VC Fund Secondary: Buy the Winning Ticket at Halftime

Venture capital isn’t for everyone. Most startups fail, and most investments return zero. Many VC funds don’t make any distributions in the first 5 years, and most of them take 10-15 years or longer to fully exit. The lack of predictability and a long period of illiquidity makes venture capital a challenging asset class for all but the most patient of investors.

That said, top VC funds can perform far better than the rest of the market, and the best tech companies can turn into unicorns that generate 20X, 50X, or sometimes even 100X returns.

If only there was a way to skip ahead five or more years and invest in just the VC funds that are doing well, wouldn’t that be great?

Skip The J-Curve: Buy VC Funds After They’re Already Winning

What if you could arrive at the game at halftime and bet on the team that was already ahead by 10 points? And what if you could buy that winning ticket at a discount? Imagine your friend called you up from the stadium and said, “Hey, I’ve got an emegency and have to leave the game right now – do you want my seat for half-price? I’ve also got a bet on the team that’s winning, but you have to stay until the end of the game to collect.”

Sound too good to be true? Well, it really does happen. Some fans who come to the game might need to leave early. Some investors in VC funds want liquidity before the fund term is over. Fans who leave at halftime will sell their seats at a discount. Investors who want early liquidity will take a haircut on returns in order to cash out immediately. This is the benefit of buying secondary in a VC fund after the first five years, aka “Skip the J-Curve.”

Why VC Secondary? No “Blind Pool,” Faster Growth, Shorter Liquidity

Beyond upfront discounts of 25-50%, there are other key benefits to investing in VC fund secondary.

Because portfolio companies are already established and growing, buyers have a better sense of what they’re getting for their money – they aren’t investing in a “blind pool” of unknown future assets. After five years or more, successful VC funds should have established winners at Series B or C and perhaps even early exits and distributions. Seeing the first few years of performance in the rearview mirror provides insight into how well the fund manager is doing and how well the fund is likely to perform in the future. Again, it’s kind of like checking the score at halftime to see which team is ahead.

Because funds over 5 years old may already be making distributions, investor capital is returned more quickly, perhaps in just a few years. And because Series B and C winners are scaling up fast (often 50-100% or more annually), their growth rates tend to drive the portfolio. As these companies become unicorns, typically one large outcome will dominate the portfolio and drive a power-law distribution of returns.

Finally, the typical 10-15 year holding period for a traditional VC fund can be cut in half when buying fund secondary. This reduces the long illiquidity period of venture capital substantially, making it more competitive with other alternative asset classes such as private equity, private credit, hedge funds, or real estate.

Fund Secondary vs. Company Secondary

Sometimes people may confuse buying fund secondary (partnership interests in a fund) with direct or company secondary (common or preferred stock in a company). Both types of transactions may be called “secondary;” however, they are quite different. Fund secondary is like buying a slice of the entire portfolio, rather than a stake in a single company.

Company secondary (also known as “direct secondary”) has become a popular strategy for retail investors to buy unicorns and get access to venture capital – although due to increased competition, there may be fewer bargains to be found than in the past. Because fund secondary is less common, and because there are often more sellers than buyers, significant discounts are typically available to those investors willing to buy a slice of the portfolio.

Another difference is that because funds contain many assets rather than just one company, they are usually more complicated to evaluate and diligence (especially for investors less familiar with venture capital). And because there are multiple companies in a portfolio, fund secondary is usually more diversified than direct secondary in a single company.

Why are Discounts BIGGER for Fund Secondary than Company Secondary?

Fewer Buyers, More Arbitrage

Because there are fewer buyers specializing in Fund Secondary and because many sellers are competing for liquidity, buyers have greater leverage relative to sellers. Fund Secondary is a buyer’s market.

Basket of Assets, Harder to Value

Fund Secondary is often heavily discounted because it’s more complex to evaluate a basket of assets than just a single company. As former managers and LPs in over 40 venture funds, PVC has extensive experience evaluating multi-asset portfolios.

Unicorns Matter, Horses Discounted

Larger companies close to IPO or acquisition are in greater demand; smaller companies that are still growing are in less demand. Multi-asset portfolios are valued primarily based on current unicorns; future unicorns and other non-IPO winners are more heavily discounted.

Why do LPs and GPs Sell Winning Portfolios Early?

Non-institutional LPs may sell because:

  • HNWIs and family offices need liquidity when change happens (death, divorce, retirement)
  • Corporate LPs change strategy every few years, just as CEOs/CFOs come and go
  • LPs may need liquidity when purchasing a major asset (e.g., real estate)
  • Market volatility and uncertainty may increase the need for cash

Early-stage GPs may sell (or partner):

  • Sell a portion to show realized gains as they raise their next fund
  • Sell to generate cash for operational expenses, recycling, or distributions
  • Sell to hedge and take (some) money off the table
  • Partner (raise capital) to exercise pro-rata rights
  • Partner (co-invest) to increase investment in follow-on rounds

Conclusion

VC fund secondary combines the growth of venture capital with a shorter liquidity timeframe and the opportunity to invest at significant discounts. Buying fund secondary after the first five years of performance allows investors to pick funds that are already winning and return capital more quickly. Market downturns increase the need for liquidity, and since there aren’t many buyers for fund secondary, the discounts can be substantial.

Sometimes people really do need to leave at halftime. For those willing to stay until the end of the game, excellent seats are available.

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