such advisory services) and should not be viewed as advice or recommendations (or an offer of advisory services).

Certain information contained in this article (including certain forward-looking statements and information) has been obtained from published sources and/or prepared by other parties, which in certain cases has not been updated through the date hereof. While such sources are believed to be reliable, neither Industry Ventures and any general partner affiliated with Industry Ventures or any of its respective directors, officers, employees, partners, members, shareholders, or their affiliates, or any other person, assumes any responsibility for the accuracy or completeness of such information.