Private Capital Pulse: Episode 3 – Venture Life Cycle

TRANSCRIPT EPISODE 3

Hello, my name is Jon Ireland, I'm a corporate funds partner at DLA Piper based here in Sydney, and welcome to the latest edition of Private Capital Pulse.

Private capital markets have absolutely shot up like a rocket in recent years and exhibited absolutely stellar growth in terms of their size, and in some senses we're exhibiting and seeing investors pivoting out of public markets as they chase higher yields and returns from private capital spaces. Now measured in the trillions of dollars, we're seeing a huge number of dynamics coming together globally and both locally in these markets.

With Private Capital Pulse, we're charting the trends and analysis in this space with the benefit of insights from DLA Piper experts and market leaders in their field.

And today, I'm absolutely delighted to be joined by Elliott Cheung, who's a corporate M&A partner with a specialism in venture. And in fact, the whole of life cycle through structuring investments and managing exits as well. So Elliott, it's great to have you with us today.

Thanks for having me on, Jon.

Terrific. Okay. We'll kick off with a general one here. Elliott, I'm keen to get your insights as to what you're seeing, generally speaking, in the market at the moment?

Yeah, I think it's fair to say that the venture capital space has been through a bit of a lull in the last year, a year and a half. So I think before I want to get into it, there's really three key market factors that I want to touch on that's driving what's happening in the venture capital space at the moment.

The first is a lot of the large leading venture capital firms or the well-known ones in the Australian market, they first set up their funds back in 2012, 13, 14. So now we're really nearing the end of their fund horizon. That means that they are in a position or they will shortly be in a position where they will need to return capital to those early investors.

The second factor is a lot of those funds also raised new funds back in 2022, right before the valuations across the tech sector started falling.

So the third factor playing into all this is around those depressed valuations. And when they're going to return to a little bit of normal or when they're going to correct. I think we're starting to see a little bit of that, but that's really driving two key issues in the market as I see it.

The first is around liquidity and how that liquidity is achieved, particularly with a lot of portfolios held by these institutional investors that have been devalued compared to the valuations at which they invested previously.

The second is around getting that confidence in investing new capital into new companies, where they have a recent experience of investing high, but then their portfolio going lower.

So I think they're just exercising a little bit of caution in both respects and that's going to play out in the next year and a year and a half.

That's an interesting point around the dynamics of valuations and how investors that are managing that in particular the dry powder in the market as well. So just maybe putting a focus on the capital raising piece, what opportunities and challenges do you see with capital raising in this environment at the moment?

Yeah, I think it's something that we've seen for quite a long time now. There is a lot of dry powder out there as you noted, Jon, and these are sitting in funds that raised or closed their capital raisings in 2022. So they really do need to start deploying that capital.

The challenges that I'm seeing that a lot of these investors, they are taking a much more cautious approach and they're being more robust in their due diligence. They really want to make sure that they've got confidence not only in the founder, but also that the companies that they're investing in are sustainable in the near term, medium term, and obviously in the long term. And that there is that near term pathway to profitability. I think the other factor that they're very conscious about is around making sure that after they invest, there'll be other funds in the near term at the next valuation inflection point, they'll be ready to provide growth funding as well. So that when the investor invests today, they know that there'll be another investor down the track that will, I guess, take the reins going forward or help take some of the burden going forward in terms of that funding.

In terms of the valuation gap, I think what we'll see is creative structures being implemented. So we're seeing a lot of convertible notes recently. I think there'll be a lot more of that going forward. But there'll be some, I think, unusual creative mechanisms built into those convertible notes, including fluctuating floor mechanisms or other ways of topping up the founders to avoid excessive dilution, for example by granting more than they otherwise would have granted under an employee share option plan.

So as the confidence returns to the market and there's more venture capital activity in terms of capital raisings, I think you'll start to see a snowball effect with the deal making starting to return.

It's a confidence piece. These are long term, holdings in some respects. It has a particular liquidity profile I guess you could say, or predominantly non liquid. In terms of managing liquidity events and exit opportunities, how are you seeing that part of it play through?

I think the one that's most often talked about is the IPO as the aspirational exit event, it's the one that gives, I guess, the company credibility in the market that they've made it to the next level. But I think more often than not, the more usual route to an exit or liquidity is actually a trade sale.

But just touching on the IPOs for one moment,I think that based on market sentiment, a lot of the later stage companies high growth companies are ready for an IPO yet. I think that once that reopens, we will see some pursuing a listing and obviously it has been a tried and tested avenue for companies to achieve some liquidity on an IPO and then ultimate liquidity through an exit, through a take private a few years after listing, and a few recent examples of that are ones like K2fly and Ansarada and Nearmap, all of whom were on the radar of large global US private equity funds that managed to do a full acquisition shortly after listing.

But I think that if I look or crystal ball gaze in the next year, year and a half, I think the more likely liquidity event will be a secondary or sell down by some of the earlier invested VC funds. And the reason behind that is the need to return that capital to investors. And the secondary is a way that gives them that pathway. It's not something that we've seen too often in the past, but that's because there wasn't really a need to do that. But now, because of that need, I think we're going to see that more and more often. And a great recent example of that was obviously the VC funds selling down their interest in Canva to private equity.

That is really interesting. Just to be able to put this, potential exit set of options into the context of our series because, as you mentioned, you know, the IPO does have an important role to play. And some big names that you just mentioned have been able to leverage that as an exit opportunity. I guess I'm interested in terms of that, you know, the trade sale option. That appears to be still on the cards. What are the hurdles, though, that you'd be seeing in anticipating a potential trade sale for venture?

It's interesting thinking about a trade sale in the context of a venture capital backed company. These are ones where they would have gone through multiple rounds, and each round has a different class of preference share on issue that has slightly different rights to the previous class of preference share.

So working through the preference stack and one making sure there is something I like to call value alignment. And what I mean by that is making sure that each investor understands the proceeds that it will actually receive on an exit event to make sure they're going into that deal with eyes wide open.

The second issue is around making sure the company can deliver 100% over the company to an eventual buyer. A buyer will want 100% because they want the benefits of not only accounting consolidation but also tax consolidation and in an environment where there is a valuation gap to be plugged, you'll see purchase price involving a combination of probably script consideration, deferred consideration or earnout consideration and how that works with the drag mechanism and also how it flows through the preference stack and that liquidation waterfall, I think is something that hasn't really been tested yet. And it's something that will definitely be front and center in exits via a trade sale in the next little while.

That's great. That's really interesting. And thank you so much. Even at those inserts, I think just demonstrate the degree just the number and the weight of different considerations that are impacting fund sponsors and investors in the venture space through that whole life cycle. So, we'll leave it there. Elliott, thank you so much for joining us.

Thanks for having me, Jon.

Terrific. Well, that winds up this episode. We'll be coming back, again, in the not too distant future. So please do keep an eye out for future episodes of Private Capital Pulse. In the meantime, if there are any particular topics that you're interested in us covering, don't hesitate to reach out. The notes are in attachment to the episode. Alternatively, you can contact us direct, myself, jon.ireland@dlapiper.com and in the meantime, we look forward to seeing you next time around and look forward to delivering the next one of our Private Capital Pulse episodes. See you next time.