By Christian Munafo
Chief Investment Officer, Liberty Street Advisors, Inc
Update on April 22, 2022
In less than a decade, late-stage venture capital investing has transformed from a small group of companies defying private company norms to a diverse universe where hundreds of highly valued companies have created their own market.
This evolution has occurred as it has become more attractive for late-stage venture capital companies to stay private than to go public earlier in their growth trajectory. This reality means that investors in the public markets have less opportunity to participate in the accelerated growth paths of high growth companies because they are often entering the public markets at a later, slower growth phase of development. Also, many of these companies get acquired by tech behemoths without ever going public.
In 2014, there were 42 late-stage venture companies worth more than $1 billion. Today, there are more than 900, a 21x-fold increase. At the same time, the diversity of these companies continues to increase, as technology bends the innovation curve by moving into sectors that weren’t traditionally hotbeds of innovation.
Today, successful late-stage venture companies have more options than ever to monetize their success beyond traditional IPOs and M&A, including direct public offerings (DPOs) and special purpose acquisition vehicles (SPAC ) mergers. Similarly, shareholders in these private companies have more liquidity options driven by the evolution of secondaries market. While these additional liquidity paths are a positive development for participants in the late-stage venture ecosystem, investors need to be more discriminating than ever to choose the eventual winners amid the rising tide that has lifted all.
How the Private Late-Stage Venture Capital Market Has Changed
The growth in the late-stage venture capital market stems from the trend of private companies staying private for longer. Previously, companies needed to tap public markets for funding at a much earlier stage in their development to finance their growth. That meant that a great deal of growth occurred as a publicly traded company.
As capital has moved from the public to the private markets, companies can and are delaying their entry into the public markets. In addition to the availability of capital, company management teams and boards increasingly choose to stay private for as long as possible to optimize their business models, avoid what can be burdensome administrative and regulatory requirements, and maximize shareholder value.
This explains why so many companies are reaching – and exceeding – valuations of $1 billion. Many of these companies are generating significant revenue (some profitable) and exist in many different sectors, including software, security, big data, cloud technology, FinTech, EdTech, media, commercial services, health tech, genomics, biotechnology, transportation, industrial and more. Many of these companies never actually do go public; instead, they are acquired while still private.
In aggregate, these developments have attracted institutional investors that increasingly favor opportunities outside of the public markets to generate alpha and to avoid unnecessary volatility often created by idiosyncratic behavior.
Evolution in Innovation
The late-stage venture capital market has benefitted from an evolution in innovation that involves applying technology to improving businesses across sectors and industry, including areas not widely thought of as being ripe for disruption. The COVID-19 pandemic served as a gigantic use case for what happens when in-person functions shift online, pulling innovation forward in ways that were hard to imagine before March 2020.
For example, as restaurants across the country were forced to close due to COVID-19 surges, owners and managers turned to delivery to try to make up lost revenue. However, the operating expenses involved in unused restaurant dining rooms made this pivot financially challenging. Enter ghost kitchens, operations in which numerous restaurant concepts operate delivery and takeout-only models out of the same industrial kitchen. In fact, the global ghost kitchen market could reach $1 trillion by 2030, according to Euromonitor.
In a similar way, application of technology to a variety of business processes has allowed companies in other verticals to achieve critical mass in market penetration and adoption. This pull-forward effect from COVID-19 has coincided with large amounts of available capital seeking to fund innovation. As reported by the NVCA Venture Monitor, in 2021 US venture-backed companies raised nearly $330 billion – roughly double the previous record of $166.6 billion raised in 2020 – of which approximately $230 billion represented late-stage deals. Furthermore, nontraditional investors such as corporate venture funds, hedge funds, Private Equity (PE) firms and sovereign wealth funds participated in nearly 77% of total annual deal value.
A Rapidly Growing Market
As investors in private companies have gained more options to monetize their stakes, the market for these companies has exploded.
While there was only a handful of early movers in the secondaries market that started providing liquidity solutions at the private company level over the last couple decades, the broader secondaries market recently started adapting to these changing market conditions and growing needs of private company shareholders. As a result, we can expect to see significant growth in this segment of the secondaries market in the years ahead, a market that in 2021 generated $130 billion in annual transaction volume, according to Greenhill Cogent and Jeffries.
Special Acquisition Companies (SPACs) activity set a new annual record in 2021 with 556 new vehicles and roughly $134.9 billion in capital raised compared to $83.4 billion raised in 2020. That said, sentiment regarding SPACs began to trend negatively in early 2021 with underperformance and increasing questions on long-term viability. While SPACs becoming mainstream could signal an inflection point, they may become a permanent fixture in the late-stage venture ecosystem, particularly if sponsors of SPACs become more discerning with asset selection.
SPACs recently gained popularity because they cut the time and hassle of going public. While a traditional IPO can take up to six months or more to complete, SPACs can occur in just a few months. By going public within a SPAC, private companies can avoid gag rules around financial projections that bind companies going public via a traditional IPO. However, there are some tradeoffs as SPACs may result in greater dilution to existing shareholders compared to IPOs and often do not immediately garner institutional research which could impact trading. As a result, SPACs may face additional regulatory scrutiny going forward. Also, rules require SPACs to acquire a target to take public within a specific period of time, usually within two years. That means all of the SPACs launched in recent years need to find companies to purchase or risk returning investors’ money without a deal.
More companies than ever before are accessing public markets through direct public offerings, which also bypass traditional IPOs. The U.S. Securities and Exchange Commission approved a plan in December 2020 that allows companies to raise new funds as part of a direct listing. Previously, companies were not allowed to issue new shares and raise funds as part of the direct listing process.
There is some concern that rising inflation and interest rates may dampen the appetite for late-stage venture companies, particularly those burning significant levels of cash and without a near-term path to profitability. During periods of increased inflation and macro uncertainty, there tends to be a greater dispersion between high quality and lesser quality companies which can impact capital raising, valuations, and exit opportunities. Conversely, these periods can create attractive risk-adjusted entry points for discerning investors looking to take advantage of market dislocations that bring a longer-term perspective.
In aggregate, the cash descending on the late-stage venture capital market has further enabled innovation while often driving up valuations, but investors must be careful because not every company is viable or a worthwhile investment.
Applying Active Management to Late-Stage Venture Capital Markets
The potential bubble forming around this market means that investors need to be highly discriminating in selecting late-stage venture companies to invest in. Similarly, private company capitalizations can be quite complex as there are often multiple classes of securities, each with different economic and voting rights. There are many ways to potentially take advantage of this type of market dislocation to focus on the highest caliber of available assets.
Utilizing a combination of qualitative and quantitative analysis – known as a top-down and bottom-up approach – works well to distinguish companies worth pursuing and those to put aside. When engaging in fundamental analysis, examine:
- Quality of management
- Experience and strength of investors
- Quality of the business and operating model
- Addressable market opportunity
- Competitive landscape
- Capital structure
- Path to profitability if not yet profitable
While most sophisticated, institutional-grade investors will maintain discipline during all market cycles, these market developments combined with the participation of less experienced investors have increased competition for the most attractive opportunities. This results in an increase of valuations across the market, which often includes lower-quality companies. In this situation, discriminating investors will often win; others may not be as successful.
While even non-viable companies can attract significant capital in these environments, many are ultimately not likely to succeed. The companies that are the most likely to run on the rocks are those that have not demonstrated sustainable business models or an ability to retain customers at attractive margins, exhibit significant capital burn rates, and have inexperienced management that has not dealt with hardship. Others may be trying to innovate in highly crowded environments without clear differentiation, which is another warning sign.
SUMMARY OF KEY POINTS
- The private late-stage venture capital market has grown exponentially in size, number of companies, and sectors
- COVID-19 pulled innovation forward, creating a boom in the application of technology across nearly all sectors of the economy including financial, security, healthcare, industrial, aerospace, and agriculture
- Capital has been pouring in through secondaries, SPACs, DPOs, IPOs and M&A
- The market boom requires investors to exert discrimination, applying top down and bottom-up fundamental analysis to succeed
- Macroeconomic and geopolitical headwinds often create dislocations that may serve as attractive entry points for investors, particularly those with longer-term horizons
ABOUT CHRISTIAN MUNAFO
Christian has 22 years of experience in financial services and investment management, with the last 17 years focused on secondary investments involving venture-backed and growth equity-oriented companies and funds. During this time, he has also served on the boards of many of these companies and funds.
Prior to Liberty Street Advisors, Christian was CIO of SPIM overseeing all investment related functions. Christian still serves as one of the portfolio managers of the Private Shares Fund, formerly the SharesPost 100 Fund, and a member of the investment committee.
Prior to joining the Private Shares Fund investment management team and Liberty Street Advisors, Inc., Christian was Co-Head of the Global Private Equity Secondaries Practice at HQ Capital based in New York, a $10+ billion alternative investment firm headquartered in Germany. Prior to that, he served as Head of Secondaries at Thomas Weisel Partners. Christian started his career as an investment banker at Banc of America Securities.
In aggregate, Christian has helped raise more than $1 billion globally from institutional investors, corporations, pensions, endowments and family offices, and has completed or overseen the completion of more than 100 secondary transactions representing over $1 billion in capital commitments.
Christian received his BA from Rutgers College.
ABOUT LIBERTY STREET
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As of February 14, 2022 Liberty Street has entered into a strategic partnership with GAM Investments to provide clients with access to high-quality late-stage privately-owned technology and innovation-driven companies for non-U.S. investors.
GAM is a leading independent, pure-play asset manager. The company provides active investment solutions and products for institutions, financial intermediaries, and private investors. The core investment business is complemented by private labelling services, which include management company and other support services to third-party asset managers. GAM employed 652 FTEs in 14 countries with investment centres in London, Cambridge, Zurich, Hong Kong, New York, Milan, and Lugano as at 30 June 2021. The investment managers are supported by an extensive global distribution network. Headquartered in Zurich, GAM is listed on the SIX Swiss Exchange with the symbol ‘GAM’. The Group has AuM of CHF 103 billion (USD 110.4 billion) as of 30 September 2021.
For more information, financial professionals should contact their wholesaler by calling HRC Fund Associates, LLC. Advisors, Inc. at firstname.lastname@example.org or 212-240-9726. Individual investors and shareholders should contact their financial advisor, or the Fund at 800-207-7108.
As of December 9, 2020, Liberty Street Advisors, Inc. became the adviser to the Fund. The Fund’s portfolio managers did not change. Effective April 30, 2021, the Fund changed its name from the “SharesPost 100 Fund” to “The Private Shares Fund.” Effective July 7, 2021, the Fund made changes to its investment strategy. In addition to directly investing in private companies, the Fund may also invest in private investments in public equity (“PIPEs”) where the issuer is a special purpose acquisition company (“SPAC”), and profit sharing agreements. The Fund’s investment thesis has not changed.
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The Fund focuses its investments in a limited number of securities, which could subject it to greater risk than that of a larger, more varied portfolio. There is a greater focus in technology securities that could adversely affect the Fund’s performance. The Fund is a non-diversified investment company, and as such, the Fund may invest a greater percentage of its assets in the securities of a smaller number of issuers than a diversified fund. The Fund’s quarterly repurchase policy may require the Fund to liquidate portfolio holdings earlier than the Investment Adviser would otherwise do so and may also result in an increase in the Fund’s expense ratio. Portfolio holdings of private companies that become publicly traded likely will be subject to more volatile market fluctuations than when private, and the Fund may not be able to sell shares at favorable prices. Such companies frequently impose lock-ups that would prohibit the Fund from selling shares for a period of time after an initial public offering (IPO). Market prices of public securities held by the Fund may decline substantially before the Investment Adviser is able to sell the securities.
The Fund may invest in private securities utilizing special purpose vehicles (“SPV”s), private investments in public equity (“PIPE”) transactions where the issuer is a special purpose acquisition company (“SPAC”), and profit sharing agreements. The Fund will bear its pro rata portion of expenses on investments in SPVs or similar investment structures and will have no direct claim against underlying portfolio companies. PIPE transactions involve price risk, market risk, expense risk, and the Fund may not be able to sell the securities due to lock-ups or restrictions. Profit sharing agreements may expose the Fund to certain risks, including that the agreements could reduce the gain the Fund otherwise would have achieved on its investment, may be difficult to value and may result in contractual disputes. Certain conflicts of interest involving the Fund and its affiliates could impact the Fund’s investment returns and limit the flexibility of its investment policies. This is not a complete enumeration of the Fund’s risks. Please read the Fund prospectus for other risk factors related to the Fund.
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