Since the market corrected in 2022, late-stage funding rounds have been few and far between. It’s been hard to predict what is still attractive to investors in the later stages of the venture market or what any of the existing “unicorns” are worth today. The secondary market therefore gives us some valuable context as to how investors are thinking about valuing companies.
The secondary market wasn’t immune to market conditions, though. Investment volume in this space has ebbed and flowed since the market correction, albeit less dramatically than on the primary side. If the startup IPO window reopens in 2024, as many are predicting, the secondary market will likely start to return to normalcy.
But how are investors in the secondary venture market thinking about the market now? To find out, TechCrunch+ surveyed five venture secondaries investors, and they said that there are many aspects of the current venture secondary market worth getting excited about.
John Zic, the founding partner at EQUIAM, for one, sees extreme discounts even for shares of companies that are maintaining attractive growth and financial trajectories. “We’re seeing attractive opportunities in many sectors, particularly in fintech, cybersecurity and marketing tech,” Zic said. “A number of firms within these sectors have continued to deliver on their financial targets throughout the same period.”
Other investors also said they are using this time to bolster their equity positions in existing portfolio companies.
“We are doing extensive follow-on [investments] in all performing companies in our portfolio,” said Michael Szalontay, the co-founder of Flashpoint. “It���s a great time to buy, especially with a discount [on] a secondary basis. The major driver of our decision is growth, profitability and also the length of runway of each portfolio company.”
Everyone agreed that prices for these company stakes have come down considerably and that valuations likely haven’t reached the nadir quite yet. There wasn’t a consensus on how close valuations are to the bottom, though: While Szalontay said the positive signaling from the Fed regarding interest rates could be considered a sign that we must be close to the bottom, others didn’t necessarily agree.
Read on to find out what sectors investors think are too hyped in the secondaries market, why some investors aren’t sure primary VCs should rush back into the space if things open up next year, and why LPs aren’t actually as hungry for liquidity as you’d think.
We spoke with:
- John Zic, founding partner, EQUIAM
- Kelly Ford Buckley, general partner and COO, Edison Partners
- StepStone Ventures Team
- Michael Szalontay, co-founder and general partner, Flashpoint Venture Capital
- Michael Bego, managing partner, Kline Hill Partners
John Zic, founding partner, EQUIAM
Where do you see attractive opportunities in venture secondaries currently?
We’re seeing attractive opportunities in many sectors, particularly in fintech, cybersecurity and marketing tech. Amidst the broader tech slowdown since the beginning of 2022, these sectors experienced even more acute valuation downturns. However, a number of firms within these sectors have continued to deliver on their financial targets throughout the same period.
Have these opportunities changed since the heights of 2021?
By the end of 2021, almost every subsector of the tech market was overvalued (on a historical basis), so I wouldn’t use the word “attractive” to describe any particular pockets of the market.
From a deal flow perspective, there was significant secondary deal flow in blockchain/cryptocurrency firms as the final act of the crypto bull market played out. As you can imagine, deal flow in these companies has ground to a near total halt over the past 2 years.
Are valuations currently as low as they are going to drop in the secondary market?
It’s nearly impossible to predict the future, at least on a total market basis, so we’re more focused on identifying swaths of the secondary market where pricing has dipped below historically attractive levels.
For instance, if fintech has historically traded at 7x forward revenue on average over the past 15 years, with a low-water mark of 3x during the financial crisis, we would be looking for fintech companies that have strong financial metrics but are trading in that 3x–4x range.
So, without predicting the directionality of the secondary market as a whole, we target specific firms with meaningful upside from both a historical and normative perspective.
Are there sectors or areas that you think could drop further?
Yes. In particular, valuations in the AI sector appear increasingly tenuous. While the transformational nature of the technology is poised to justify some of these valuations, there are likely companies in the sector that have become inflated by the proverbial rising tide. Recent primary financing transactions have been priced at 50x or even 100x trailing revenues, which bring back frightening memories of the overexuberance of late 2021.
Another sector that may be getting ahead of itself is defense tech. Geopolitical upheaval has provided tailwinds to the sector, but we also don’t believe the current dynamics support valuations of 50x trailing revenues. In order to be fairly valued against public peers, private defense tech firms would need to consistently grow revenues at nearly 500% annually over the next several years. These valuations assume an upward trend of global instability over the intermediate to long-term.
What sort of changes have you noticed in which buyers are in the market?
For a while, there were simply no buyers at all (e.g., Q1 2022 through Q3 2022). We began to see signs of life in the market toward the end of 2022, which has stabilized at a low but more consistent level over the past eight to 10 months.
The buyers in the secondary market include hedge funds, crossover funds, VC funds, VC secondary funds, family offices and HNWIs. Over the past year, we have seen more sophisticated buyers (e.g., institutional buyers) outpace the family office/HNWIs that were extremely active in 2020 and 2021.
Do you feel pressure from LPs to sell stock early just to get cash, even if it harms long-term total returns? What is your strategy to deal with this pressure?
We have made selling early a feature of our funds. We have clear return targets for each fund we launch. As such, if we believe that future upside on a position is more limited, we will consider an exit. Conversely, if we believe a position has significant downside risk, we will consider an exit.
We realize that we are narrowing the return distribution of our funds by cutting off both the right tail (winning side) and left tail (losing side). However, this allows us to return capital faster to our LPs while minimizing total portfolio risk and reducing our chances of experiencing a total loss.
The other element that guides our decision-making is the relatively short duration of the funds we manage (four to six years). Because of this shorter fund life, we do not seek out 100x return profiles (which typically also carry outsized risk profiles), but rather seek to invest in companies that will reliably return 2x to 4x. We strive to achieve these levels of results across more than 70% of our investments.
Do you plan to use the secondary market to increase your existing company stakes at a discount? What are the primary factors involved in your decision-making?
Since inception, more than 80% of EQUIAM’s deal flow has been sourced via the secondary market. We have continuously found the secondary market to be an excellent sourcing pathway due to the idiosyncratic nature of deal timing (we don’t have to wait for companies to raise money in primary rounds) and more control over deal pricing (each deal is individually negotiated).
Right now, the median deal pricing in the secondary market is as attractive as we have ever seen. Many companies are not only trading at significant discounts to their 2021 primary rounds but are trading at discounts to their public peer groups. We see this as a unique driver of near-term upside.
Do you think other firms are doing this?
There are a handful of known players that have invested via the secondary market for several years and remain active. In addition, there are a few new entrants to the market, and we assume this trend of new participants will continue.
On the flip side, the VC space, as a whole, has certainly fallen out of favor with many allocators, which I think has repressed buy-side interest in the secondary market, most likely due to over-allocations after a long period of strong returns in the sector. However, as noted earlier, sophisticated buyers are beginning to invest in dislocated opportunities and will likely be rewarded for their conviction.
Which secondary platform do you consider to be a leader in the space?
Historically, a sizable portion of our transaction volume has been done on Forge Global. In addition, we interact on an almost daily basis with several other brokerage platforms (such as Setter, CartaX, Hiive, and Caplight), boutique investment banks, bulge-bracket secondary desks (Goldman, UBS), and private wealth groups to source supply.
The secondary market ecosystem is rapidly maturing and we’re excited to see how the battle for market supremacy plays out. My guess is that there will be some centralization or consolidation over the next few years that will allow for smoother transactions, faster execution, and higher fidelity pricing data.
Kelly Ford Buckley, general partner and COO, Edison Partners
Are valuations currently as low as they are going to drop in the secondary market?
We’ve seen anywhere from 10% to 30% discounts on secondaries over the last 12 months or so. For the capital-efficient, growth-stage companies we are selling or investing/buying, I don’t see this changing.
What sort of changes have you noticed in which buyers are in the market?
Rather than step into existing class structures, certain buyers are seeking the same preferred investor rights on secondary investments as they are getting on their primary investment. It’s egregious.
Do you feel pressure from LPs to sell stock early just to get cash, even if it harms long-term total returns?
Generally, we do not. Our LPs appreciate our disciplined approach to allocating capital and exiting, which has endured market cycles.
Do you plan to use the secondary market to increase your existing company stakes at a discount? What are the primary factors involved in your decision-making?
We are always looking for opportunities to acquire more ownership in our best-performing companies.
StepStone Ventures Team
Where do you see attractive opportunities in venture secondaries currently? Have these opportunities changed since the heights of 2021?
During periods of higher valuations (2019–2021), we were mostly focused on direct secondaries, situations where our capital provides liquidity to existing shareholders of venture-backed businesses. Direct secondaries afforded us the ability to proactively select individual companies that we believed were the emerging category leaders to garner exposure, typically at a discount to the valuation of the last financing round.
We were less active on the LP interest and GP-led sides. This was due to two main factors. First, fund secondaries were trading at modest discounts at that time (a 12% average discount in 2021) driven by strong performance and liquidity in the asset class. Second, in fund secondaries, an investor acquires an entire portfolio of companies, some of which could be obvious outperformers with meaningful upside, while others may not be. When discounts are modest, we would prefer to proactively select individual companies we want to own.
Following the reset in 2021, there are several macroeconomic dynamics at play creating an attractive opportunity set in the secondary market, particularly for LP-interest purchases and GP-led deals. Those include the denominator effect, the massive amount of unrealized value embedded in mature venture funds, and the rise of new managers that raised first-time funds over the last 10 years or so.
The denominator effect is the phenomenon by which performance in other, more liquid asset classes (i.e., public equity markets and fixed income) declines more rapidly and materially than in the private markets. This, in turn, throws off asset mixes within institutional portfolios, creating over-allocation in the private markets.
In the immediate aftermath of the correction (2022), the denominator effect was the main driving force behind the volume of LP interest sales. While public equity markets have recovered in 2023, the simple fact remains that many asset owners are still over-allocated to venture capital. As a result, we’ve seen a robust volume of deal flow at deeper discounts than in prior periods.
Venture capital portfolios have experienced tremendous NAV [net asset value] growth, driven by strong recent performance; 2010 to 2018 vintage upper quartile U.S. VC funds have generated a 28% net IRR [internal rate of return] as of March 31 this year. Given fewer recent exits, there is now over $1.4 trillion of unrealized NAV embedded in older venture capital funds. As a result of the scale of the unrealized value, lack of liquidity, and strong prior performance, there is greater urgency to sell and more acceptance of higher discounts.
Over the past 10 years, more than 2,000 first-time venture funds raised approximately $89 billion. While some of these firms have developed into well-known brands with no issues securing investor commitments, the majority must continue to prove their track records through realized returns to successfully raise capital.
With portfolios awash in unrealized value, fewer immediate exit opportunities, and longer hold periods on the horizon, GPs are beginning to get creative in order to generate liquidity. Many are considering restructuring more mature funds through various GP-led transactions such as LP tenders, strip sales or continuation funds.
Are valuations currently as low as they are going to drop in the secondary market?
According to our research, NAVs have been marked down 24% on average for VC funds from Q4 2021 to Q2 2023. While this represents a material reset, we do believe the potential for additional downward valuation movement exists.
Over $340 billion was invested into startups in 2021, which is roughly two times more than any other year in the history of venture capital. As a result of the quantum of capital raised, venture-backed companies have extended cash runways and many have gone to great lengths to operate their business in a more capital-efficient manner.
Companies with less operational traction generally still have sufficient cash on their balance sheets that they do not yet need to raise “down-rounds.” In the coming quarters, we expect there to be more down-rounds, putting further pressure on fund performance. This in turn, should create an excellent opportunity in the secondary market, with companies marked to valuations that better reflect market realities.
Are there sectors or areas that you still think could drop further?
We believe that there remains further downside valuation risk in companies with lower-quality business models. For instance, those with low gross margins, high proportions of one-time/nonrecurring revenue, unproven unit economics, companies offering “nice-to-have” versus “must-have” solutions, or balance sheet intensive operations.
Those businesses continue to face a challenging fundraising environment, and therefore remain at risk of down-rounds, recaps, fire sales, or bankruptcies, and so would be priced quite differently than where they are held in many VC portfolios today.
What sort of changes have you noticed in which buyers are in the market?
Despite the attractive market opportunity, only a handful of organizations are active in the market, and we don’t see this materially changing in the future for a few reasons.
First, venture is much tougher to diligence than traditional private equity. Lack of profitability and limited access to information makes it challenging for non-venture-focused investors or investors without a large primary fund business to conduct an accurate underwriting process.
Additionally, most VC fund managers have clauses in their limited partnership agreements that allow them to veto secondary sales. Many will solely accept secondary buyers who are existing primary investors in their funds. Others will simply connect LPs interested in selling to a small number of pre-approved buyers, most of whom are long-standing partners. This is where having a scaled primary fund business is additionally helpful.
Because of the significant variability in VC-backed company performance in this environment, rapid shifts in underlying technologies like AI/ML, and inconsistent valuation methodologies, we believe this environment is especially challenging for generalist private equity secondary participants.
Buying “venture beta” at a discount is unlikely to be a winning strategy, even with the high discounts available. So while there may be more generalists seeking to capitalize on the high discounts, we believe that time will show that it remains challenging for them to be successful.
Do you feel pressure from LPs to sell stock early just to get cash, even if it harms long-term total returns?
Given our venture secondaries strategy is focused on shorter-duration investments (i.e., target liquidity events within two to four years of initial investment), we have not felt acute pressure from investors to sell positions prior to the point at which we believe full value will be achieved.
Do you plan to use the secondary market to increase your existing company stakes at a discount? What are the primary factors involved in your decision-making?
Yes, we do view secondaries as an opportunity to supplement existing positions in value-driving companies. When there is sufficient data to evaluate the ability of a company to consistently execute to plan or above plan, supplementing an existing position is a great way to concentrate the portfolio and layer into potential outperformers.
Do you think other firms are doing this?
We are aware of several similar platforms and direct venture firms that take a similar approach. However, it’s worth noting that many firms have restrictions on the amount that can be invested in direct secondaries, limiting the participation of many direct venture capital funds in a meaningful way.
Michael Szalontay, co-founder and general partner, Flashpoint Venture Capital
Where do you see attractive opportunities in venture secondaries currently?
The best opportunities are in midsized companies with ARR [annual recurring revenue] of $30 million to $100 million. This is where the risk is already moderate, especially if the company is well-funded, and the discounts continue to be quite deep.
Have these opportunities changed since the heights of 2021?
There has been a significant shift in the market. Back in 2021, deals were sometimes being done with no discount. Now discounts can be as deep as 50%.
Are valuations currently as low as they are going to drop in the secondary market?
Depends on one’s view of the general macro [environment] and interest rates, in particular. If you believe that interest rates are at their highest in this cycle, then we are close to the bottom of the market.
Are there sectors or areas that you think could drop further?
Sectors affected negatively by the rapid progress of AI.
What sort of changes have you noticed in which buyers are in the market?
It’s clearly a buyer’s market. Also, internal demand for secondaries from within the cap table has dried up, so it’s much easier to get through the ROFR [right of first refusal] process to get into a private company than before.
Do you feel pressure from LPs to sell stock early just to get cash, even if it harms long-term total returns? What is your strategy to deal with this pressure?
We do not yet feel such pressure, because our funds still have several years remaining in their lifetime, and we have already demonstrated good DPI [distribution to paid-in]. However, many managers are feeling the heat and exploring every avenue to generate liquidity for their LPs.
Do you plan to use the secondary market to increase your existing company stakes at a discount? What are the primary factors involved in your decision-making?
We are doing extensive follow-on [investments] in all performing companies in our portfolio. It’s a great time to buy, especially with a discount on a secondary basis. The major driver of our decision is growth, profitability and also the length of runway of each portfolio company.
Do you think other firms are doing this?
Especially the ones that have raised funds in 2022. Also, private equity funds seem to be pursuing midsized companies with a secondary in mind, more so than in 2020–2021.
Which secondary platform do you consider to be a leader in the space?
Forge is the leading platform in Europe, in our opinion.
Michael Bego, managing partner, Kline Hill Partners
Where do you see attractive opportunities in venture secondaries currently?
We see great opportunity within venture secondaries. It is a completely different paradigm from 2021. Back then, we were cutting off a majority of tech investing given excessive valuations combined with peak secondary market pricing for tech (discounts as low as 10% to 15%).
Today, the situation is vastly different with many assets having seen markdowns (or at least flat valuations despite substantial growth) and discounts that have expanded greatly. There are many companies that will be technology leaders that are currently available on the secondary market for very large discounts. What’s missing? Knowing which companies they are and who is selling.
Are there sectors or areas that you think could drop further?
Secondary pricing has been on the upswing through 2023. Recently, pricing on even venture and growth funds has ticked up (though still at lofty discounts from a historical perspective). We see valuations of tech funds potentially having continued declines through the summer of 2024. In addition, there may be some large blow-ups and bad news for the sector as companies struggle to get and find financing challenging. As such, there could be volatility on pricing for tech assets until this plays out.
Do you feel pressure from LPs to sell stock early just to get cash, even if it harms long-term total returns? What is your strategy to deal with this pressure?
With M&A volume down over 60% and the IPO market essentially shut down, LPs have been clamoring for liquidity where they can find it. That said, LPs that I have spoken with on this have unanimously declared a strong distaste for funds to take on NAV lines for the purpose of making distributions. LPs would rather manage their own cash and debt, which they can do much less expensively.
Fortunately, we have not had pressure from LPs for additional liquidity, as we’ve been able to generate strong natural liquidity from our portfolio.
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