Industry Ventures Provides Little-Known Pressure Valve for LPs
In business lore, venture capitalists are revered as steely-eyed daredevils, directing millions of dollars to unproven, potentially brilliant ideas through sheer force of acumen.
But it’s a largely undeserved reputation. Few VCs ever put their own money on the table. The real gamblers in the venture industry are the limited partners (LPs)— the individuals or institutions who invest in venture funds in hopes of big profits when the funds cash out, typically after 10 years.
It’s an uneasy position to be in, especially as venture firms have struggled in recent years to show decent returns. And so it should be no surprise that some LPs lose the stomach for it along the way.
But as it turns out, there’s a secret pressure valve in the venture business—a set of meta-investors who help distressed, discouraged, or diversifying LPs cash out of a venture fund before it formally matures. They’re called secondary funds, and they help keep the whole venture merry-go-round spinning by offering a hand to investors who, for whatever reason, want to get off.
Early on in the evolution of the secondary market, back in the dot-com era, many sellers were financially distressed, meaning their fund shares could be bought at big discounts. More recently—with the exception of the 2008-2009 financial crisis—the market has settled down, the discounts have disappeared, and LPs who want to unload their venture shares are often just looking to diversify or shift their investments.
Either way, the existence of secondary funds is a boon for LPs who need liquidity. And the secondary funds can be interesting investment opportunities in themselves—at least, for sophisticated institutions that understand the game the funds are trying to play.
I’ve spent the last year and a half getting to know one secondary fund in particular: San Francisco-based Industry Ventures, a 10-man team founded in 2000 by former software entrepreneur Hans Swildens. In a series of interviews, Swildens has educated me about the mechanics of the secondary market, explained how Industry Ventures makes investing decisions, and shared his unvarnished opinions about other corners of the Silicon Valley investing scene. (For example, he’s deeply skeptical about SharePost’s loan program for startup employees, which is designed to help them exercise vested stock options before their companies go public or are acquired.)
Like the venture industry itself, the secondary investing world is shrinking, a victim of the same lackluster returns and investor nervousness that’s turned many venture firms into “zombie funds” that are unable to raise new money or make new investments. A few years ago there were upwards of 50 secondary funds, according to Swildens; now there are about half as many in operation. But about 10 of the secondary funds have managed to thrive and keep investing.
Industry Ventures, which has more than $1 billion under management, is apparently one of the hardy ones. “Unlike the private equity market, this market is much more challenging to invest in,” says Swildens (pictured above right). “You’ve got imperfect, hard-to-find information. You have to get [purchases] approved by the companies. That’s why you only have firms like ours doing this. But we’re generally very happy and bullish about what we are doing.”
It’s probably a good thing that at least a few secondary funds have survived, because the pressure on LPs has never been greater. The main reason: it takes far longer today for most venture-funded startups to achieve an exit, whether in the form of an acquisition or an initial public offering. In 2001, the mean period from founding to exit for venture-backed startups was 3.5 years. Today, it’s closer to 10 years. That means it can take far longer for a venture fund to show positive returns.
The reasons for this dramatic shift are legion, but Swildens points to two in particular. First, there’s legislation like Sarbanes-Oxley, which imposes steep financial reporting and compliance costs on public companies—thus creating an incentive for growing companies to put off an IPO as long as possible. Then there are reforms in the financial markets that have reduced both the fees that investment banks can collect for taking a company public, and the bid-ask spreads that formerly allowed them to make a killing on IPO day.
On top of all that, there’s simply less appetite in the markets for IPO stock. Put those factors together with the lingering effects of the financial crisis—as well as sector-specific troubles such as the decline of cleantech—and it’s no wonder more LPs are looking for early opportunities to cash out their venture shares.
“The average LP in this market has not made a dollar in 10 years,” says Swildens. “They are fed up. Which makes us extremely bullish, because the minute everyone runs away is the minute you should get very active.”
Swildens says the secondary market was “extremely small” when Industry Ventures started out. “That first year, there was less than $200 million a year in volume,” he says. “Now we think there is over $2.5 billion in volume.” If that’s correct, then the secondary market makes up a huge shadow economy in the venture business; new venture investments in 2012 totaled only $4.2 billion.
Industry Ventures has gone after its share of the growing market by increasing the size of its own fund. Since 2007, the company has doubled the size of its staff and doubled the amount it’s got invested, Swildens says. Most of its money goes into funds that invest in enterprise software—meaning infrastructure, communications, and software-as-a-service. Between 5 and 10 percent is invested in cleantech and healthcare. There are still a few consumer Internet funds and companies in its portfolio, but nowadays the firm avoids the consumer market, Swildens says.
By the way, Industry Ventures isn’t a pure secondary fund, Swildens explains. On occasion, it also buys company shares directly from shareholders, such as founders. It also maintains a “fund of funds,” in effect acting as an LP in about 15 small venture funds. And once it owns a position in a specific fund or company, it’s frequently a very active shareholder.
While most of Industry Ventures’ deals are shrouded in non-disclosure agreements, the firm was able to share one recent example that illustrates its style.
In 2012 Industry Ventures bought out an LP in a fund that had invested in GetWellNetwork. The Bethesda, MD-based startup turns the TVs or computer monitors in hospital patients’ rooms into portals for personalized health information designed to speed their recovery and reduce readmission rates. It was founded in 1999 by Michael O’Neil, who survived an episode of cancer that year and says he had “a terrific medical outcome but a really challenging experience from a patient standpoint.”
According to Industry Ventures, GetWellNetwork was the most promising company in the venture portfolio it was buying into. So promising, in fact, that Swildens decided to make a direct secondary investment, buying out two of the three funds that had participated in GetWellNetwork’s Series A round seven years earlier. That made Industry Ventures one of the largest shareholders in the company.
“As Hans came in, in the secondary, it really was the perfect fit,” O’Neil told me. “These guys are typically looking at companies where the organizations themselves aren’t struggling or tired, but you may have shareholders who want or need an exit for whatever reason, internal or external. Hans found his way to our deal in that typical way.”
What was uniquely welcome about Industry Ventures’ involvement, however, was that Swildens promised to help position GetWellNetwork for an acquisition, O’Neil says. “The company was at a point where we felt like there was an exit in sight, in a fairly short amount of time, and we wanted a more action-oriented, involved presence at the board level.”
Swildens joined GetWellNetwork’s board and immediately became co-chair of a new M&A committee charged with finding a buyer for the company. In short order the company entered discussions with Welsh, Carson, Anderson & Stowe (WCAS), a New York-based private equity firm focused on healthcare and technology.
O’Neil says Swildens provided valuable expertise and insights, and helped to keep the discussion with WCAS alive throughout 2012. “Industry is a firm of action, which matches Hans’s personality,” O’Neil says. “He was helpful all along the way in making sure, A, that this was big enough, that there was great momentum behind the company, and B, really keeping us very action-oriented and making sure we were moving forward.”
On January 3 of this year, WCAS announced it had completed the acquisition of GetWellNetwork. The company will now have the resources to grow quickly, O’Neil says. “We spent the first five years trying to convince everyone that patient engagement was important,” he says. “With Welsh, Carson, we have an opportunity, on day one of Act Two, to set out to build what we believe will be one of the most important healthcare companies of the next 10 years.”
It’s standard for Industry Ventures to get more involved in a fund or a company than the shareholders it’s replacing, who have typically been holding out for five to 10 years. “One type of seller might be a venture fund that was raised in 2000 and is now at the end of its term and wants to sell the investments so it can close the fund down,” says Swildens. “Another might be a founder who has been in a company for nine years and has a paper net worth of $50 million and wants some diversification, and sells $5 million or $10 million in stock.”
Without a secondary market, Swildens argues, the venture industry would be having even more trouble raising new funds than it already is. (The number of funds raising money in the first quarter of 2013 was the smallest since 2003, according to the National Venture Capital Association.) The secondary market “allows the venture market to get exits and cash back, which in turn allows them to raise more capital and found new companies,” he says. “Almost every entrepreneur we buy from wants to start a new company, but not until they get an exit. So the secondary market actually creates more innovation.”
That’s a useful buffer at a time when the larger capital markets are so unforgiving toward venture-backed companies (though hope might be coming in the form of the JOBS Act, passed in 2012 and intended in part to smooth startups’ path to an IPO). “There is nothing wrong with the companies here” except that it’s still so much harder for them to go public than it was before 2001, Swildens says. “We constantly talk around the office about how if we owned it in the 1990s, our entire portfolio would already be public.”
That’s scant comfort for startups, their venture investors, and LPs—but for those who’ve run out of patience, Swildens and other secondary investors offer a way to start fresh.