Finding The Exit

Market Perspectives
July 1, 2021
Tristan Terry

Australian tech companies continue to smash records in all corners of the market. Melbourne-based technology company MessageMedia was bought in a AUD1.7B deal by Swedish rival Sinch. This followed shortly after another monster deal where A Cloud Guru was bought by US firm Pluralsight for AUD2B. The MessageMedia deal is the third largest for an Australian tech company, behind KKR’s purchase of MYOB and A Cloud Guru. Listed electronic design software company Altium has also rejected a AUD5B takeover offer from US giant Autodesk. Corporate training marketplace Go1 is also mooted to be Australia’s latest unicorn with its Series D surpassing AUD1B valuation. High profile venture capital rounds continue , including Sendle’s AUD45m Series C, UpGuard banking AUD25m, Sonder raising AUD16m, Rich Data Corporation banking AUD15m, Demyst’s AUD30m funding round and our own Integrated’s AUD5m funding round.

The Australian Venture Capital eco-system has been a beneficiary of this activity as more capital flows into the asset class. But as much fun as it is handing over your hard-earned money to a Venture Capital fund to invest into exciting new technology companies — there comes a time when you just want your money back. This article is less about how long your capital should be locked up for and more to review the options available to the portfolio manager to deliver you those juicy cash distributions.

Most investors either already investing in Venture Capital or considering an investment in the asset class understand that it requires patient capital — however there is no question that the illiquid nature of the asset class can create a barrier for some investors. A longer duration product can sometimes result in uncertainty and in a world that is changing rapidly — some investors require liquidity beyond what a Venture Capital fund can provide.

As a result, investors looking for capital growth lean into more-liquid investments, like listed equities, that whilst possess a number of benefits — may not always help them reach their long-term investment goals. For example, illiquid assets like Venture Capital portfolios come with an illiquidity discount that enables them to potentially access higher rates of return. Much has also been written about the potential benefit of Venture Capital and its ability to supply low correlated assets to a wider portfolio. Low correlated assets provide diversification away from assets that all move in tandem. However, there is also research that suggests Venture Capital funds are probably more correlated to public markets than previously thought. What is certain though is that Venture Capital funds, if properly prepared and funded, can benefit from disruptive environments through their ability to invest in companies that are innovative and can pivot quickly. These sorts of companies can help deliver long term performance for any portfolio.

In all, there are three available paths for Venture Capital funds to crystallize the gains of portfolio companies and return capital to investors.

1. Initial Public Offering (IPO)

There is perhaps no way more glamourous for a fund to achieve liquidity than through the coveted IPO. Lots of fanfare, ringing bells, publicity, etc. Many of our most loved brands have entered our lives and become part of the vernacular through IPO’s. Think Afterpay, Booktopia and Atlassian (although US listed) here in Australia and tech giants; Facebook, Coinbase and Snowflake in the US. These listings all netted their early VC investors returns in very, very big numbers, up to 200,000% in Facebook’s case.

Airbnb and DoorDash were the two most highly valued venture-backed companies to go public through IPOs in 2020 and they did not disappoint. Airbnb that listed at USD47B and had raised USD6B over no less than 24 funding rounds gave its panel of early investors plenty to celebrate. The stock is already up about 2x from listing. DoorDash which went public at a valuation of USD39 billion but off a much smaller capital base, USD2.5B over 11 rounds, has also been solid since listing and made its Seed and Series A backers more than 23,000%.

In 2020, there were 13 VC backed companies that listed at valuations north of USD10B of which all were in the States (which is the highest count in the last decade). Unsurprisingly, there were no Australian companies in this list, but that does not mean Aussie IPO’s disappointed. Australian VC backed companies are consistently getting themselves into positions to list on the ASX and although the numbers are not as striking as their US counterparts, the listing valuations relative to capital raised are comparable — meaning that return metrics are still extremely impressive.

Hipages, an online job marketplace, needed only AUD12m over two rounds and got through the gates at the back of 2020 north of AUD 300 million. That is an incredibly small amount of capital to build a company of that size which speaks to the quality of the strategy and management’s ability to execute it. Returns on the listing for the early backers were rumored to be in the 1,000%’s of which some were crystallized into cash. Prospa, a fintech backed by well-known Australian VC’s successfully listed in 2019 at a market capitalization of greater than AUD600m and performed extremely well for a few months before the market sold it down to around AUD150m from which it has never recovered. Unfortunately for some of Prospa’s early investors, escrow prevented any selling into the IPO which meant they were unable to capitalize on the company’s post-listing momentum.

This is one of the key challenges associated with this exit path for a VC fund and effectively forces them to take their chances with a public company that operates in a much different, more unforgiving environment. In addition to this, IPO markets are highly cyclical and the act of listing itself is onerous, costly and requires a huge amount of key management’s time. This adds complexity to the process on top of the critical elements of company performance.

Sometimes these hazards are so great that, in retrospect, some companies probably wish they had never pursued the public path in the first place. Nuix, which recently listed to pomp and pageantry rarely seen in this country — has gone from bad to worse since becoming a public company. Missed earnings, reports of poor corporate governance, high staff turnover and now police raids have decimated the stock price and a huge amount of confidence in the IPO’s sponsors in the process.

Having said all of this, when well-timed and executed with the right team and careful preparation, IPO’s remain an extremely rewarding way for a fund to achieve liquidity. They will typically represent about a quarter of all exits (by dollar) for Venture Capital funds in any one year.

2. Trade Sale

Trade sales are by some way the most common and generally considered the cleanest ways for funds to achieve liquidity. They are often executed by parties that are highly strategic and therefore willing to pay a premium for that strategic value and the controlling interest that they are acquiring. As a result of this, trade sales can often yield high returns for their owners. Additionally, some of the headaches mentioned above i.e. public market scrutiny, on-going administrative requirements, etc. are eliminated.

Companies executing trade sales will do so for one or more of the following reasons: vertical integration, diversification (horizontal expansion), rapid growth, geographical expansion, economies of scale, or to acquire intellectual property or strategic assets. It has been suggested that funds can achieve higher returns with horizontal trade sales rather than from vertically motivated ones which is amplified in trade sales where there are large information asymmetries. This effect can be reversed however in boom phases of the market.

When a company has executed well and the right parties are at the table — the results can be magnificent….think strategic alignment, synergies, complementary teams, etc. When Facebook paid USD19B for Whatsapp back in 2014, early Whatsapp investors obviously did extremely well. MessageMedia — mentioned above, a global SMS service provider and probably the biggest Australian company you have never heard of, was recently acquired by listed Swedish giant Sinch for AUD1.7B in cash and shares. The acquisition opened up a new range of features for Sinch as well as MessageMedia’s 60,000 strong customer base and growth in the US. MessageMedia had raised AUD42m from five international VC’s back in 1999 and more recently from Aussie private equity.

Early investors in Sparesbox, Australia’s largest online car parts marketplace, did well through a sale to global giant GPC Asia Pacific aka Repco — the country’s second biggest car parts retailer — who were looking to turbocharge their online sales offering and were happy to pay to play. The deal specifics were not disclosed but it was reported to return investors an IRR in the mid 30%’s which is generally considered a very solid return. When the deal was done in early 2019, it had been a relatively quiet couple of years on the exit front for VC’s so the was news welcomed by most members of the eco-system.

In 2020, 41 venture-backed companies were acquired for more than USD1B, selling for USD104B collectively. Similarly, to IPO’s this was the highest count and amount for billion-dollar exits over the past decade. There is no question that the abundance of cheap money in the system at the moment is the main driver of this.

Having said this, trade sales are not always highly accretive to their owners and Venture Capital funds may be just as keen to get an underperforming company out of the portfolio than to realise gains in a one that has done well. In this sense, they can provide a fund with a degree of flexibility in terms of finding liquidity outside of the IPO and Secondary sale (see below) that typically require a company to be executing its plan with a high level of confidence. This is a valuable option to have in the case of a company that has entered the zombie state and is ‘trading’ sideways.

There are of course obstacles for the parties involved unique to a trade sale i.e., post-acquisition integration, extraction of synergies, lock-up of shares, etc. — but the advantage of a trade sale for VC investors is that they are usually released at the time of acquisition and what comes next is for the acquirer and acquiree to work out. For these reasons, trade sales usually represent around three quarters of all exits (by dollar value) for Venture Capital funds in any one year.

3. Secondary Sale

Secondary sales in Australia are a relatively recent means available to portfolio managers looking to provide their investors with liquidity. Secondary markets exist for most other asset classes…real estate, credit markets, etc., so it would seem logical that they have now presented themselves for private assets. Secondary sales allow funds to access liquidity by selling their shares in a private company to a willing buyer (typically a later stage investor) and remove the reliance on the company needing to go through one of the above-mentioned methods. This can be particularly useful when macro-economic conditions do not support corporate activity — which is not the case at the moment. And even when an IPO is on the cards, secondary sales can be used strategically to clear out specific shareholders rather than keeping them around to dump stock once the bell rings.

The presence of secondary sales in Australia has usually been through the enterprise of large US and UK based VC funds looking for a way to get their foot in the door with our most promising early-stage companies. Local investors are starting to catch-on, however. A number of Australian funds have recently raised capital with mandates to cash out early investors, founders, and employees in Aussie companies. A very well-known Australian VC fund recently trimmed some of its exposure in one of the countries rare unicorns which enabled it to return cash to its limited partners and enabled the secondary fund to provide its own investors with exposure to a difficult to access company. This can only be described as a win-win for both parties.

So where once upon a time — secondary sellers were funds looking to exit under distressed circumstances, they are now an important and very much discretionary tool in the hands of a portfolio manager looking to achieve the fund’s investment objectives. Liquidity through secondary sales still only represents a small portion of the market but it is generally accepted that as the demand for liquidity grows, the secondary's market will grow with it.

How much time is required before one of these precious events arises is unclear. What is clear though is that portfolio managers need to start thinking about liquidity a long time before they actually need it. To complicate matters further, companies are staying private for longer as they can now access sufficient amounts of capital through private funding rounds which tempers their needs to go public. The upside is that Venture Capital funds can capture significantly more value than they have been able to historically. So for patient investors — allocating to Australian technology through Venture Capital funds can be a sensible consideration in an investment portfolio. The importance of investing with managers who have experience in providing liquidity for their investors remains; investing the fund is easy — the challenge is finding the exit.