Not All Distributions Are Equal
Ask a CIO #36
How do you feel about "manufactured DPI" through secondaries?
Let me just say that this topic can provoke pretty strong feelings, depending on who you ask. So to spare myself from the very strong opinions of folks on either side of this debate, I’m going to not directly answer your question in this public forum (sorry). I will, however, offer abbreviated versions of the aforementioned opinions, with some commentary.
But first, to level set for everyone, I’ll take a minute to explain your question and share a bit of background on how we got here.
Some weeks ago, we talked about the life cycle of private investment funds, with a focus on how investors manage liquidity in terms of capital calls and distributions. My “Cliff Notes” version of a buyout transaction: a private equity firm calls capital from investors to buy a company (throw on some debt), spruces up the company (value creation!), then sells the company (ideally at a nicely appreciated price), and distributes capital back to investors. In a “normal” environment, this process from start to finish, the holding period, takes approximately 3 to 5 years.1
Suffice to say, the past several years have not reflected a normal environment. Holding periods have grown meaningfully longer, and investors are anxious to receive capital back. Part of the impatience stems from cash flow expectations that investors use to manage their total private portfolio allocations. When distributions dry up, it can throw a whole private investment program off balance.
On the other side of the equation, when investors don’t receive capital back, they’re also not as willing to make new private investments. This, of course, poses a problem for private investment managers who want to raise new funds.2
The solution to this conundrum? An increase in GP-led secondaries, or as you referred to it, manufactured distributions (DPI).3
As I wrote previously:
A GP-led secondary is a transaction where a private equity firm sells a portfolio company not to another fund or strategic buyer, but to a continuation vehicle (“CV”) that is established by the private equity firm specifically to purchase the company. The argument generally goes: the portfolio company is doing really well, the private equity firm wants to return capital to existing investors (because investors like capital back), but the private equity firm believes it can generate a lot more value by holding on to the company a while longer. In comes the CV as a solution. The fund sells the company to the CV, returns capital and gains to the LPs that want the distribution, and the fund continues to run the company through the CV.
The challenge for investors in this scenario is that the CV presents a significant decision point – take the manufactured distribution or stay invested (roll over) into the new CV? In the past, before CVs became increasingly common, exit events were liquidity events. There were no additional decisions for an existing investor to make.
With the rise of CVs, the decision is more complicated. On the one hand, the investor is being offered liquidity – that’s good! On the other hand, is it good?
As part of the CV transaction, there is always a new investor stepping in. With a third party added to the mix, the alignment of interests starts to blur. Is the GP pricing the CV to maximize value to the existing LPs or to entice this new investor, the secondary buyer? Is the GP rolling over their full incentive allocation from the investment into the CV, and possibly even adding capital? Did this CV just become the GP’s largest single holding, and thereby largest investment and capital at risk? How much of the GP’s attention and care stays on the CV versus the rest of the remaining portfolio?
But back to the first hand, if the investor passes up the liquidity, rolls into the CV, and the CV does poorly, ouch. Manufactured DPI is great, except for all the hard questions it raises.
One more detour before we wrap up. All of what I’ve discussed above about GP-led secondaries is primarily relevant for private equity buyouts. Yet there is another section of the private market that has arguably been even more liquidity challenged in recent years – venture capital. And here, I’ll offer a couple of thoughts, both of which pertain more to early stage venture.
The first is related to investor expectations. As you know, there was a stretch of years, ending in 2021, where venture investors benefitted from an unusually high rate of both valuation markups and exits.4 Putting aside the painful market correction (and ensuing zombie unicorns), my sense is that this experience distorted expectations for what venture fund investing looks and feels like to some investors.
I would say that return expectations for venture funds shouldn’t start before roughly year 7, and liquidity expectations should be even later. If it sounds like a long time, that’s because it is. Venture investing requires a really long-time horizon, by far longer than any other asset class. In the time frame leading up to 2021, venture funds began generating performance much earlier, which seems to have left some investors expecting returns much earlier. It may take some time for these investors to adopt more normalized venture expectations. It is what it is.
My second thought has to do with portfolio management within venture funds. Venture capital is an exercise in finding outlier investments. It’s therefore not uncommon for a single company, or maybe two, to represent the vast majority of the value of a successful venture fund.
In these situations, particularly as the fund reaches its later years, there’s a strong argument to be made for partial derisking through secondary sales and manufacturing some DPI, when possible.5 In my experience, a surprisingly large number of venture funds don’t proactively engage in this kind of portfolio management, but perhaps more should.6
That’s it for this week, thanks for joining! As always, feel free to reach out with questions: askacio@ivyinvest.co.
Until next week,
Wendy
Which is basically all private fund managers. In my experience, 3 years is the typical time in between fundraises for private equity managers, and that’s about how long the market has been in this slower to exit phase.
Also manufactured sometimes through NAV loans, but we’re not going to go down that rabbit hole here. GP-led secondaries can also be multi-asset continuation vehicle (CVs), but multi-asset CVs tend to be associated with older funds that are looking to clean up assets and wind down the fund, which doesn’t pose the same challenge to LPs.
Six charts that show 2021's record year for US venture capital - PitchBook (January 18, 2022)
Secondary liquidity in venture generally looks nothing like buyout secondaries. In venture, it more typically occurs during a funding round, in which new investors might invest to provide both new capital to the company and to provide secondary liquidity to certain existing investors.
It might sound like I’m contradicting myself here, since I advocated patience just above. But here I’m talking very specifically about outlier winners, investments marked at 50x, 100x, etc.