Secondary funds bloom as venture capital investors seek more exit options

While India has historically been a tough market for exits, that has been changing in the last decade, with outcomes such as Flipkart (sold to Walmart), CaratLane (sold to Titan), apart from a dozen unicorns going public.

An increasing number of fund managers are now moving away from investing primary capital via venture capital funds and are setting up their own secondaries fund as they look to build more exit options that go beyond initial public offerings (IPOs) and mergers and acquisitions (M&As).

A secondaries fund is one that buys shares in a firm from an existing backer. The transaction is between one investor and another, nothing goes into the company’s cash chest, unlike a primary fund raise. During secondary deals, private company shares are also available at a discount, sometimes as high as 40 percent, giving an entry option to those who may have missed out earlier.

Funds with this kind of expertise are far and few between in India which explains the increasing interest from veteran fund managers.

Examples of VCs leaving to launch secondary funds include Raj Dugar, co-founder of WestBridge, and more recently the Managing Partner at Eight Roads Ventures, Nitin Agarwal, MD – India at TPG NewQuest, Piyush Gupta, MD at Peak XV and Sameer Brij Verma, MD at Nexus Venture Partners, all of whom have stepped down in the last year.

Moreover, at least three limited partners (LPs), including institutions and family offices (FOs) who invest in funds, told Moneycontrol that they have seen an increase in the number of inbounds from executives looking to start their own secondary funds. They, along with industry executives, admitted that secondary funds are “in vogue” and the category is a “huge white space” in India.

“You speak to any of the top 10 venture funds and if they’re not doing secondary transactions right now, they’re definitely doing something wrong. That’s how hot the market is currently,” a seasoned fund manager, who recently quit and is likely setting up his own secondaries fund, told Moneycontrol.

There is ample opportunity.

Shares of Innovaccer, BharatPe, ShareChat, Cultfit, Swiggy, Meesho, among several other large companies, are all in the market and changing hands in different secondary transactions, multiple industry participants told Moneycontrol. More recently, Urban Company saw a secondaries transaction of Rs 400 crore and investors exited Purplle and made way for others in a Rs 600-700 crore round, underscoring the heightened activity.

Secondary transactions have emerged as a bright spot, as per DC Advisory India, an investment banker. About two-thirds, or 23 of the 37 deals in the $50-500 million range that materialised during the January-June period were secondary transactions or buyouts. External primary investment rounds accounted for only about 13 percent, underscoring a changing preference, data from the banker showed.

“Given the increasing pressure to deliver Distributed to Paid-In Capital (DPI) and in particular in a scenario where the Indian public market sentiment starts to moderate, we do foresee a significant uptick in portfolio level or multi-asset secondary activity,” DC Advisory India said in a note last month.

Increased activity will be an incentive for more fund managers to set up dedicated funds for specialised transactions.

Founder secondaries

Apart from investors, founders also sell shares in their companies. While some say that implies the founder is losing conviction in the firm, the others support the move.

“I'm an advocate for founders to take some money from secondaries when their company is scaling, they should take some money to take care of pressing personal expenses like home loan etc... so that their mind is free…Most of us come from a middle-class background. We have not seen enough money in life,”  Girish Mathrubootham, Freshworks founder and executive chairman, said while speaking at the Moneycontrol Startup Conclave.

Founders of Swiggy, FirstCry, Nazara all sold shares recently.

The cycle

Naturally, secondary funds are part of the evolution of private equity/venture capital because investors who put in money eventually need an exit a few years later. “But, there's a realisation that liquidity events aren't happening in the time frame that investors need it to happen in. There's a need to sell. So, while there are enough sellers, there are not enough buyers – that’s when the need for a secondary fund arises,” a second fund manager, who left a venture fund recently, contemplating to start his own secondaries fund told Moneycontrol.

In India, a venture fund raises money from LPs/fund sponsors and returns the capital, with interest, in 8-10 years plus a predetermined extension of two years. So, when the deadline looms, funds make moves to ensure the capital is back with their sponsors.

“Now, the 2016 funds are also looking and saying I am in trouble if I don’t give liquidity to my LPs. So, now you've got so many funds suddenly saying we've waited long enough, we can't wait an incremental three-four years, the exits need to happen now. But the portfolio companies are doing really well which is why secondary transactions and funds become all the more attractive,” the person quoted above said.

The carry structure and management fee are also different for secondary funds. While most venture funds have a 2/20 structure (2 percent management fee and 20 percent carry), secondary funds have a lower management fee and hurdle rate after which the carry gets triggered.

That is largely "because the companies where secondaries happen are also fairly mature at that point in time unlike fresh assets that need a lot of time and effort. The secondary fund will likely not be the largest investor on the cap table, may not have a seat on the board, so active management may not be as rapid. The high hurdle is a sign of conviction of the upside potential and is needed to convince investors...the more money an LP makes, the more money the manager also ends up taking home," Siddarth Pai, Founding Partner and CFO, 3one4 Capital and Executive Council member of the Indian Venture Capital Association (IVCA), said.

Secondary deals are also happening as there is a dearth of investible assets in the primary market.

"The best assets don't want to end up coming and getting priced in the market right now because they enjoyed eye-watering revenue multiple times from 2020/2021. They may not be able to enjoy the same multiple as of now unless things have dramatically changed. They're still in the transformation phase. So most of the boards and founders are very hesitant to go and raise external cash as of now, but existing investors still need an exit which has fueled secondary deals," Pai added.

Change in style

However, as action in secondary markets picks up, the way transactions happen and the nature of conversations have changed when compared to early-last year.

Earlier founders asked investors for a higher primary valuation and also offered secondaries at a massive discount. That way, the blended cost per share for an incoming investor would work out to be lower and the valuation of the company also did not diminish – it was a win-win agreement, experts said.

“But, now what's happening is that there's significant desperation to sell shares from the investor side unlike earlier when secondaries were happening because of desperation from the founder’s side. There’s been a switch,” a Partner who dabbles in this space said.

And because the quality of companies has improved over the years “a majority of secondary players aren't necessarily looking for distressed sales anymore. They're looking for great businesses but distressed investors,” he added.

Investors want to sell shares because they have to return capital to their LPs and there are takers for these shares because the companies have more legs to run.

For incoming investors, there are multiple ways for them to buy into companies. One is a straight/direct share sale of a single company from an existing backer to a new investor. Next, some specialised companies also facilitate share sales by employees and founders which later finds buyers in a wider market. There is another, more common route, is when an existing investor sells a block of assets to another fund in full.

For instance, Chiratae Venture Partners recently sold some shares of its portfolio companies bundled with shares of Lenskart – one of its hottest properties – which made the entire block more attractive and was easier to find buyers, one of the persons privy to the developments told Moneycontrol.

“The general partner, who's giving you a prized asset, which he can very well sell to others in the market, will also want to offload a little bit of his lemon assets. However, the secondary fund buying will want to buy just the prized assets. So, it all boils down to the buyer and how much command they have over the deal,” a third person, who runs a secondary fund, said.

“I would rather give a fair value to a good asset than a lower value to a bad asset because the bad asset is unexitable or is difficult to sell…however if I'm able to get a higher discount on the lemon assets, then my overall entry price, as a basket, also reduces…that's why I buy some of the distressed assets,” he added.

Primary versus secondary funds

Even as fund managers find the secondary space attractive, the going may not be very smooth just yet.

“The good part is that not too many people understand the secondary space in India and don’t know what to look for in these deals. The talent is very limited…it will be more rewarding for managers who know the game,” an industry expert said.

Continuation funds especially are a big white space in the Indian secondary funds scene “because every single fund will have one or two trophy assets which they don't really want to sell. In a normal scenario, when the fund life ends, they have to sell the asset. However, if the fund ropes in an LP who can fund a continuation fund, it can manage the prized assets even more by rolling it over,” the expert said.

A continuation fund is when a fund manager picks a few companies from its portfolio and rolls it over to the next fund.

Unlike the other venture funds, which typically have a holding period of 10 plus two years, secondary funds have a shorter holding period of four to five years because the companies these funds are buying into are more mature ones. The returns, or the internal rate of return (IRR), are also in the 20-25 percent range similar to other venture capital funds.

All said and done, while there will be an uptick in the number of secondary funds being set up in India, only the fund managers who have cut their teeth in similar sectors will be able to enter at the right price, deliver desired results and prove their mettle.