Part of our jobs as venture capitalists is to have a view on where the puck is going in markets we want to invest in. We also pay attention to where the puck is going in the investment markets broadly. One major shift, that we also expect to continue, is the large-scale rotation into private equity, including venture, which means more mega funding rounds and a greater need for liquidity options. We’re starting a podcast, Liquidity, to explore the evolution of exits in private equity. This post details the trends we expect to see and discuss on the podcast.
We’re in the midst of a great shift of active investment allocation from public to private equity. Institutions are looking more toward private equity to generate alpha in portfolios than public equity, where investors continue to shift more toward indexing. While there is reason to worry about sustaining the pace into private investments, it doesn’t seem that the trend will end any time soon with healthy venture fund raises continuing as well record net cash flows coming back to VC LPs for redeployment. There’s also a record level of dry powder on the sidelines, over $2 trillion, in the broader private equity market.
As we’ve been thinking about where the puck is going regarding the public/private equity markets, we see several outcomes relevant to venture capital as well as the broader equity markets, particularly related to liquidity.
Supply and Demand
The biggest impact and most of the downstream effect is simple supply and demand. Supply of private capital continues to increase with a limited quantity of quality companies to fund, meaning GPs have more money to put to work in those companies, so deal sizes and valuations increase (per the most recent NVCA data), which means either exit expectations must also increase or investors have to expect lower return for their investment. Something has to give. The supply and demand issue could create several trends related to venture and the public markets:
- Given bigger valuations and bigger exit expectations, M&A could become a less viable option for many late-stage private companies. In the past 10 years, there has been just over $700b spent on $500m+ acquisitions across 348 deals, an average of about $2b per acquisition (NVCA, again). While the data isn’t readily available, the median would be much lower than $2b, although a $2b acquisition wouldn’t be a spectacular outcome for many late-stage unicorn-makers. This means that late-stage companies may need to look to the public markets more often as a means to exit. We are potentially already seeing this with the recent IPO wave of 2019.
- This doesn’t necessarily mean going public earlier. The trend of waiting “longer” to go public will probably continue given available private capital.
- Related, with the large amount of private capital available, late-stage companies may favor direct listings or other alternative public avenues rather than traditional IPOs. If companies can easily raise large rounds of private money and don’t need the public markets for financing purposes, only liquidity purposes, the tax of a traditional IPO makes less sense.
- We expect to see some innovation on the direct listing concept that will allow companies to raise money as part of a direct listing, but it may take time for regulators to figure this out. In the interim, SPACs may serve this purpose for some companies looking for liquidity, while many others will just raise large, late-stage rounds shortly ahead of a direct listing.
- The nascent narrative that venture-backed companies need to think more about profitability earlier is false. Higher valuations and larger check sizes mean higher future exit expectations from investors. Companies can only grow into big valuations, not profit into them. This doesn’t mean profitability doesn’t matter, but it does mean that the biggest winners tend to own large, winner-take-all markets which will, in almost all cases, require rapid and aggressive growth.
Liquidity Spectrum
With the amount of private capital available, we expect to see significantly more secondary activity in private markets and more funds focused on buying secondary shares from employees and smaller venture funds. As a result, we expect venture investors and their portfolio companies to look at liquidity more as an ongoing reality than a single event — a sort of spectrum from highly illiquid in the earliest phases of venture funding to semi-illiquid in the “private IPO” phase (the first private $100m+ round raised) to fully liquid in the public phase.
- Real price discovery should begin to happen more often through secondary sales. More effective private price discovery will make it easier for companies to roll into a direct listing when they want to give investors and employees full liquidity.
- Creating the liquidity spectrum will require some reduction in information asymmetry between existing investors and employees and investors interested in buying in secondary markets. Information asymmetry is a double-edged sword in that it creates the opportunity for alpha, but the bigger the asymmetry, typically the lower the demand and thus lower the liquidity.
- This may be man with a hammer given Loup’s research background, but as non-traditional GPs like pension funds, endowments, and family offices look at buying secondary shares from late-stage private companies, the need for investment research will increase. Just as public equity research has declined in value over the past decade-plus because of the symmetry of information, private equity research will increase in value with more participants looking to invest in more opaque opportunities.
On Liquidity, we will share our own insights related to these trends from a decade of experience in public equities, including numerous IPOs as sell-side analysts, as well as talk to expert guests. The first episodes are available on iTunes and other podcast platforms now.