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Limited Partner Secondaries and Signals of Defaults

February 25, 2016

This article is co-authored with Amir Malayery, Vice President, Industry Ventures.

The recent stock market correction and ongoing volatility signal that another cycle of increased secondary volume driven by Limited Partner (“LP”) sales may be imminent. It has been over seven years since the industry has experienced defaults in any meaningful volume, and we are now starting to see an increase in this activity.  This primer identifies the market dynamics that lead to LP defaults and the criteria that GPs employ to fill in the gaps with appropriate, valuable investors.

How the LP Secondary Market Works

Transactions in the secondary market for company shares and limited partnership interests are much less public than in the primary venture market. When a VC invests in a company, both the company and the venture fund typically promote the investment via social media and a press release.  Secondary transactions seldom get announced, and one-off LP interest transfers are never publicized by venture capital funds.  It’s not surprising that general partners and their respective limited partners want to keep this activity quiet – an LP interest transfer resulting from a very practical reason could unnecessarily be misconstrued as a vote of no confidence by the LP or a signal of an LP’s poor financial health. Contrary to popular belief, almost every venture capital fund experiences LP transfers.

LP Defaults on the Rise and Transfers

Like a VC-backed company has investors, a venture fund has investors (i.e. the Limited Partners or “LPs”) who sign Limited Partnership Agreements (“LPAs”) that legally bind them to fund a certain amount of money (i.e. commitment amount). Unlike VC-backed companies, limited partners do not fund the entire commitment amount on day one. Typically, the general partner of a venture fund draws down capital over a three to seven year period on an as-needed basis. LPAs usually state that if a limited partner does not fund a capital call (i.e. a request for part of the commitment amount as part of an investment in the portfolio), then the limited partner may be placed in default. When an LP default occurs, the general partner will seek to find a new limited partner to buy out the defaulting LP and take over the unfunded liabilities.

The secondary market typically experiences increased selling and transfer activity in venture funds after a public market correction or a liquidity crunch (i.e. the current energy market crisis). When investors lose large amounts of capital in the public market (e.g. more than a -15 to -30% correction in the NASDAQ), individual and non-traditional limited partners in venture funds traditionally start to sell or reduce their stakes to reduce or eliminate their unfunded liabilities (i.e., future capital calls).

Suitable Secondary LPs

What type of new limited partner does a venture fund want? Assessing over 200 venture capital fund secondary transfers where our firm acquired interests, we identified several criteria that venture capital managers use to find a new limited partner:

  1. A stable balance sheet and understanding of the asset class and company risk levels
  2. A  long-term capital source with prior experience in the asset class
  3. An existing limited partner relationship with the desire to increase fund ownership
  4. Ability and pre-disposition to invest into new partnerships in the future
  5. Ability to help portfolio companies with value-added introductions, strategic advice, and direct co-investment dollars
  6. Straightforward internal processes
  7. A proven commitment to the asset class through both up- and down-cycles
  8. Diversified capital sources (i.e. not only invested in one area)
  9. Prior experience with secondary transactions

Quickly identifying appropriate LPs can help minimize the inevitable negative impact of defaults on venture capital funds and portfolio company management teams. Working with an experienced and trusted partner solves this problem, and allows the industry to function in a healthy way regardless of fluctuating market cycles.

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