VC secondaries: types, trends and a comparison to PE secondaries

Secondaries transactions have become increasingly popular as a solution for LP liquidity across the private investment funds industry. For decades, the term "secondaries" has been used to broadly cover a wide range of transaction types across asset classes and investment strategies. However, with the development of various individual market segments, casual reference to the "secondaries market" risks obscuring key differences in how such transactions are structured and transacted for specific asset classes and investment strategies.

The purpose of this article is to cover the differences in deal structure, vernacular, and execution of secondaries transactions within the venture capital ("VC") segment of the private investment funds industry.

Deal pricing ?

At first glance, there is an obvious distinction between secondaries in the VC market as compared to traditional private equity ("PE") secondaries. For PE deals (i.e., largely buyout funds), secondaries buyers traditionally use a pricing model based on the net asset value ("NAV") of a portfolio of interests in private companies. That is, the price in a secondaries transaction in the PE context often ties to the current financial condition of the underlying portfolio, which is somewhat readily available or discernable

By contrast, in VC, the book value of a fund's underlying portfolio companies is frequently tied to the portfolio companies' previous financing rounds and is not always reset on a rolling/moving basis, so it may present a dated snapshot of a particular company's actual financial condition. Because the book value of assets is often vastly different from a fund's NAV, it can be difficult to mark-to-market portfolios of LP interests in VC. And, even if a VC firm determines the book value of its portfolio by periodically marking to market, there remains a stark disconnect in the way that portfolios are underwritten by secondary investors as compared to VC fund managers.

Transfer restrictions ?

Most VC investments in the United States utilize documents based, at least in part, on the National Venture Capital Association 's model legal documents. Among these documents is a Right of First Refusal and Co-Sale Agreement, which may limit the ability of a portfolio company's shareholders (especially common stock shareholders) to freely transfer their ownership.

While transfer restrictions are also common in the PE context, PE investment agreements often include certain affiliated party exemptions and carveouts which are quite broad and can be used to efficiently allow secondaries transactions. These same exemptions and carveouts, however, are not always present in VC agreements. Indeed, many venture-backed companies (including "unicorns") specifically craft their constituent documents in order to make transfers very difficult. In particular, VC agreements generally include much narrower exemptions and are almost always accompanied by a mosaic of additional transfer restrictions which must be waived (or if not waivable, complied with), making transactions more difficult or, at times, impossible.

Regulatory implications ?

Another deal-structuring obstacle in VC secondaries stems from the Investment Advisers Act of 1940 ("Advisers Act"). Under the Advisers Act, fund sponsors advising with respect to securities generally must register with the Securities and Exchange Commission unless they qualify for an exemption. For many VC fund sponsors, the "Venture Capital Exemption" in Section 203(l) of the Advisers Act is used to avoid SEC registration and its oversight requirements.

The Venture Capital Exemption sets out stringent requirements, including that at least 80% of a VC fund's investments must be "qualifying investments." Unfortunately, securities purchased in a secondaries transaction are not qualifying investments. Thus, VC funds must be careful not to breach the 20% cap on non-qualifying investments when engaging in secondaries transactions. If care is not taken in structuring a secondaries deal — and, in particular, general partner-led ("GP-led") continuation fund transactions — VC fund sponsors risk jeopardizing their Advisers Act exemption and may become subject to regulatory oversight (including additional custody, reporting and audit requirements).

Tax considerations ?

When making VC investments, funds and VC professionals often aim to take advantage of the Qualified Small Business Stock ("QSBS") benefit for U.S. federal income tax purposes. The QSBS tax benefit provides favorable capital gains treatment in connection with the sale of certain investments in qualified small businesses.

In a GP-led secondaries transaction in the PE context, care is often taken to ensure that the general partner and existing LPs are able to preserve their existing tax treatment. In similar transactions in the VC context, it is often difficult to preserve such QSBS capital gains treatment, and specific attention is needed in deal structuring if preservation of such treatment is a goal.

Direct secondaries ?

VC secondaries transactions also differ from traditional PE deals in that certain transaction types are more widely available in VC. For example, unlike in PE, VC investors often engage in "direct secondaries." In such a transaction, the secondary buyer purchases interests in one or more portfolio companies directly from the shareholders of such companies (rather than purchasing LP interests in a fund from such fund's LPs). Such transactions may also include buyouts of the existing management team's interests in a portfolio company.

Direct secondaries provide a common liquidity solution for the shareholders of privately held companies and can provide an option for VC investors to increase their exposure to certain privately held companies. In PE, where portfolio companies tend to be majority-owned by the selling firm, direct secondaries are less practicable, and the cleanest liquidity solutions tend to arise at the fund-level.

Portfolio company tenders ?

A second VC-specific secondaries option is the so-called "Portfolio Company Tender Offer." When the term "tender offer" is used in the PE industry, one generally thinks of a GP-facilitated "tender offer" in which all existing fund limited partners are given the option to sell their fund interests to one or more new secondary buyers.

In the VC context, liquidity programs structured as "tender offers" often refer to Portfolio Company Tender Offers, in which a third-party institutional buyer (such as a dedicated VC secondary fund) purchases interests in a portfolio company from existing shareholders (including common stock directly from current or former employees).

Because VC funds typically take minority positions in portfolio companies, VC-led tender offers at the portfolio company level are far more likely to occur than in traditional PE, where the PE sponsor typically desires to hold a majority of common stock or shareholder capital of a portfolio company. Moreover, VC-led third-party Portfolio Company Tender Offers allow companies (including the most successful unicorns) to facilitate liquidity to achieve goals such as employee retention without raising additional capital that may be dilutive to the founders and early institutional investors.

Portfolio sales ?

Like Portfolio Company Tender Offers, "Portfolio Sales" are another VC secondaries transaction that borrows concepts from traditional PE secondaries and limited partner-led secondary transactions. In private equity, "strip sales" are commonly used to sell a portion or "strip" of each portfolio company held by a fund to a new sponsor-managed vehicle to provide LPs partial liquidity with respect to a number of portfolio companies. In such transactions, a portion of each fund portfolio company is sold to a GP-led continuation fund with backing from a secondary buyer.

Portfolio Sales similarly refer to the sale of a portfolio of investments; however, in the VC context, there is often no continuation fund acting as buyer, and such transactions can be used as a complete exit option for VC sponsors to fully liquidate a fund's portfolio. In some cases, Portfolio Sales are used to bundle a fund's "crown jewel" assets with other assets to provide a more efficient and timely exit for a VC fund of its remaining portfolio of assets, rather than selling each asset individually over time. Care needs to be taken as these portfolio sales often borrow concepts from different types of secondaries transactions and don't always resemble "true" venture M&A-style exits.

Sales of limited partner interests ?

As noted, the VC pricing methodology can be an obstacle when marketing and executing secondaries transactions. This is also true in situations where limited partners seek to rebalance or dispose of limited partner interests in one or more VC funds.

Where macro-economic conditions are strong, the pricing reference for a portfolio of VC limited partner interests may be viewed as too low to capture the "true" value of a portfolio of underlying VC funds. By contrast, in a difficult macro-economic climate, pricing derived from previous financing rounds can be too high to drive significant buyer interest in those same underlying VC funds.

Because of this potential for significant discounts and premiums to the value ascribed to these underlying VC fund portfolios, it can be difficult for limited partners to sell large portfolios of limited partner positions purely in VC funds. However, institutional limited partners still actively manage their exposure to VC funds, but often do so when bundled with larger portfolios which also include PE, real estate, growth and infrastructure fund positions — particularly in very large block or portfolio trades.

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Krishna Skandakumar , a partner in Goodwin 's private investment funds practice, advises sponsors throughout the lifecycle of a fund. Within his private funds practice, he specializes in advising clients in connection with secondary and related liquidity transactions. He also has expertise in more traditional LP portfolio sales. He is based in New York and can be reached at [email protected] .

Jamie Hutchinson is a partner in Goodwin's private equity group. His practice involves a broad range of corporate and commercial transactions, including representation of private equity and growth equity funds and their portfolio companies, family offices, and other institutional investors in leveraged buyouts, mergers, acquisitions, divestitures, and growth equity investments. He has expertise in structuring and executing secondary transactions and private tender offers for late-stage private companies and represents clients in a variety of industries, including technology, software, financial services, media, business services, health care, education, consumer products, and energy. He is based in Washington, D.C., and can be reached at [email protected] .

Lia Schmidt is a partner in Goodwin's business law department and a member of the private investment funds practice. Her practice focuses on the structuring, formation and operation/ongoing management of private investment vehicles (including US domestic and international venture capital, growth equity, private equity, impact, secondary, and debt funds) and their management companies/general partner entities. She has experience with limited partnerships, limited liability companies, joint ventures, venture capital financings, private placements, and merger and acquisition transactions. She also represents institutional investors in connection with their investments into venture capital and other private equity funds. She is based in Silicon Valley and Washington, D.C., and can be reached at [email protected] .

This content was originally published on Westlaw Today . The use of this content is with the permission of Thomson Reuters .