THE ISRAELI FOUNDER: USING DATA TO DRIVE INVESTMENT DECISIONS
OPPORTUNITIES IN THE SECONDARY MARKET
Over the past several years, we have seen significant developments in global financial markets, which have driven investors, private and institutional alike, to reconsider their traditional asset allocation framework. As highlighted in our previous newsletter, private equity and venture capital have taken a prominent role in such transition and have attracted substantial capital and attention. Within the venture capital asset class, recent studies have shown the superior performance of the fund of funds model, which has outperformed the average performance of a random portfolio of funds by 10% between 1987 and 2007, and by 17% when taking into consideration the superior access which fund of funds have to the top performing funds in the market. The risk-adjusted outperformance of the fund of funds model is even more significant when accounting for the sizeable diversification which the model offers, by limiting downside risk. While the merits of investing in the fund of funds model in the venture capital asset class are substantial, certain investors express concern over the long horizons before reaching distributions in the asset class. This has driven certain investors to consider investment strategies which are less exposed to the long J-curve, mainly by investing in the secondary market. Such secondary models have historically proven to improve the time-to-liquidity by offering a shortened J-curve and a superior IRR (see chart below) for investors. Theoretically, secondary models also offer investors with superior diversification across vintages, having the option to allocate to all vintages preceding the investment period of the fund. Additionally, secondary transactions may reduce the “blind pool” risk, increasing predictability on the expected exits of the portfolio’s assets. Indeed, the advantages of the secondary model are appealing to many venture capital investors. However, the model does suffer from substantial caveats, which limit the attractiveness of the model. The attractive IRR of the model is driven by the short time to distribution, and tends to suffer from lower cash on cash returns vs. primary positions in new funds. While the J-curve in the model is mitigated (i.e. shortened), the capital required to acquire positions at net asset value creates a sharper (i.e. more downward sloping J-curve in the first few years) J-curve for investors. Additionally, private markets encompass a strong asymmetry of information between seller and buyer. This asymmetry may lead to an over appreciation of the underlying assets by buyers, resulting in an unfavorable premium to the buyer. Finally, pricing in the secondary market is highly influenced by market conditions. This is something we have seen on the eve of the 2008 financial crisis when private equity strategies traded at over 100% of net asset value (based on Greenhill Cogent data). Naturally, secondary funds of such vintage years have shown very poor performance as a result when compared to other vintage years (see chart below).
Investment strategies dedicated solely to the secondary market of Israeli venture capital funds may face challenges. While Israeli venture capital funds have raised substantial capital in recent years ($1.6 billion in 2016 and $1.5 billion in 2015), historical fundraising has not been as strong. Moreover, the number of LP’s in Israeli venture capital funds, who are potential sources of supply to the secondary market, are limited in size, especially when compared to Europe and the US. These factors have led to a limited secondary market. When taking into account that over the past 14 years the proportion of secondary transactions in relation to the unrealized value of private equity (i.e. value of portfolio companies which has yet to be distributed) is quite small and accounts for less than 2% (based on Preqin and Capital Dynamics) it is difficult to envision that the total secondary market in Israel can exceed $60 million in its peak years and as low as $20 million during its down years. When discounting the less attractive transactions from such amounts, we find that deploying a comprehensive secondary program dedicated solely to Israeli venture capital funds is cumbersome to execute.
Recognizing the attractive features of primary and secondary models, as well as their limitations, our view suggests that combining the strategies into a single investment structure can result in a sum that is greater than its parts. Being cautious about the size of the Israeli secondary market and the additional risk factors attributed to secondary investments, lead us to believe that an optimal balance between the two strategies is in the sphere of a 80%/10% split in favor of primary investments, with an additional 10% dedicated to a co-investment pocket. Such combination offers sufficient capital for attractive secondary positions and sufficient contribution to the mitigation of the long J-curve.
NOTABLE INVESTMENT ROUNDS
Buildup, an Upwest Labs and TLV Partners portfolio company, secured its series A funding for $7 million from TLV Partners, UpWest Labs, 01Ventures and Abstract Ventures. Buildup is a job site collaboration platform for construction companies, including developers, general contractors, subcontractors, and property managers. Available on mobile devices and the web, Buildup helps companies identify and resolve tasks and issues with unprecedented efficiency.
SCADAfence, a Jerusalem Venture Partners and iAngels portfolio company, secured its series A funding for $10 million from Jerusalem Venture Partners, iAngels, NexStar Partners, Global Brain, 31Ventures Global Innovation Fund and DS Strategic Partners. SCADAfence is a pioneer in securing industrial networks. SCADAfence's solutions provide visibility of day-to-day operations, detection of malicious cyber-attacks as well as non-malicious operational threats, and risk management tools.
Logz.io, a Vintage Investment Partners, Giza Venture Capital and 83North portfolio company, secured its series C funding for $23 million from OpenView, Vintage Investment Partners, Giza Venture Capital and 83North. Logz.io provides log management and log analysis services.
NOTABLE "EXITS"
Alibaba, a Chinese e-commerce, retail and technology conglomerate, acquired Visualead, a developer of a new ‘dot-less’ QR code for an estimated amount of $40 million. Visualead was a Kaedan Capital and Entrée Capital portfolio company.
Lear Corporation, a leading global supplier of automotive seating and electrical systems, acquired Exo Technologies for an undisclosed amount. Exo Technologies, an UpWest Labs portfolio company, is a developer of GPS technology providing high-accuracy solutions for autonomous and connected
vehicle applications.
NOTABLE FUND FORMATIONS
Israel-based technology investment group Viola has announced the closing of a $100 million global fintech fund. Viola FinTech is a cross-stage venture fund investing in fintech companies alongside leading venture investors with the mission to bridge the gap between the world of financial institutions and innovative startups.
RECOMMENDED VENTURE CAPITAL READS
Thanks to an $11 million investment made four years ago, the Winklevoss twins have become Bitcoin billionaires. [The Verge]
Spotify will soon go public. And since the company doesn't really need the public's money, it's taking the opportunity to reinvent the tech IPO. [The Wall Street Journal] Each bitcoin transaction requires enough electricity to power nine homes for a day. By the middle of 2019, the crypto network will use as much power as the entire US. [Grist]
The stock market boom of the 1920s had the NYSE. The tech bubble of the 1990s had the NASDAQ. And the cryptocurrency frenzy has Coinbase. [The New York Times]