Exploring Private Exchanges

It’s no secret that the venture industry is reeling from a liquidity crisis – we’re constantly reminded that venture-backed IPO and M&A activity is at historic lows. And while there have been recent glimmers of hope via the IPOs of OpenTable and SolarWinds, we’re far from the proverbial IPO window being open again. To address the issue, the National Venture Capital Association (NVCA) laid out a “Four Pillar Plan to Restore Liquidity” back in late April. As part of the plan (the second “pillar”), the NVCA encouraged the use of enhanced liquidity mechanisms such as private market exchanges. While yet to gain much traction, a number of these newer private exchanges have garnered attention of late. They might turn out to be great for the venture industry, but I see a few issues, including the fact that they all seem to be doing very similar things meaning the space is very fragmented right now, and volume is much too low to put a dent in the liquidity issue. Here’s a rundown of some of the major new players:

Backed by venture firm Draper Fisher Jurvetson, XChange will use a bid/ask pricing system to allow the sale of private securities to qualified institutional brokers. I’m not clear on whether or not this includes LP interest in venture funds or just shares in a start-ups employees or venture firms may hold. XChange will also offer companies the ability to do a primarily issuance of shares (they’re calling it an “XPO”). Still new, the exchange is not yet fully operational.

With the support of the NVCA, a number of venture capital firms (Oak, NEA, Venrock, Versant, DCM to name a few) and apparently 200 institutional investors, InsideVenture might be the private exchange with the most industry support right now. InsideVenture offers “Hybrid public-private offerings” in which start-ups would have to file the same way as they would for a regular IPO, but the shares would first be offered to investors that are affiliated with InsideVenture. It does not seem like there is the options to do smaller secondary sales of direct ownership stakes in companies like with XChange. InsideVenture is open to only institutional, PE and accredited investors.

SecondMarket is one of the better established private exchanges. They claim to have 3,000 market participants, with $10 billion in traded assets. In addition to shares of private companies and limited partnership interests in private equity funds, the exchange is for all types of illiquid assets including auction-rate securities, bankruptcy claims, CDOs, and MBSs. To help attract bidders for these illiquid assets, SecondMarket has developed a proprietary "ManhattanAuction" which essentially pays bidders for bidding. The exchange is open to institutional and accredited investors only.

The newest private exchange on the block is SharesPost. In fact, it just went live with its public beta release yesterday. The interface is much more open than other private exchanges - after a basic registration process, you are able to view the shares of top venture-backed companies that are for sale, what the bid and ask prices are and, for some companies, the implied valuation (more on this later). It costs $34/month to post or interact with other posts (buyers and sellers), there are no commission fees, but there is an escrow fee of $2,500. Sellers remain anonymous except to the buyers of shares (who must be institutional or accredited), but all SharesPost members can view restrictions sales are subject to and prior agreements once even one trade is made on a company. The minimum proposed transaction size is $25,000.

Of the four private exchanges I've highlighted (there are plenty more that are not as sexy, including NASDAQ's PORTAL Alliance, the NYPPEX, and TSX Venture Exchange), SharesPost stands out the most due to its openness. Both SharesPost and SecondMarket only allow for the secondary sale of private company holdings. InsideVenture seems to do just primary (semi-public) issuances and XChange looks to do both. All complete the mission of providing liquidity, particularly for employees and smaller shareholders (save for InsideVenture), but I still think the larger liquidity issues will remain. It’s unrealistic to expect many substantial full-blown venture-backed exits through any of these exchanges, at least to the point that it alleviates the industry’s liquidity issues. They’re more of stop-gaps in my opinion, and I think they know that.

The fragmentation I mentioned earlier probably hinders all of them which is why I think there eventually will have to be some consolidation in the space to allow for more efficient marketplaces. For now, they will all face competition from not just each other, but traditional IPO and M&A exit avenues (if/when they come back) and a growing crop of direct secondary and traditional secondary funds which have the upper hand when it comes to negotiating terms since they can make purchases in larger chunks while keeping the transaction private. Speaking of which...

It probably hurts companies that list on a more open exchange like SharesPost if they are looking to obtain additional rounds of funding. It’s understandable why SharesPost went the more open route (because it should attract more buyers and sellers), but a lot of private equity and venture capital firms would not be comfortable with investing in a company that has so much of its information public (sorry, but obligatory: “it’s called private equity for a reason”).

One interesting piece of information that ends up out there is a company’s valuation – and even if it’s not out there or accurate, there are implications for venture capitalists invested in the companies beyond just maybe having that information public. A layer of complexity could be added to valuating companies under FAS-157, which has established the framework for measuring fair value. Under FAS-157, investors have to mark an asset to market, which I think would mean that venture and private equity investors in companies listing on a private exchange would have to take into account transactions occurring on those exchanges when it comes to quarterly reporting to LPs. Not a fun prospect.

It will be interesting to see what impact these exchanges have. I’d like to do a follow-up examining each one in more detail if possible. I’d also like to examine the SharesPost model a bit further in a future post because of the tie-ins to my previous look into crowdsourced venture capital; the purely on-line transactions, openness of information, and allowing regular individuals to participate.

The 1999-2000 Problem

The fact that venture capital has not produced quality returns for 10 years has been getting a lot of attention lately, particularly as LPs start having to make tough decisions about whether or not to continue to commit to the asset class. When a typical LP looks at their portfolio, what do they see?

Let’s assume that it’s a fairly well established institutional investor who has been in the asset class since the early 1990s. My best guess is that it looks something like this: reasonable commitments and excellent distribution activity from (vintage year) funds up to 1997-1998. Then things hit a wall. The good times ballooned out of control into the “irrational exuberance” (I hate that term) of 1999 and 2000 when LPs went gangbusters committing to VC funds. Needless to say these did not perform well. So next, the tech bubble bursts and you have a massive pullback - there are probably relatively much fewer vintage year 2001-2003 funds in most venture portfolios. Too bad, because these funds, on average, have performed pretty decently. Then investing activity picks up again, you see more 2004 and 2005 funds, which have had acceptable performance and some distribution activity but are still young enough to hold further promise. Commitments probably increase significantly (though not as much as with buyouts) in 2006 and 2007 as the economy was firing on all cylinders. These funds are too young to have produced meaningful returns, as are 2008 funds which most LPs pulled back on investing in due to liquidity issues.

So with this picture of what LPs are looking at let’s go back to the 1999 and 2000 funds: The returns, everyone can find a way to live with. If you’re a 1999 or 2000 venture fund, an IRR of 0% would be above average, and most funds would be happy simply returning commitments at this point. VCs can live with this because most have already moved on: “hey we think we can return all of your capital in what were two really crappy years for everyone, and we’ve learned our lessons and promise not to mess up again.”LPs are probably willing to accept the returns as well. But there’s one problem- so many of these funds have so much capital still unreturned. It’s one thing to have these returns down on paper; it’s another thing to actually achieve them. We’re talking about funds that have to wind down operations in the next year (ok, throw in a couple years of fund extensions, but it’s still going to be a challenge). At year end, the net asset values of 1999 and 2000 funds was some $33 billion – a huge chunk of all venture capital, even after huge write-downs in Q4 of 2008.

What’s going to happen to all these investments and funds? Venture firms are going to have to either get really creative, really lucky, or liquidate at massive discounts. This is a major issue that isn’t talked about enough, but will be over the next couple years, I think. And it raises further questions which don’t have clear-cut answers, like: Will 2005-2007 funds be faced with similar issues if the exit markets don’t improve? And is this more of a fundamental issue with venture capital now? Take, for example cleantech deals and funds – there are already questions around being able to build, develop and exit solar or biofuel companies in five to seven years. I’m not saying venture is dead, there’s definitely a need and place for it, but it’s going to be different. For one, we may be looking at longer fund terms which means more illiquidity and higher return expectations. It may also mean a rise in liquidity options, such as special markets for illiquid assets, and secondary funds specializing in companies or LP interests in venture funds that need to conclude operations.