VC Secondary Market Partner Perspectives: Mike Bego

In this fourth release, in a series of interviews with successful figures in the secondary market, Derek Minno talks with Michael Bego , an important player in the secondary industry since 2005. He founded Kline Hill Partners in 2015 to provide liquidity to the underserved niche of the secondary market focusing on transactions smaller than other institutional firms would pursue. This article features Derek's takeaways from the conversation along with his insights, as written by Derek himself.

Story Voices Derek Minno (interviewer and author) — Derek has served as a GP in a domestic VC Fund; a GP in an international PE Fund, a LP in multiple PE and VC Funds, and a C-level executive in VC backed companies. He is the President of Point Capital .

Mike Bego (interviewee) — Mike founded Kline Hill Partners in 2015 to provide liquidity to the underserved niche of the secondary market focusing on transactions smaller than other institutional firms would pursue. Now Kline Hill is one of the leaders in this industry having completed over 500 transactions and with more than $3.5 billion in AUM.

While the majority of Kline Hill investing is focused on the buyout space, they have extensive and successful experience investing in venture and growth assets. This article will focus on some insights and trends based on Mike’s nearly 20 years of venture secondaries experience.

Before jumping in, a note from the author: “This collection of conversations will feature insightful interviews with successful figures in the venture capital secondary market. Discussions are focused on the perspective of opportunity analysis, historical evolution, and the current as well as future market trends and activities. The participants of these interviews offer insights and contribute diverse perspectives. We will summarize the interviews and provide both key information and wisdom honed from experience.”

VC Secondary Market Partner Perspectives: Mike Bego

History

Mike discusses the long history of the venture capital secondary market, with key inflection points and a gradual shift towards a more sophisticated and competitive landscape. The history of the venture capital secondary market can be summarized as follows:

• Dayton Carr is credited with being the founder of the private equity secondary industry in the early 1980s and was the first institutional investor focused on venture secondaries.
• The industry slowly matured and grew. However, even in the early and mid-2000s, there was a lack of understanding and awareness among limited partners (LPs) about the possibility of selling or transferring LP interests in venture funds. The entire secondary market was relatively small, with annual volume in the mid-single digit billions at this time. At that time, while most buying was buyout-focused, the primary buyers of secondary venture investments at scale were firms like HarbourVest Partners , Lexington Partners , and Partners Group . Competition in the market was limited, and many deals over $20 million were syndicated.
• While there was some focus on secondary direct investments in the late 2000s, the volume was relatively limited until Second Market and other nascent platforms started. Most deals in this era were for smaller tech companies, which were smaller in terms of revenue and profitability compared to the deals in later years.
• Many investors viewed the secondary approach to venture investing as offering better risk-adjusted returns and quicker liquidity compared to primary investments. Secondary investors entered the market between years 5 to 15 of a fund's life, allowing them to avoid the early losers and focus on companies with product-market fit and revenue.
• The great financial crisis of the late 2000s had a significant impact on the market, and awareness of secondaries increased during this time. Secondaries were an important resource for many distressed sellers and were a great investment opportunity at that time.
• In the 2010s, limited partner volume ramped up substantially. GP-led deals began to emerge in early scale in 2015 initially focused on “restructuring” older assets (including venture funds) until transitioning to more commonly trophy buyout assets at the end of the decade. The market saw a reduction in the number of syndicated LP deals as secondary funds raised substantially larger funds.
• While more of a trend for buyout assets during this era, many of the largest institutional investors drove volume growth by instituting regular, periodic portfolio reviews to identify assets to sell. This style of portfolio management allowed these LPs to sell LP interests if they discontinued relationships with managers, free capital for new relationships, manage exposures, and conduct other beneficial clean up. The volume of secondary transactions was relatively small, accounting for approximately 1% of total net asset value in the industry.
• Competition in the venture capital secondary market grew, but in the early 2010s it was not as intense as grew to be by 2021. Fewer firms of scale and capital pools were competing, and the sourcing of deals was less efficient than in later years.
• Some investors pursued secondary direct investments (acquiring positions directly into companies), but many found these investments (understandably) had a far different risk-return profile with a wider range of outcomes than LP secondaries. The LP secondary market remained a good approach to achieve attractive risk-adjusted returns.
• Today, the venture market has matured and now could reach $10-20 billion of LP secondary and GP-led volume in 2024 with an additional component from secondary direct sales that could more than double those figures. Traditional secondary firms, venture secondary specialists, and even VCs themselves are all active participants providing liquidity to LPs, venture-backed companies, and other sellers of venture assets.

Analysis

Kline Hill focuses on smaller transactions across its diversified platform, including when looking at venture secondary transactions. They typically focus on limited partner deals below $20 million and continuation vehicles below $300 million. The VC secondary market involves unique challenges, and the VC market differs from PE in terms of volume, information availability, GP restrictions, and valuation issues. These are niche areas that requires a significant amount of time and effort to source. To provide sellers with fair value, Kline Hill conducts thorough due diligence and analysis, even for deals smaller than $1 million to 2 million in size. Given the challenges involved underwriting venture assets, firms like Kline Hill with deep experience and broad networks in the space have an advantage in being able to triage and underwrite a select set of the best opportunities.

VC asset turnover as a percentage of net asset value (NAV) is significantly lower than that of buyout funds. This discrepancy is attributed to several factors:

1. Lack of Information: VC deals often lack much of the standard information that buyout funds provide. While buyout deals typically provide data on revenue, margins, EBITDA, and cash levels, VC transactions may lack these metrics if buyers do not have access to the GP or companies themselves. VC companies also have more variables to consider, such as new product launches and product strategies.
2. Restrictive GPs: Some general partners (GPs) in the VC space tend to be more restrictive in allowing secondary funds onto their funds. This can limit competition and result in lower pricing for potential sellers, causing some to decide not to sell.
3. Valuation Challenges: The ultimate value of VC assets can be very difficult to discern and often be not closely tied to today’s operating performance. New technology emergence and competition can create substantial risk. Often, sponsors have high marks for VC assets that force more conservative secondary investors (with less information and sector confidence than primary investors) to offer material discounts.

Market

Though venture capital secondary market has experienced a slowdown in recent years, it is expected to resume its growth in the future. Continuation vehicles and strategies to proactively address liquidity issues are gaining importance. Valuation methods and approaches are also being reconsidered to better represent the true value of companies in the secondary market. Mike discusses the state of the venture capital secondary market and the factors influencing it. Here are the main points:

1. Boom and Slowdown: The venture capital secondary market experienced a boom period after the financial crisis and continued to have high volumes until at least 2020. Going into 2021, Kline Hill and many other investors slowed their pace of venture secondaries given the high valuations at that time. The overall volume remained strong until the first quarter of 2022. However, there was a significant cooldown in capital formation and liquidity in the market since then that began to thaw a little toward the end of 2023. ?
2. Long-Term Growth: Despite the recent slowdown, Mike expects the venture capital secondary market to resume its growth, possibly in 2024 or early 2025. This growth is part of a long-term trend where the private equity industry has been growing over 10% per year and secondary activity growing a bit faster than that. ?
3. Liquidity Challenges & Factors for Growth: The current venture market is characterized by low liquidity. This puts pressure on funds to generate liquidity for their limited partners (LPs) by proactively managing assets rather than waiting for an exit. Three key factors that could increase liquidity in the venture capital secondary market. These are (1) adjusting valuations to more appropriate levels which Mike expects could wrap up in the fall of 2024, (2) return of an exit market of both M&A and IPOs for tech companies, and (3) an improved financing environment for successful companies that require capital (which may include the failure of many tech companies that should not have been funded at the valuations they were in the frothy 2020-2021 period). ?
4. Continuation Vehicles (CVs): CVs are seen as a valuable tool to address liquidity issues. They provide flexibility for LPs who desire immediate liquidity while allowing GPs to continue managing their assets with high conviction. Mike suggested that continuation vehicles could account for a significant portion of exits in the future, possibly up to 20% especially at times when other exit avenues are limited. However, adoption within the venture capital segment remains a fair bit behind buyouts. ?
5. Discounts on Liquidity: The discounts on liquidity differ by asset class. Infrastructure funds may have lower discounts, followed by senior private credit funds, buyout funds, and venture capital, which can have higher discounts. Many are hesitant to sell assets at significant discounts, especially in the venture capital space. ?
6. Waves of Investors: Various types of investors have entered the private equity space over the years, including hedge funds, mutual funds, and pre-IPO investors. However, these investors tend to exit when they realize the higher risk of the asset class. Many of these helped drive up secondary pricing into 2021 but now have departed (and many with large portfolios of assets bought too expensively) ?
7. Diligence Challenges: Due to the fundamentally difficult nature of assessing technology companies whose outcomes could vary wildly and may be hard to predict, often restricted information, and the need for a high-level knowledge and experience in often narrow tech sectors, the venture capital secondary market faces challenges related to assessing the risk-adjusted return for individual companies. One result is that it is often safer to invest in diversified pools of high quality, well priced tech assets and only taking on concentrated exposure with great care and selectivity. Firms such as Kline Hill with deep experience investing across venture cycles and broad networks within the industry have an advantaged starting point in being able to conduct the appropriate diligence on venture opportunities.

Key Interview Quotes?

“Compared to buyout, venture-focused secondary investing has had a slower capital formation period and less volume on the secondary market. Since the implosion of tech valuations starting in 2022, venture exit liquidity has weakened. But trends like these tend to go in cycles. So, I would expect discounts to shrink and material volume to resume, potentially in 2025 after tech valuation markdowns from their 2021 frothy peak are complete. It’s part of a larger long-term trend where the private equity industry has grown at a faster rate than the public equity market and secondary liquidity is increasingly tapped.”

“In today’s market, there is super light liquidity and that puts pressure on funds to more proactively generate liquidity for their LPs. Outside of traditional M&A and IPO exits, they can do that through a few of routes via the secondary market, including continuation vehicle GP-led transactions, sponsoring a tender process for limited partnership interests, taking on NAV lines, or selling portfolio company interests to secondary funds.”

“One of the biggest challenges with venture and growth secondary investing is conducting appropriate diligence for the opportunities and determining an appropriate risk-adjusted return for individual companies. Asset selection, diligence and pricing are all a primary focus at Kline Hill and the main reason we’ve grown the team to over 50.”

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Disclaimer: The information presented in this post is the sole opinion of the writer and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation.