2021 has been an incredible year, with venture funding globally reaching almost 300 billion, an all-time high. It feels like we’ve entered a new stage of venture capital being considered an asset class that compares favourably to some of the more mature ones worldwide.
In Canada, many more tech companies are now at the pre IPO stage today than over the previous ten years combined. From seed to IPO, there are always opportunities for new investors to participate and for existing long-term investors, LPs, CEOs and employees to get some liquidity. As some of these companies merge and go public and become global category leaders, many venture investors don’t necessarily want to sell their position, thus driving a lot of creativity around continuation transactions.
During this episode of the Inovia Sessions, Inovia Partner Karam Nijjar sat down with Veena Isaac, Managing Director of the BlackRock Secondary & Liquidity Solutions team, and Daniel Saks, Co-Founder and President of AppDirect, for a conversation about the growth of secondaries and continuation funds and their benefits for LPs, GPs and founders.
Karam: Veena, you’ve been in the secondary space since 2009. Can you give us some background on the concept of secondaries and the explosion of activities around this type of transaction?
Veena: In a nutshell, secondary transactions provide liquidity to the holders of illiquid private equity or private market assets. Unlike public equity, where you can trade in and out very efficiently when a limited partner commits to a private equity vehicle, they’re often committing for ten to 12 years. So, to the extent they need to sell before that, secondaries are the primary way to do this.
Traditional secondaries are the acquisition of an LP stake in a private equity fund and are the bread and butter of secondaries transactions. It’s how the industry evolved and how limited partners can more actively manage their private equity and private market book, just like they might manage their public market book.
The second category includes GP-led continuation vehicles, like the one that we’ve partnered with the Inovia team on. These have been gaining in popularity as vehicle life management tools. There’s a growing awareness among GPs about the increasing ways they can use secondaries. Before, it was more for vehicle life management for tail-end vehicles. Now, we’re seeing GPs also use continuation vehicles to raise follow-on capital and for portfolio construction reasons.
There has been a significant shift in perception about secondaries. Initially, they had a distressed connotation with the view that the limited partners that accessed them needed to sell for liquidity reasons. That perception has evolved over the last 20 years. Now secondaries are increasingly recognized as a straightforward portfolio construction tool for LPs. And for GPs, it’s become a very efficient vehicle management tool.
Karam: One other aspect of a continuation fund is that it provides the ability to transfer the existing asset and potentially invest additional capital over the next few years to execute the roadmap, be it M&A or some roll-up strategy.
Dan, how important is it for you to have a cap table that has the flexibility to continue to support you in your plans, as opposed to the other way around where perhaps the economics of the fund life cycle are dictating your exits?
Dan: At AppDirect, we’ve looked at different opportunities, whether going public or staying private a little bit longer. The flexibility of the continuity fund has allowed us to take our time in the private markets, which we see as really beneficial.
AppDirect has had a very long-term vision from day one. We want to be the leading company for technology merchants and help businesses find, buy and use the digital technologies they need. We want to build a huge business. The Continuity Fund allows us to partner with Inovia for the long haul to ensure that we are well-positioned with the scale we want when we have the opportunity to go public.
One of our strategies is to have a concentrated base of investors on the cap table who know us well, understand the strategy, and, more importantly, want to minimize dilution. What’s great about the Inovia value proposition is as we’ve scaled, you’ve been able to find creative ways to either take positions yourself or facilitate through your relationships to allow us to continue. That enables us to be much more agile. When we see an opportunity, instead of going out and raising another series, we can evaluate the opportunity to raise a quick round across the board table to make that happen.
We’ve received advice from several board members that our business can grow much more effectively with low dilution through debt. That’s been an excellent way to think about an effective model to scale to IPO. It is an example of how across our board table, we have confidence that whatever strategy we decide to take, we won’t feel forced to accelerate a timeline to go public to fund our growth.
Karam: Veena, you talk about misconceptions around secondaries. One of them is that it’s a short-term outlook, but here we have Dan talking about AppDirect and how they continue to grow that business. Within the context of secondaries, how do you view your need for liquidity or your investment time horizon and how does it align with entrepreneurs like Dan running their businesses with an eye on a very audacious goal?
Veena: Typically with secondaries, we’re entering mid-life into a fund. In the case of Inovia, some of these assets have been in the portfolio for several years already. The way we are thinking about continuation vehicles specifically is they enable the GP to hold an asset or assets for another four to five to six years and allow them to continue working with the management team to take the company to the next level versus forcing an unnatural exit.
We view the duration to be four to five years, which we think is usually the right amount of time, both from the management team’s perspective at the underlying company, as well as the GP for continuation vehicles. It is particularly the case wh
en an asset has already been part of that portfolio for, say, ten years.
Karam: One of the other interesting aspects of raising this fund was the diligence. BlackRock did a lot of work on AppDirect and some of the other assets in the portfolio. Can you talk to us a little about that process? What are the things you’re looking for in the underlying companies, their leadership teams and the markets they play in that ultimately make a fund like this attractive?
Veena: From a high level, we look at the overall portfolio construction. In this case, we thought it was very interesting that the portfolio was well-diversified. AppDirect was a larger position, but it didn’t represent the majority of value; there was sufficient diversity with the other companies in the portfolio.
Additionally, the end markets were also very diversified. It was more of a technology-oriented growth portfolio but serving what we thought were broad end markets. In each company’s case, we liked that the companies were generally market leaders but still had significant TAM and the opportunity to grow either via M&A or through organic options.
With COVID over the last year, our diligence approach has evolved. One of the things we’re very focused on is buying into high-quality companies that can be resilient across different cycles and where we think we’re getting in at good entry multiples, relative to what the growth opportunity is. We’ve also spent a lot of time getting to know the Inovia team. It was clear to see the team’s enthusiasm around the assets and the go-forward commitment to supporting the underlying management teams as they grew into their next stage. That alignment is critical because we are partnering with both the GPs and the management teams on a go-forward basis.
Karam: What criteria should VC funds look at to evaluate if the companies are IPO-ready or should be raising funding for continuation funds and others?
What do you think of IPOs in the context of a portfolio — are they the end of the road or a milestone where you expect to continue to grow value post IPO as part of the portfolio?
Dan: From our perspective, we think that there’s a variety of different mechanisms that can make you IPO revenue-ready; obviously, the governance track and making sure that you have a CFO with financial controls, history and track record of auditing. There are also the business elements and even leadership maturity elements. You are thinking about the brand you want to take to market and having that maturity. What do we believe about repeatable, scalable growth versus business model shifts?
The ambition for our business was expansive. And we’re still adding new, go to market and moat that we believe will be really accretive, so we think it will be best for us to go public once the kind of future brand is established. While we have the revenue scale and financial profile, this flexibility will allow us to maximize the power of the event as both a marketing opportunity.
So we see the IPO not as the end goal but just as another milestone along the way. Therefore having the time has been really helpful. While we considered going public at various times and we evaluated the pros and cons, we’ve realized that there are still ways we can navigate just as effectively on the private markets in a non-dilutive way, leveraging tools like debt to fund our growth. So we believe that staying private a little bit longer will end up being super beneficial to the overall value, and we’ll give a great return to investors like Inovia and BlackRock.
Veena: We’ve invested in transactions involving continuation vehicles that had assets that IPO’d very quickly after we did the deal, and that was part of the thesis. There were several positives to going public and the way we underwrote that was still very much like a private company in terms of growth. In some cases, depending on the GP, the management teams and what they and we think is appropriate, it can make sense to take liquidity in the near term after an IPO. Still, in other cases, we view it as more of a milestone event for the company and expect to continue supporting them.
Karam: With more companies staying private longer and the number of public companies being 50% less than what it used to be, it leaves less of the valuation upside available to public markets. Do we think the ongoing trend will be towards more large funds, like BlackRock finding ways to invest in private companies in this manner? If so, what does that mean for public markets in the long run?
Dan: I think that each business is different, and they’re going to have rationale and reasons to either seek liquidity or an IPO earlier. I believe that optionality will be very effective for many businesses. The entrepreneur founders in our cohort, so let’s say 2007 to 2011 or 2012 have more trepidation to go public. They saw some of the ebbs and flows of the challenges on the public market.
For us, it was apparent that the average IPO, based on that cohort, was maybe ten years after founding, and we were kind of in that zone. I think many younger businesses these days can go public faster, and there are precedents to that. So younger entrepreneurs that founded their companies more recently may seek liquidity earlier. I don’t necessarily think staying private longer is the only way for everyone. Still, I believe that having the optionality in the markets is healthy for the entrepreneur, investors and the broader population.
Veena: I think Dan covered it very well. There’s no doubt, though, that the number of public companies have gone down — public companies have declined by 45% between 1996 and 2018. From an LP perspective, alternatives are becoming less alternative, and are a critical part of asset allocation and portfolio construction For BlackRock, it is an area that the firm has publicly said that we are leaning into as a key growth driver, and it’s really because of this dynamic that alternatives are increasingly becoming an essential part of an investor’s portfolio to take part in some of the growth that they otherwise would miss.
It does depend on the company. I don’t think it’s one size fits all.
Karam: Multiples on invested capital, expectations differ between normal fund investments and continuity funds. Are continuity funds expectations closer to public market expectations than venture return expectations?
Veena: I would say that it is probably somewhere in between. Expectations wouldn’t be the same as a VC fund because we are buying later in that fund’s life, and the companies tend to be much more mature but we are still buying into illiquid assets How we think about the level of returns depends on the investment. Suppose we’re buying two assets where one asset represents 90% of the value; this type of deal has a specific risk-return profile. We would look for a return commensurate with the risks that we’re taking there and this would be different than what we would look for in a more diversified portfolio with more downside protection. So it does depend. It’s very case by case relative to the risks that we’re taking in any specific situation.
Karam: If we have this conversation in a year or two, it might be more mainstream. Are there other structures, geographies, things of that nature that are becoming more compelling to you?
Veena: One of the most exciting things about the secondary market is that the awareness around the market has continued to grow. It has been an under-the-radar type market for many years, with the key role of providing liquidity. Over the last five years, particularly in the previous two, we’ve seen a spike in awareness among GPs. So, it feels like we’re just at the start with respect to innovation within the GP-led space.
When we look forward five or ten years from now, we think there’s a significant opportunity on the GP led side as GPs uncover more and more ways to partner with secondary buyers, and for secondaries to really become more of a solutions-oriented strategy for all parties involved.
We’re seeing similar trends in growth on the LP stakes side. For the reasons that we just spoke about, LPs are increasingly more interested in investing in alternatives. However, they are looking to actively manage their private portfolio similar to how they manage their public market books, and secondaries allow them to do that.
The opportunity is really across the board because of how young the market is. It’s a broad and deep market, and buyers have an attractive opportunity to pick and choose where they lean in, which is what’s exciting about it right now.
One of the things I would add is that secondaries will likely become more solutions-oriented and much more partnership-oriented over time, with secondary buyers working with management teams and GPs to get to the optimal outcome
Dan: I think the theme here is long-term partnership. It’s incredible to see the evolution of the partnership we’ve had with Inovia and the doors it’s opened for us to meet new great people like Veena and others.
I think the power of the Inovia network speaks volumes to the strength of partnerships, loyalty and growth.