As alternative investments increasingly enter the mainstream, retail investors are gaining access to opportunities and investment strategies that traditionally had been available only to institutional investors. We’re reviewing more programs that fit this description for our clients these days. Many of these programs are structured as closed-end interval funds, which require periodic liquidity for shareholders. Interval funds feature diverse investment strategies, including traditional alternative investment asset classes such as real estate and credit. They may also be used for more esoteric strategies, such as insurance linked securities or structured finance securities.
Most of us are steeped in the canon of startup success stories. According to CB Insights, there are currently 239 private companies that were startups as recently as 10 years ago, now valued in excess of $1 billion through funding rounds or otherwise, commonly known as unicorns. Meanwhile, IPO activity among these startups has diminished as many firms have remained private.
We sat down with Sven Weber, managing director and portfolio manager, SP Investments Management, and president and trustee of SharesPost 100 Fund, to get his perspective on current opportunities in late-stage, pre-IPO investment. SharesPost 100 Fund is a closed-end interval fund that invests in late-stage venture capital-backed companies. As of this writing, its top 10 holdings included Lyft, SoFi, and Spotify.
FactRight: With venture capital-backed enterprises, don’t I need to get in on the ground floor, or at an early stage, to make money?
Sven Weber: We believe that in the past few years a new asset class between venture capital and the public market emerged, consisting of late-stage private companies that used to go public but today choose to stay private. This profile of companies has a different risk-return profile than traditional early stage venture capital in which you need outsized winners to compensate for a significant loss rate. In the new “private growth equity” asset class we believe that we have a much higher probability of avoiding losses, and as a result, need a lower expected return on the companies that are winning investments. Our general thesis is a return profile of 2 to 3x in 2 to 3 years with a typical annual revenue hurdle of $50 million as an entry point, and 30% to 50% year-over-year revenue growth.
What kind of financial information is available for review prior to an investment in a series offering of a VC-backed enterprise?
In a new round of financing, the company typically provides extensive information on financials and its forward-looking plans. However, in a secondary transaction the company does typically not provide the same level of information. The SharesPost 100 Fund is investing both in secondary and in primary offerings and we typically utilize financial statement information, funding status, secondary market transactions, and public and private market comps in assessing whether or not we want to take a position for our portfolio.
What are the trends in exit strategies for early stage and later series investors in these VC-backed enterprises?
Although the IPO market gets the most attention, the clear majority of VC-backed companies are acquired, with over 200 M&A’s per quarter compared to about 8 to 12 tech IPOs per quarter. The IPO is the exception.
Over the last 15 years, the typical timeframe of an exit for early stage companies extended from about 6 years to now over 10 years, leading to the new private growth asset class that represents our investment target. With the implementation of the JOBS Act in 2012, which increased the maximum shareholder threshold from 500 to 2,000 (without having to publicly register), the exit trend is that more and more VC-backed companies stay private longer. Early investors achieve their liquidity needs by private secondary transactions or tender programs facilitated by the companies.
Is the Spotify direct listing something that I should anticipate as a path for liquidity in some of these VC-backed enterprises?
Given that the direct listing of Spotify went relatively smoothly, potentially more companies will consider this unusual path of going public. Keep in mind that in the case of Spotify, the company floated a much higher percentage of its stock to the public; it also did not raise any more capital and did not participate in the traditional IPO syndicate raise and road-show process.
As a trade-off, the company saved itself a large sum in underwriting fees and the listing price was not negotiated “behind back doors” but determined with the supply-demand mechanism of the direct listing process. We do anticipate that other well-established brands, with strong balance sheet positioning, will pursue this route at some point in the future. This path obviously gives us as investors flexibility to sell our shares right away in the market, and not have to endure a discounting mechanism and a 180-day duration of potential downside market risk.
What does investment in late-stage companies do for portfolios that other asset classes and investment types can’t?
An investment in late-stage companies can not only serve as an access to private growth equity but also as an equity stabilizer, stripping out a large percentage of systematic risk from the portfolio. As shown in our Performance and Risk Report [available to advisors], our correlation to public market equities has been quite low since the inception of the fund.
Furthermore, our fund serves as a completion-strategy, on a linear investment growth timeline. If a company stays private for longer while growing, there must be an equal an opposite reaction on the public side. An opportunity cost. Our opportunity set is otherwise an investor’s opportunity cost in not making this a piece of the allocation pie.
What is a typical failure rate and return profile for investment in late-stage companies?
As I stated, we look for companies that have the potential to return 2 to 3x in 2-3 years and that have typically at least $50 million annual revenues at the point of investment, with an annual revenue growth rate of 30% to 50% or more. Respective to our model, we anticipate that approximately 1/3rd of our investments will have a negative impact on the portfolio. We model this grouping to return an average of 60 cents on the dollar, in a negative impact scenario.
Interval funds have minimum repurchase requirements on a regular basis. How does a program like SharesPost 100 Fund, which is looking to provide investors with exposure to illiquid VC-backed startups, plan for periodic repurchasing of investor’s interests?
We match off our quarterly redemption liability and always hold at least 5% in cash to meet these demands. The fund has never had to prorate an investor in the operating history of the fund, dating back to March 2014.
Valuations for some of the VC-backed tech companies, including some of the younger ones, like Peloton, seem astronomical. Is there reason to be concerned that there is a “unicorn bubble”? If so, how would this unwind for late-stage investors?
Valuation analysis is certainly a very important part of what we do in managing to our mandate. Companies are staying private for longer; in turn, they are being funded with larger and larger rounds than ever before. These rounds serve as “quasi-IPO” events and have served to increase the overall valuation of companies, sometimes rapidly, in efforts to fuel growth.
Understanding the intricacies of this investment discipline is one of our key value propositions at SP Investment Management. There are investments that we say “no” to on a daily basis, and many times the reason is because of the valuation.
Our accounting process mandates that we carry many of our positions at discounted levels to “consensus market valuations” to build in a risk discount for lack of marketability, down-rounds, lower sale prices, etc.
Do any of the series available to late-stage investors provide any meaningful ability for investors to participate in the corporate governance of the VC-backed firm?
In a new financing offering, the company typically grants board seats to significant investors. The SharesPost 100 Fund is typically holding less than 5% of a company and by that is unlikely we will have board representation, but fund management is typically in active conversations with executives and board members of the portfolio companies.
Do you have any parting words for our readers?
In the last 15 years, technology-focused companies have been the driver of the US GDP growth. Innovation can now be found in every industry: from classic technology sectors to transportation, travel, financial services and many more.
Many innovations are still to come and will change the world as we know it today – just imagine the potentials of artificial intelligence or new genetic treatments. It is this future in which we are investing in.
Note: this post does not constitute FactRight’s endorsement or recommendation to purchase or sell any investment securities. The views expressed by the interviewee in this post are solely those of Mr. Weber. FactRight has been engaged to provide regular due diligence reviews on SharesPost 100 Fund behalf of financial services clients, available on FactRight’s Report Center for eligible parties to access.