Uber, the world’s largest ride-sharing company, has raised $8.8 billion since it was founded eight years ago, and has a current value of $68 billion on the private market - a figure that makes it the biggest unicorn in the world. Presumably, there have been - over the past 8 years - investors, including angel investors, as well as managers and employees who wished to liquidate their holdings, rather than wait for Uber to go public on Wall Street, which would enable its shareholders to sell their shares at the touch of a button. Uber is in no hurry to go public. This growing trend among tech giants is part of the reason for the expanding secondary funds market - funds which mainly acquire holdings of venture capital funds, private equity funds, angel investors, entrepreneurs, and managers and employees of mature high-tech companies, effectively providing liquidity in an environment without any; i.e. instant liquidity as enjoyed by investors in a public company traded on US stock markets.
Secondary funds emerged in the US 30 years ago, and began to develop in Israel almost 20 years ago. Today, given the aforementioned trend, secondary funds are picking up speed, becoming an investment instrument in themselves, alongside venture capital funds, private equity funds, and so on.
In Israel, at least according to online database Preqin, there are few active secondary funds, the most prominent of which is Vintage Investment Partners, which operates a secondary fund with $350 million in assets under management. The second, and less known fund, is Israel Secondary Fund (ISF)which exclusively operates in the secondary market and only in Israel, and which has $150 million in assets under management. ISF recently closed $100 million in financing for its second fund.
ISF is the newest and purest player in this market, which is why we chose to go to its offices in Herzliya in order to understand what secondary funds are, what differentiates them from venture capital funds, and why high-tech companies and their investors, managers, and employees need them.
According to ISF, the private equity market, includes buyout funds, venture capital funds, growth funds, and secondary funds. In general, the American investors market has a 6% exposure to the total private equity market.
ISF was founded in 2009 by Shmuel Shilo and Dror Glass. Shilo created the Israeli secondary funds market in 1998, and, until 2005, was the managing director of Evergreen Venture Partners’ Harvest Secondary Fund. Glass, an investment banker in his more distant pass, was the Israeli representative of Britain’s GreenPark Capital, before teaming up with Shilo to found ISF. Three years ago, they were joined by Nir Linchevski, who began his career in Israel as a partner in Formula Ventures, the venture capital arm of Formula Systems. He subsequently served in the US as managing director at VantagePoint Capital Partners, before returning to Israel as a partner in Shiraz Investments, a private equity firm whose investments included Altshuler Shaham Investment House, one of Israel’s largest asset managers, and subsequently, he served as its chairman. Following the sale of his holding in Shiraz Investments to his partner, Nadav Dotan, and taking a year-long sabbatical, he joined ISF as its third managing partner.
ISF has raised two funds to date. The first fund, which was launched in the summer of 2009, raised $50 million and no longer makes investments. It invested in just over 100 Israeli companies, and chalked up 35 exits, including the sale of Waze to Google, the Nasdaq IPO of SolarEdge Technologies, and the sale of PrimeSense to Apple. “This fund was ranked in the top quartile of funds in its class, on the basis of performance, according to Preqin,” says Glass. However, he does not disclose the return ISF yielded to its investors. The ISF II Fund, just closed the raising of $100 million, and it is now seeking to replicate the success of ISF’s first fund and to continue developing Israel’s secondary market.
“Secondary means creating liquidity in a world without any,” explains Glass. “Large pension funds, such as CalPERS, one of the largest institutional investors in the world and which invests in venture capital and private equity funds, manage their non-tradable assets as if they were tradable. Let’s assume that it invested in a fund such as FIMI and in shares of Teva. The fund can sell the Teva shares at any time, but it cannot immediately realize the holding in a fund like FIMI. This is why an instrument like secondary funds were created - to make holdings in non-tradable funds and new high-tech companies liquid.”
The secondary market is normally divided into three segments: a limited partnership (LP) deal, i.e. a transaction in which the secondary fund acquires the holding of limited partners in venture capital and private equity funds; a direct deal, i.e. a transaction in which the secondary fund acquires holdings in technology companies; and a structured deal, i.e. a transaction in which the secondary fund provides a venture capital or private equity fund with additional financing.
“Regardless of the type of deal, we always acquire minority holdings,” says Glass. In the case of the first category, these transactions are created, in part, due to regulatory changes or changes in the institutional investor’s investment strategy. “For example, because of Basel III (the banking capital adequacy supervision plan) Citibank was forced to sell its holdings in venture capital funds. In another example, we made a deal with CalPERS, after it decided to reduce the number of its investments, especially investments smaller than $75 million, in order to minimize the number of relationships, regardless of whether they were good or bad. In other words, the seller had an internal need, not a regulatory demand.”
Globes: This change in investment strategy does not mean that the investment offered for sale was unattractive in the eyes of the seller, correct?
Linchevski: “No. I repeat the explanation about the time span until the exit. An institutional investor which invests in a venture capital fund usually receives the return on its investment after 13 years, which is a long time. It’s a long-term commitment, and during this period there are regulatory changes and/or changes in the institutional investor’s preferences. In other words, it has no choice but to sell, unrelated to the performance of its investment.”
Isn’t this your edge, because the sale may be made at a discount on the price at which the investment was made or at which it was priced in the private market?
Glass: “It’s true that there are more buyers in the public market, which is why it is hard to lower the price, but the big secret of our industry is that there is no correlation between the size of the discount in a particular transaction and the yield that we will ultimately get from it. In some of our transactions, we made really nice yields on transactions with no discounts.”
The fastest-growing of the three categories is the acquisition of direct holdings in high-tech companies. “Technologies take 8-13 years to reach an exit, i.e. an IPO or sale of the company. In that case, the motivation of the private seller is very similar to that of an institutional seller," says Linchevski. “The entrepreneur sometimes has to pay off a mortgage, an angel investor needs the money to invest in another company, and so on. In other words, there is a need for liquidity.”
“In this category,” says Glass, “the seller may be entrepreneurs, angel investors, or company managers and employees. A small investor, who invested a few hundred thousand dollars in a new company, after eight years cannot keep up with the pace of investments needed by the company and has already made a significant cash multiple on his investment - a secondary fund makes it possible for him to realize the holding without waiting for the company’s exit, i.e. an IPO or sale. Another example is an employee who left the company and wants to exercise his options, but lacks the capital to do so. We can buy from him the shares he received from the options exercise.”
Just a moment; you sometimes buy from an individual employee?
Glass: “Yes. It depends on how much he holds, but in principle - yes.”
Linchevksi: “In these cases, we take care to acquire holdings from employees in companies that are already mature; i.e. they’ve been on the road for 5-6 years. Furthermore, as time passes, both investors in companies and company managers realize that this is an efficient instrument for them, because it creates value for everyone. This allows companies to continue to grow with as little pressure as possible to make an exit. That is why investors and companies strongly favor the involvement of secondary funds. After all, a person can’t build a company for 8-13 years without receiving some kind of compensation.”
There is another reason why they favor you: you invest quietly, you don’t take a seat on the board of directors and you don’t create headaches for the company’s management.
Glass: “Absolutely! We don’t even demand a seat on the board of directors. We only want to bring value.”
Linchevksi: “We do have one demand, and it has to do with the trend of high-tech companies not as active pursuing an IPO as they did in the past. I think it is wrong for a company to declare that isn’t going to go public, because ultimately all high technology companies should become public to create as much value as possible.”
Because the greatest value is created in a public offering?
Linchevksi: “Correct. That is why, when we invest in a company, we check with its entrepreneurs that they are planning to float it, because we also don’t want to become partners for indefinite periods in a private company. In other words, we need our certificate of security.”
And because the exit point of a secondary fund is only an IPO or sale.
Glass: “Correct, but it is the same in the case of a venture capital fund. Venture capital funds favor secondary funds because they help them build bigger companies. Venture capital is aligned with us, and if there are no venture capital or institutional investors in a company, we won’t invest in it. Moreover, we have an exit alternative in the form of a sale to private equity funds. In one of our deals, we acquired the holding of an angel investor and sold it to a private equity fund.”
ISF uses Preqin data to demonstrate that investing in secondary funds is more rewarding, because it provides very high yield at low risk- a median IRR of 15%, based on the funds from the 2002-2012 harvest. “Furthermore, money we invest returns more quickly because we invest in a company when it is already mature and closer to the exit point,” says Linchevski.
Glass makes it clear that the profile of investors in secondary funds is quite similar to that of investors in venture capital and private equity funds. “In Israel, in contrast to the rest of the world, there is a huge shortage of players which create liquidity; i.e. which make it possible to recycle or realize part of investors’ holdings in technology companies over a 13-year period,” says Linchevski.
Glass emphasizes, “Israel is almost 20 years behind the world in the development of the secondary market, which is why the Israeli market is very new and has quite a substantial potential."
Do secondary funds render the need for the TASE redundant?
Glass: “No, not at all. On the contrary, we’re a complementary product to investors in the Israeli capital market.”
What about online platforms, which allow employees to sell shares, such as SecondaryLink? Are they competitors?
Glass: “Ultimately, such platforms have not really succeeded, because the main problem is that the companies are private, and the information about them is confidential, so thee shares on these platforms are purchased on the basis of a lack of information. It’s like buying a lottery ticket on the share. It isn’t really a secondary market. We won’t make a deal if we don’t obtain the relevant information about the company and the permission to proceed from the investors and management.”
Linchevski: “For example, we made a deal at Valens Semiconductor, which recently raised $60 million, and it is a company that wants to be big in its field.”
But sometimes, the investors’ interests are opposed to those of management.
Glass: “The secondary fund has therefore become important. For example, an entrepreneur who has shares with a paper value of $10 million, and who wants to sell them - it’s a life changer for him and for his children. The venture capital funds which invested in the company want to continue to grow it, which is why they can tell him, ‘Sell all or part of the $10 million and buy a better home or repay the mortgage, or diversify your risk’, thereby buying the entrepreneurs’ patience. In other words, the secondary market creates an alignment of interests between the investors and the entrepreneurs, not a conflict of interests. This is especially true for entrepreneurs for whom this is the first company, and who do not yet have the financial wealth and still have a mortgage hanging over their heads.”
But that is mainly true for entrepreneurs for whom this is their first company, not for entrepreneurs who have built more than one company, not to mention serial entrepreneurs.
Linchevski: “We’ve had deals in which we’ve acquired the holdings of entrepreneurs who previously built companies and achieved an exit. It is important for venture capital funds that the entrepreneur focus on the big picture and not constantly check what is going on among his friends who are working at Google or Facebook for a larger monthly salary and maybe an annual bonus, while he has spent years at his company. Over time, when you build a big company, you learn, and we’re looking for places that operate wisely. We have contrary examples: the first angel investor in a company in which we made a deal, who is a good friend of the CEO, nagged him and said, ‘I want the money’. The CEO told him that he did not want to rush, the company was growing nicely. We entered the picture at this point, acquiring the angel investor’s holding, giving him a fantastic exit, and allowing the CEO to continue working on his dream. Both parties were satisfied.”
Glass: “It’s enough to look at Israeli companies which have raised more than $100 million and achieved a valuation of at least $1 billion at the exit, such as Wix, Mobileye, CyberArk, SolarEdge, and Waze. It took them 6-16 years, which means that there were a lot of investors in each company, former investors, employees and former employees, all of whom were locked for ten years. It would be better if they worked together and did not rush for an exit. Israel has a real need for a secondary market. In other words, in order to continue growing Israeli high-tech industry and to create more $1 billion companies, there is a need for a secondary market.”
In other words, secondary funds are an instrument to create big companies here?
Linchevski: “Exactly; to allow the high-tech industry to grow.”
Secondary funds - a global perspective according to Preqin
The US has 43 secondary fund managers; Israel has three. Market forecast: positive.
To learn a little more about secondary funds, we dived into the recently published 2016 annual report of the global research firm, Preqin, a report which can teach a lot about the private equity and venture capital industries.
First, strong demand for secondary funds continued last year and this demand is reflected, inter alia, the closing of huge, even mega, fundraising by secondary funds. Last year saw the largest-ever fund raising by a secondary fund - $10.8 billion for the seventh fund of Europe’s Ardian; the company sought to raise “just” $9 billion - the size of its sixth fund. Additionally, the top five secondary funds raised $35.7 billion altogether in 2015-2016 and this money is now looking for investments, just like the ISF II Fund.
Preqin says that the demand for such finds is evidence of investors’ (especially institutional investors) confidence in this instrument, which is attractive for three main reasons: first, an attractive risk profile; second, the diverse portfolio of secondary funds, i.e. they invest in different harvest years, and with different strategies and geographies; and third, a smaller J curve, because secondary investments are made when the company is much closer to an IPO/sale (exit), which means that the investors make a faster return on the money.
The geographical distribution of secondary funds’ operations indicate that 37% of funds which raised capital last year focus on the European market, and 58% focus on the American market. As of January 2017, there are 40 secondary funds worldwide which have an aggregate $36 billion in assets under management, up from the 32 funds with have an aggregate $28 billion in assets under management at the beginning of 2016. The geographical distribution of active secondary fund of funds shows that the US 43, the UK has 16, and Israeli, Germany, and Japan have three each.
Preqin offers a positive outlook. “The supply is driven by limited partners seeking how to actively manage their portfolios: according to a survey by Preqin, in the past year, 536 investors expressed an interest in selling private equity holdings within one to two years. In addition, the wish of general partners to offer liquidity solutions to investors in their long-term funds will also contribute its share to the deal flow.”
“Israeli venture capital funds have world-class performances. There is someone to talk to here”
“There are quite a few Israeli institutions that invest with us, both in our first fund and in the second fund, and they are quite substantial in the second fund,” says Glass. Linchevski explains, “Our perspective is different: when we announced the raising of $100 million for the fund, we have taken note of something- and we’re free of any interests when we say this - almost all the institutional investors in Israel have done their homework since 2000, and nearly all of them have teams that specialize in private equity and have a strategy that determines what they do in the world and in Israel. I heard from a venture capitalist friend, who tried to raise capital from Israeli institutions, and claimed that he feels that was competing against foreign venture capital funds for their hearts. Israeli funds that have world-class performance, find someone to talk to here.”
In the case of secondary funds, it isn’t exactly called investment in venture capital.
Glass: “Our investors are exposed to the high-tech industry and to venture capital in another way and with a lower risk profile. Take into account that it takes time to build such an allocation, because, per year, there aren’t many Israeli venture capital funds raising money. There are relatively few funds and little money.”
Linchevski: “Our message is that the train is moving. It began moving after the 2008 crisis. There has been a change for the better, and it simply takes time.”
ISF
Year founded: 2009
Function: make liquid the holdings of venture capital and private equity investors, as well as those of entrepreneurs, angel investors, and the managers and employees of mature technology companies that have not yet gone public or sold in full.
Managing partners: Dror Glass, Nir Linchevski, and Shmuel Shilo
Number of funds: two
Total capital under management by the two funds: $150 million ($50 million by the first fund and $100 million by the recently closed second fund). A few investments have been made and ISF believes that such a fund will be exposed to 200 companies.
Average deal size: $3 million
Something else: according to Preqin, only three secondary funds operate in Israel, and ISF is apparently the second largest. Vintage Investment Partners is the largest, but it has corresponding venture capital funds, which means that ISF is the largest pure player in the Israeli secondary fund market.
Published by Globes [online], Israel business news - www.globes-online.com - on June 4, 2017
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