January 26, 2024

Venture Capital in Transition: Navigating New Realities in Secondary Markets and Realigning GP Incentives

Venture Capital in Transition: Navigating New Realities in Secondary Markets and Realigning GP Incentives

Fresh data from Jefferies Financial Group focuses on the current state and future expectations of the secondary market for venture capital and private equity.

In my latest research I break down and analyze JFP’s key data points and propose an honest discussion regarding the concept of recalibrating venture capital funds in terms of purpose and incentives for General Partners (GPs).

The worldwide secondary transaction value was $112 billion in 2023, a 4% increase year-over-year, with expectations for 2024 to reach or surpass $130-$150 billion. The growth is driven by pent-up demand for liquidity, large secondary buyers with record-sized funds, and cooperative public markets.

Intermediaries are licking their chops because the higher interest rate environment impacts asset selling prices, leading GPs to seek liquidity through secondary markets without losing control over their investments.

Hidden in the story line though is that VC portfolios sold at 68% of net asset value in 2023, a clear indication that the venture capital ship has struck the iceberg and it’s time to board the life rafts.

Let’s be clear: While the higher interest rate environment might have been the kerosene, the tire fire was gross overvaluation perceptions and insufficient reserves for longer hold periods. As expected, buyers are cautious, waiting for venture funds to reevaluate and possibly write down assets before engaging at higher valuations.

It makes sense for Limited Partners (LPs) to sit on the sideline and stagnate innovation as penance for venture capital mismanagement. But we can’t do this for much longer.

Our country and our economy hangs in the balance.

Recalibration of Venture Capital Funds

Recalibrating venture capital funds should be viewed as more than just adjusting pricing strategies; it should involve a realignment of the purpose and incentives for GPs.

Traditionally, GPs have focused on maximizing returns through high-risk investments. However, a shift towards sustainable growth, long-term value creation, and responsible investing is necessary. This involves reassessing investment strategies to balance risk and social impact.

More problematic, GPs' incentives have often been aligned with short-term gains. There's a need for incentive structures that reward long-term success and responsible investment practices.

Impact of GP Greed

The greed of legacy GPs, focused on short-term gains and high valuations, has contributed to market issues. Overvaluation of assets, especially in venture capital, has led to a lack of trust among investors, as evidenced by brutal write downs and the lower pricing for VC secondaries. High valuations and unrealistic returns expectations have saturated the market, leading to a drying up of opportunities and a more cautious approach from investors.

Consequentially, the rise in secondary market transactions reflects the need for liquidity and the recalibration of expectations. It's a symptom of the broader issue of misaligned incentives and market saturation.

The recalibration of venture capital funds should be comprehensive, addressing not just the pricing strategies but also the fundamental purposes and incentives of GPs.

But here’s the thing: This doesn’t require a radical overhaul of modern day finance. It simply requires venture funds raising less money and hanging their hat on income derived from the fund's Carry rather than annual Management Fees.

This shift is essential to restore investor trust, achieve sustainable growth, and adapt to changing market dynamics.