The European venture secondaries market is expected to grow significantly as a lack of attractive exit options has increased the need for liquidity.

Increased volatility in the public markets for tech companies has severely reduced appetite for VC-backed exits in Europe. As of June 15, some 463 deals were completed this year worth an aggregate €16.9 billion (about $16.96 million), according to PitchBook data. That shows decreases of 61.4% in deal count and 87.6% in total deal value from the heights of 2021. 
   
As investors and companies prepare for a cold winter on the exit front, Europe's nascent secondaries market is heating up as startup investors and limited partners seek to cash out some assets. 

"Current market conditions, which are characterized by higher interest rates and a rotation away from high-growth stocks, are leading to an [exit] liquidity crunch," said Dany Bidar, principal at Octopus Ventures. "If those conditions persist, you'd expect to see increased pressure for liquidity within the VC asset class, making secondaries an ever-more-important liquidity solution."

Global venture secondaries volume is estimated to reach $138 billion by 2023, according to data from Industry Ventures, but Europe has been slower than other regions to open up to these transactions. 

This is due in part to a much smaller primary market, but the more complicated nature of venture secondaries deals also contributes. Many continental European jurisdictions restrict share transfers, and the inclusion of terms for the right of first refusal—allowing existing shareholders the opportunity to buy stakes before external buyers—can make these deals more costly and time-consuming. 

Yet as Europe's VC ecosystem becomes larger and more mature, combined with the fact that VC-backed companies are remaining private for longer, secondaries grow more appealing. 

Direct company secondaries currently account for the majority of Europe’s venture secondaries deals. Under this type of deal, founders, employees and early investors sell a portion of their stakes. Companies like fintech Wise and events business Hopin are among those that have performed secondary share sales while still VC-backed. 

Typically, direct company secondaries involve the sale of common stock with limited voting and information rights, rather than preferred stock offered in primary raises. For buyers, the increased risk of being the last one paid if liquidation occurs means the deal is done at a discount. 

The current fundraising environment may even push valuations down further, according to Rain Tamm, founding partner of secondaries investor Siena VC.

"Secondaries valuations are following the primary market," Tamm said. "Of course, if there are public comparables that are being valued at less then, investors will take that into account as well. People who are in real need of liquidity might have to accept deeper discounts."

The lack of exit opportunities could also fuel more secondaries at the fund level, according to TempoCap managing partner Olav Ostin. 

VC funds have set lifecycles, and with companies needing to stay private longer, they may exit investments early in order to deliver returns to their LPs on the prearranged timeline. In a fund with multiple assets, GPs can sell all or part of a portfolio instead of selling stakes in individual companies. 

"If you have assets left in a fund at the end of its lifecycle, then you're going to have to do a secondaries deal," Ostin said. "In the good times, LPs might give you more time, but there's no incentive when the markets go down. I think we're going to see a tsunami of these deals in 2022." 

Ostin believes that corporate venture capital firms in particular will be looking to sell as their parent companies face a potential recession. CVC participation in European VC deals has increased significantly in the past few years, reaching 1,079 deals last year, according to PitchBook data.  

Limited fund lifecycles can also be an issue for LPs directly. With exits harder to come by and causing funds to  extend past their original timeline, LPs can find themselves stuck in vehicles and unable to collect returns for longer than they agreed.  

LP venture secondaries are uncommon in Europe, particularly in countries with fledgling VC ecosystems where governmental or quasi-governmental bodies are the more prevalent source of capital for funds, according to Tamm. As the European market becomes more attractive to investors like pension funds and insurance companies, the LP segment of the secondaries market could become more active, especially if LPs need to rebalance their portfolios. 

The downturn may be causing more pressure to sell, but some investors will prefer to hold assets that may be undervalued in the current environment. GP-led secondaries are emerging as a popular way to extend a fund's life, keep hold of assets and deliver liquidity to LPs, according to Gabriel Boghossian, head of secondaries at Stephenson Harwood. While more prevalent in PE, the wider venture market has begun to embrace GP-led secondaries. 

The process allows LPs to choose to sell their interests in a portfolio or roll them into a new vehicle managed by the same GP. For a GP, it allows them to hold onto assets longer, until exit prospects improve and alleviate selling pressure. New investors have an opportunity to invest in the vehicle at a discount—albeit typically a small one as the same GP manages the fund and is unlikely to take a big hit on existing assets. 

"The attitude to GP-led secondaries has completely changed," Boghossian said. "GPs want to hold on to their trophy assets and lock in a healthy multiple and IRR for their investors, as well as benefit from the upside growth potential. In the VC space, they're still uncommon, but it's definitely growing and I think we'll see more of them." 

Featured image by Blake Little/Getty Images

This article originally appeared on PitchBook News