Venture capitalists are supposed to take risk- the clue is in the word “venture” which links them to a long line of entrepreneurs going back to the merchant adventurers who opened up new worlds – the Marco Polos, the Columbus’s and the Cabot’s. For them big rewards were gained at the risk of everything – cargo, ship and life.
But today’s adventurers play it safe.
If you invest your capital in a private company you are purchasing private equity and you hope to sell on that equity in a certain number of years , realizing yourself a profit. As John Kay and others have pointed out, this way of going about getting a return is becoming very popular and more opportunities are available now in private markets than buying and selling the shares of publicly quoted companies on stock exchanges.
Much true innovation is fostered by private equity and without it , much of the progress we have seen (inter alia in financial technology) would not have happened. My own company is founded on private equity sourced from nearly 500 angles through crowd-funding. I do not mean to bite the hand that feeds.
But I am seeing trends in the way that these venture capitalists are running private equity which worry me and should worry you , as private equity is likely to be something that your pension is invested in, especially if you are in the default fund of a workplace pension. The Government (quite properly) wants the funds into which we are invested when we are auto-enrolled into pension saving , to deliver money to venture capitalists which is invested in private equity. This means our money is potentially being put to good use, helping develop innovation and providing young companies with access to capital they would not otherwise have had.
But it looks like the venture capitalists have seen us coming and invented a new way for them to reap the rewards from private equity without taking the risk of failure. This new way is called the “secondary fund ” and if you invest in a subscription to the FT, you can read about secondary funds here.
These secondary or “continuation” funds are becoming very popular in the private equity world
and we shouldn’t be surprised that they continued to prosper in 2020 which turns out to have been a very good year for private corporate banking.
Part of this “frenzy” of deals has been the sale of private companies funded by private equity to secondary “continuation” funds. Some of these deals have been because the private companies are “stars” which the venture capitalists want to continue their relationship with, but many are “dogs”, companies that private equity companies can’t get rid of to the market because they can’t justify the price tag that the venture capitalists have put on them. If the price isn’t met, there is little no reward to the venture capitalist.
According to the FT, what is going on is the bundling of good and bad together in funds that are invested in by pension funds looking to get access to “stars”. The venture capitalists retain a small interest in these funds (to have access to the stars) but the worry is that pension funds are going to be left with the dogs.
This kind of bundling is a well-known trick of the trade amongst bankers. It’s how they got rid of all the mortgages they knew wouldn’t be repaid prior to the 2008 banking crisis and it’s how they’ve been disposing of dogs in fund of fund hedge funds and diversified growth funds for decades. The investor is told they are getting access to private markets but infact get the stuff that otherwise have headed for the trash can.
There are a number of very good investment officers working for the larger pension funds who will already be aware of the perils of investing in continuation funds and I hope they have their eye on primary funds rather than scavenging in dustbins. However, there will inevitably be a proportion of the funds into which our pensions are invested, which will buy into these secondary funds because that’s what the venture capitalists want them to do.
So, by way of a handy cut out and keep chart, here are the main peddlers of secondary or continuation funds and the amounts they’ve managed to offload to the market through what appear to be very opaque practices.
So if you are the CIO of a big fat workplace pension and being offered a secondary fund, above is a list of the big players in the market.
According to the FT and its experts it all comes down to the price these funds are paying the venture capitalists for their private equity and at the heart of the deal is a conflict of interest as the buyer and seller are both entities controlled by the same private equity firm.
There is nothing wrong with such conflicts as long as a fair process takes place to agree a price. Some deals, such as Blackstone’s $14.6bn sale of property group BioMed Realty from one of its funds to another in October, involve a “go-shop” process in which bankers solicit higher bids for the portfolio company from outside rivals to see whether the continuation fund’s offer can be beaten.
But according to the FT and its experts many such sales are not open to outsider bidders. It looks like our workplace pensions will depend on some powerful due diligence on the way these secondary funds are run, my worry is that not many of these workplace pensions will be sitting ducks, pushed down the private equity path by Government insistence only to be the easy victims of bankers who saw them coming!
Fortunately we have IGCs and Trustees…
If you are reading this and you are a trustee or on an IGC of a workplace pension , take note. Private Equity is trappy and needs a lot of care, hopefully you will make sure that what we end up in is the right kind of private equity fund and not a kennel full of dogs!