Mar 3, 2023, 9:05 PM ETInterview, Fireside Chat

Hunter Somerville: Biggest Mistake LPs Make; Deep Dive into Secondary Markets | 20VC #985

Significant market improvement is projected for 2024 and 2025, with current years (2023) expected to remain constrained.
Liquidity in 2022 was historically low, following the peak activity of 2020–2021; 2023 is forecast to be incrementally better but not a return to previous highs.
Buyout and private equity firms are increasingly acquiring public venture-backed businesses and conducting majority recapitalizations to provide liquidity.
Direct GP sales of partial company positions are emerging as a viable alternative liquidity mechanism for managers.
The gap between buyer and seller prices remains wide, though the argument for deeper discounts is stronger now as sellers can still realize positive returns (2x) even at 50% discounts.

The secondary market is categorized into three primary types:
- Company Secondaries: Transactions involving early investors, angels, micro-VCs, and employees seeking liquidity.
- LP Interest Secondaries: Transfers of Limited Partner stakes in funds.
- GP-Led Restructurings: Scaled LP interest transactions (strip sales, tender offers, continuation funds) designed to restructure fund life or provide liquidity.
GP-led transactions in venture capital are lagging behind private equity but are expected to accelerate significantly in the second half of the current year and the following two years.

The denominator effect occurs when public equity values drop faster than private valuations, causing over-allocation in private books and forcing LPs to sell assets to rebalance.
Venture funds have reduced valuations by an average of 19% (range 15–20%), with many managers taking discretionary markdowns proactively for the first time.
LPs favor funds with proven DPI (Distributed to Paid-In Capital) over TVPI (Total Value to Paid-In Capital), as TVPI is increasingly viewed as unreliable due to inconsistent valuation methodologies.
Managers with aggressive TVPI carrying values are facing higher scrutiny and are prioritizing realistic pricing over maintaining inflated marks to appease fundraising investors.

Institutional LPs, including endowments, are experiencing constrained liquidity due to mandatory cash outflows (e.g., scholarships) and are becoming more aggressive sellers.
LPs are reducing allocation sizes in high-performing managers while exiting "middle-performing" funds to maintain portfolio quality.
LPs that failed to return cash to investors in the prior five years are at the highest risk of being cut from future allocations.
International capital, particularly from the UAE, is expected to increase its participation in US growth and late-stage venture funds to shorten investment duration.
European family offices entering venture recently via advisors face potential losses and a "sour taste" in the asset class due to exposure to large, struggling late-stage managers.

Current discount levels for LP interest secondaries range between 30% and 45%, while company secondaries trade at 20% to 35% discounts to last round pricing.
Secondary buyers are targeting portfolios where 70–90% of the NAV is concentrated in two or three high-value assets to avoid mean-reverting diversification.
A specific "camel" profile is sought in company secondaries: businesses with 3–5 years of runway that do not require immediate capital raises.
Secondary deals allow buyers to effectively create a "down round" arbitrage (30–40% discount) without the operational disruption of a formal company down round.
Transaction structures like tender offers and strip sales are logistically easier to execute than continuation funds, which are used to extend fund life and provide liquidity to LPs at the end of a fund's cycle.

Managers are advised to prune overpriced assets (offering 1.5–2x arbitrage) while riding forward assets with 3–5x potential.
Selling portions of management companies to generate immediate capital is generally discouraged unless it is the sole fundraising option, as it can lead to long-term misalignment and carry issues.
Fee structures for growth funds are shifting toward fees on invested capital rather than committed capital due to deployment uncertainty.
Performance kickers are acceptable only if the hurdle rate is at least 3x net; kickers starting at 2x–2.5x are viewed as misaligned with venture risk.
GP commitment requirements should be proportional to net worth rather than absolute dollar amounts to avoid managers recycling fees to fund their own commitments.
Organizational friction is anticipated between older, high-performing GPs staying on longer and younger, hungry partners seeking to deploy capital in favorable vintages.

Major investment mistakes in the last 18 months included underestimating human element risks (lateral hires disrupting chemistry), investing in winners of bad categories (e.g., insurtech, prop tech), and underestimating the erosion of structural protections during exits.
Emerging markets face a concentration risk shift back to the US, though India remains a specific area of interest; Latin America faces currency hurdles.
Vintage diversification is highlighted as the most critical but often ignored trend, with managers raising multiple funds in 6–9 months facing significant challenges across multiple vintages.
The secondary market is identified as the most significant overlooked trend, serving as a crucial mechanism for duration management and capital deployment in early-stage funds.
Venture capital is affirmed as essential for national innovation, R&D, and job growth, maintaining a long-term bullish stance despite current market behaviors.