New Enterprise Associates, one of Silicon Valley’s largest venture-capital firms, created a new way of exiting portfolio companies. The firm plans to sell roughly $1 billion worth of its stakes in about twenty startups. This is obviously an effort to return capital to its limited-partner investors in response to a dearth of initial public offerings. The companies at stake will mostly be those that initially raised money from NEA about eight to ten years ago, are currently illiquid, and may or may not become liquid at all.
However, what's more interesting is that the buyer of this secondary sale is a new firm that NEA is seeking to create itself. Yes, you've heard it right.
Let's draw a picture. A venture fund"s lifecycle is ending, and it has to exit all held investments in order to return capital to the limited partners. None of the commonly known exit options have happened: no IPO or M&A, and no other party bought the venture fund's stakes in the portfolio companies. What’s left to do? Create an affiliated entity that will become a buyer of these stakes, thus, providing a legitimate exit.
This type of an exit by the means of a secondary sale of this scale has never been heard of in Silicon Valley before, so we've chatted with several limited partners to get their opinion on such a deal. Mind you, the NEA's deal details are publicly unknown, so we don’t judge or analyze it in question, but rather explore this kind of transaction in general.
The limited partners we interviewed listed several questions that they’d have to ask:
- Where does the money [for the newly created entity buying the venture fund's stakes] come from? There are no limitations to the legal and stockholder structure of such an entity, so practically, general partners of the selling venture fund may be as well its stockholders, which clearly creates a conflict of interests.
- Who does determine the price of the stakes at sale? This possible conflict of interest can be very severe depending on the sale price. Let's imagine that an IPO or M&A of these companies follows soon after the venture fund has sold their stakes and distributed the proceeds to the limited partners. If the subsequent IPO or M&A gets a significantly better price than the price of the sale from the venture fund to the newly created entity, there's enough room for suspicion about this model’s incentives.
- Who does decide which stakes to sell? Because it's not clear who and how determines the price of the sale, the logic behind the choice of stakes to sell is open to question as well. The venture fund may decide to sell its stakes only in those companies that provide a better return multiple, but the company itself may be currently struggling to survive. While the promising portfolio companies whose stakes don't make general partners look better, they may receive nothing in this transaction. At this point, one can get really creative.
The entire idea of controlling the exits from one's portfolio gives general partners a huge leverage of calculating the fund's performance math to their benefit: carried interest, clawbacks, and other terms framing general partners' incentives can be manipulated. It's fair to mention that such a model can be absolutely legit as far as lawyers are concerned. Here's to the new type of exit.
In other news:
It's not only blockchain that’s able to greatly affect the venture capital landscape. A change of limited partners' strategies is much more critical for the industry.
The largest US pension fund, CalPERS, announced that it will invest directly in businesses.
The program, called CalPERS Direct, would be composed of two evergreen funds – one for venture capital-type investments, and one for long-term investments in established companies.
Why is this important?
Corporate and state pension funds have always been among the largest, most influential, and longest running investors in alternative investments. Even though pension funds tend to invest in assets with high liquidity, allocating only 10-15% to alternative assets, 27% of all capital commitments of VC funds come from them. At the end of 2017, total pension assets were estimated at USD 41.3 trillion globally.
If pension funds start investing in the tech companies directly, the competition for money among venture capitalists will become even more severe.
The program is expected to invest as much as $13 billion across the two funds and would have its own board and presumably pay investment staffers compensation closer to the private sector. This is similar to the model used by pensions in Canada and has long been a dream of very large US institutions.
The good news — everyone who has been dreaming of working in venture capital will have more job opportunities to consider.
But don’t get too excited yet: CalPERS said that the plan isn’t a done deal and that the board has many questions (ultimately, the plan requires board approval). On of the board members told the "Buyouts": “We want it to be scrutinized, we want questions to be raised, and we want it to be transparent as we get it out there.” CalPERS wants to roll out its new program next year and answer all the possible questions to put this idea through a full and extensive vetting. Such questions are:
- Will the program go in-house or will it be managed by a third party?
- How will it interact with CalPERS’s traditional PE portfolio?
- What does this mean for traditional private equity at CalPERS?
We'll keep an eye on this, so feel free to send us any of your questions, which we can address to CalPERS at some point.
Recent Industry Reports And Studies (free instant access):
2018 Global Pension Asset Study
HALO Annual Report on Angel Investments
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