Secondary market set to grow as European venture capital struggles to exit
The European secondary venture capital market is expected to grow significantly as the lack of attractive exit options has increased the need for liquidity.
Increased public market volatility for technology companies has significantly reduced the appetite for venture capital-backed exits in Europe. As of June 15, some 463 deals had closed this year for a total of 16.9 billion euros (about $16.96 million), according to PitchBook data. This shows a decrease of 61.4% in the number of transactions and 87.6% in the total value of transactions compared to the highs of 2021.
As investors and companies brace for a cold winter on the exit front, Europe’s nascent secondary market is heating up as start-up investors and limited partners look to cash in on some assets.
“Current market conditions, characterized by higher interest rates and rotation away from high growth stocks, are leading to a [exit] liquidity crisis,” said Dany Bidar, director of Octopus Ventures. “If these conditions persist, you would expect to see increased pressure for liquidity within the venture capital asset class, making secondaries an increasingly important liquidity solution.
According to data from Industry Ventures, the global volume of venture capital secondaries is expected to reach $138 billion by 2023, but Europe has been slower than other regions to open up to such deals.
This is partly due to a much smaller primary market, but the more complicated nature of venture capital secondary transactions also contributes. Many continental European jurisdictions restrict share transfers, and the inclusion of conditions for the right of first refusal – allowing existing shareholders the opportunity to buy stakes before external buyers – can make such transactions more costly and longer.
Yet, as the European venture capital ecosystem becomes larger and more mature, combined with venture capital-backed companies staying private longer, secondaries become more attractive.
Direct corporate secondaries currently account for the majority of venture capital secondaries deals in Europe. In this type of deal, founders, employees, and early investors sell a portion of their stakes. Companies like fintech Wise and events company Hopin are among those that have made secondary stock sales while still being backed by venture capital.
Typically, direct secondary shares of the company involve the sale of common stock with limited voting and informational rights, rather than preferred stock offered in primary raises. For buyers, the increased risk of being last paid in the event of a liquidation means that the transaction is closed at a discount.
The current fundraising environment could even depress valuations further, according to Rain Tamm, founding partner of secondary investor Siena VC.
“Secondary valuations follow the primary market,” Tamm said. “Of course, if there are public comparables that are worth less than this, investors will also consider that. People who really need cash may have to accept higher discounts.”
The lack of exit opportunities could also fuel more fund-level secondaries, according to TempoCap managing partner Olav Ostin.
Venture capital funds have defined life cycles, and companies needing to stay private longer, they can exit their investments sooner in order to generate returns for their LPs within pre-set time frames. In a multi-asset fund, GPs can sell all or part of a portfolio instead of selling stakes in individual companies.
“If you have assets left in a fund at the end of its life cycle, then you will need to enter into a secondary trade,” Ostin said. “In good times, LPs can give you more time, but there’s no incentive when markets go down. I think we’re going to see a tsunami of these deals in 2022.”
Ostin thinks venture capitalists in particular will look to sell as their parent companies face a potential recession. CVC participation in European venture capital deals has grown significantly in recent years, reaching 1,079 deals last year, according to data from PitchBook.
Limited fund life cycles can also be an issue for LPs directly. With releases harder to find and causing funds to be extended beyond their original schedule, LPs may find themselves stuck in vehicles and unable to collect returns longer than expected.
LP venture capital secondaries are rare in Europe, especially in countries with nascent venture capital ecosystems where government or quasi-government bodies are the most common source of capital for funds, according to Tamm. As the European market becomes more attractive to investors such as pension funds and insurance companies, the LP segment of the secondary market could become more active, particularly if LPs need to rebalance their portfolios.
The slowdown may increase selling pressure, but some investors will prefer to hold assets that may be undervalued in the current environment. According to Gabriel Boghossian, head of secondaries at Stephenson Harwood, GP-led secondaries are emerging as a popular way to extend a fund’s life, conserve assets and provide liquidity to LPs. Although more prevalent in the PE, the broader venture capital market has begun to embrace GP-led secondaries.
The process allows LPs to choose to sell their interests in a portfolio or transfer them to a new vehicle managed by the same GP. For a GP, this allows them to hold onto their assets longer, until exit prospects improve and the selling pressure eases. New investors have the opportunity to invest in the vehicle at a reduced price, although it is usually a small one, as the same GP manages the fund and is unlikely to suffer a big hit on the existing assets.
“The attitude towards GP-led secondary schools has completely changed,” Boghossian said. “GPs want to hold on to their trophy assets and lock in a healthy multiple and IRR for their investors, as well as benefit from the upside growth potential. growth and I think we’ll see more of that.”
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