In business lore, venture capitalists are revered as steely-eyed daredevils, directing millions of dollars to unproven, potentially brilliant ideas through sheer force of acumen.
But it’s a largely undeserved reputation. Few VCs ever put their own money on the table. The real gamblers in the venture industry are the limited partners (LPs)— the individuals or institutions who invest in venture funds in hopes of big profits when the funds cash out, typically after 10 years.
It’s an uneasy position to be in, especially as venture firms have struggled in recent years to show decent returns. And so it should be no surprise that some LPs lose the stomach for it along the way.
But as it turns out, there’s a secret pressure valve in the venture business—a set of meta-investors who help distressed, discouraged, or diversifying LPs cash out of a venture fund before it formally matures. They’re called secondary funds, and they help keep the whole venture merry-go-round spinning by offering a hand to investors who, for whatever reason, want to get off.
Early on in the evolution of the secondary market, back in the dot-com era, many sellers were financially distressed, meaning their fund shares could be bought at big discounts. More recently—with the exception of the 2008-2009 financial crisis—the market has settled down, the discounts have disappeared, and LPs who want to unload their venture shares are often just looking to diversify or shift their investments.
Either way, the existence of secondary funds is a boon for LPs who need liquidity. And the secondary funds can be interesting investment opportunities in themselves—at least, for sophisticated institutions that understand the game the funds are trying to play.
I’ve spent the last year and a half getting to know one secondary fund in particular: San Francisco-based Industry Ventures, a 10-man team founded in 2000 by former software entrepreneur Hans Swildens. In a series of interviews, Swildens has educated me about the mechanics of the secondary market, explained how Industry Ventures makes investing decisions, and shared his unvarnished opinions about other corners of the Silicon Valley investing scene. (For example, he’s deeply skeptical about SharePost’s loan program for startup employees, which is designed to help them exercise vested stock options before their companies go public or are acquired.)
Like the venture industry itself, the secondary investing world is shrinking, a victim of the same lackluster returns and investor nervousness that’s turned many venture firms into “zombie funds” that are unable to raise new money or make new investments. A few years ago there were upwards of 50 secondary funds, according to Swildens; now there are about half as many in operation. But about 10 of the secondary funds have managed to thrive and keep investing.
Industry Ventures, which has more than $1 billion under management, is apparently one of the hardy ones. “Unlike the private equity market, this market is much more challenging to invest in,” says Swildens (pictured above right). “You’ve got imperfect, hard-to-find information. You have to get [purchases] approved by the companies. That’s why you only have firms like ours doing this. But we’re generally very happy and bullish about what we are doing.”
It’s probably a good thing that at least a few secondary funds have survived, because the pressure on LPs has never been greater. The main reason: it takes far longer today for most venture-funded startups to achieve an exit, whether in the form of an acquisition or an initial public offering. In 2001, the mean period from founding to exit for venture-backed startups was 3.5 years. Today, it’s closer to 10 years. That means it can take far longer for a venture fund to show positive returns.
The reasons for this dramatic shift are legion, but Swildens points to two in particular. First, there’s legislation like Sarbanes-Oxley, which imposes steep financial reporting and compliance costs on public companies—thus creating an incentive for growing companies to put off an IPO as long as possible. Then there are reforms in the financial markets that have reduced both the fees that investment banks can collect for taking a company public, and the bid-ask spreads that formerly allowed them to make a killing on IPO day.
On top of all that, there’s simply less appetite in the markets for IPO stock. Put those factors together with the lingering effects of the financial crisis—as well as sector-specific troubles such as the decline of cleantech—and it’s no wonder more LPs are looking for early opportunities to cash out their venture shares.
“The average LP in this market has not made a dollar in 10 years,” says Swildens. “They are fed up. Which makes us extremely bullish, because the minute everyone runs away is the minute you should get very active.”
Swildens says the secondary market was “extremely small” when Industry Ventures started out. “That first year, there was less than $200 million a year in volume,” he says. “Now we think there is over $2.5 billion in volume.” If that’s correct, then the secondary market makes up a huge shadow economy in the venture business; new venture investments in 2012 totaled only $4.2 billion.
Industry Ventures has gone after its share of the growing market by increasing the size of its own fund. Since 2007, the company has doubled the size of its staff and doubled the amount it’s got invested, Swildens says. Most of its money goes into funds that invest in
