Recently, I asked a number of LPs the question: When VCs buy secondary shares in hot companies like Facebook and Twitter, why doesn’t it infuriate them? After all, LPs have historically chosen to invest in VC because it is the only way to gain access to private companies with huge growth potential. The secondary market, on the other hand, provides the same capability to nearly anyone with enough zeros in their bank account. I also asked the LPs why they’re willing to pay management fees for the service, when seemingly, they could invest in the companies directly.
I wound up writing a column on the topic, but I wasn’t able to use much of the feedback of one very thoughtful and high-profile institutional LP, who asked not to be named. For readers interested in the perspective of the LP — an investor in pretty much every so-called top-tier fund –here’s what I was told:
1.) “These investments provide venture funds with an opportunity to be part of an ecosystem that will undoubtedly spawn future start-up (in other words, true venture) investment opportunities.”
2.) “This is not ‘venture capital.’ It’s opportunistic pre-IPO growth equity investing. The risk/return characteristics of these opportunities should be compared not with early-stage VC but with other growth capital opportunities. Many LPs prefer the shorter holding periods associated with such investments and perceive the risk to be lower. Some of these pre-IPO deals may well fit these characteristics in the near-term market environment.”
3.) “Pre-IPO investing has always been cyclical. We are coming off a decade of constrained IPO activity, and public market investors are looking for growth companies. The true breakthrough companies might well receive unprecedented valuations. But the number of breakthrough companies will be short, and the pre-IPO opportunity will be limited in time and scale. There’s a good chance the top tier venture groups making these investments today won’t be making them several years from now, and they are well aware of that possibility.”
4.) “Because the number of real breakthrough companies is small — perhaps a dozen — and those companies can hand-pick their investors, access to these pre-IPO shares ‘in size’ is very limited. Venture fund LPs cannot obtain large positions directly. So this is an opportunistic strategy that a relatively small number of firms like Andreessen Horowitz, Kleiner, and TCV, have the best good shot at succeeding with.”
5.) “As an LP, I worry about venture capital fund managers that don’t recognize that this opportunity might be short-lived. Those that scale their organizations in a way that is not easy to back off from or that raise capital in a structure that creates pressure to invest all of it, even if the opportunity fades, are most vulnerable to making investment mistakes. I also worry about venture funds that can’t access the top 10 to 12 breakthrough companies and dip below them, while paying premium prices pegged off the marquee deals. Lastly, I worry if this ‘moment in time’ opportunity causes VCs to neglect their more lasting opportunity to fund the next generation of great start-ups. I don’t see too many signs of this right now, but the longer this opportunistic window stays open, the more the risk increases.”