Time to join the strip club?

This is the conversation that every corporate investor dreads having with their mothership:

“The strategic returns have been great, thanks for that. But when do we start seeing some financial returns?”

It’s been a uniquely difficult venture market the last 36 months, with exits scarce and valuations under pressure. If you’ve received that phone call from the mothership, you’re not alone.

What are your options for generating liquidity?

There are four:

1. Sit tight

The IPO window may be opening up, and the overall VC climate is improving by some measures. So you might elect to do nothing for the moment, in hopes that exits will begin flowing again of their own accord, without the need to pursue other liquidity solutions. But when it comes to predicting where the economy and the venture market are headed, our view is that nobody knows anything. Doing nothing and waiting for a hoped-for increase in exits via IPO or M&A is likely not a great option. (And it may have some career risk.)

2. Collateralised fund obligation

This is a newer flavour of a collateralised debt obligation, in which the CVC generates liquidity by issuing tranches of debt collateralised by the CVC portfolio. The tranches are rated by Moody’s or a similar ratings agency, with differing interest rates and preferences. For corporate venture arms whose parent company is a financial institution it may be an attractive structure. But given the high degree of complexity and compliance required with overcollateralisation and other covenants, it can be a challenging option for non-financial parent companies.

3. Secondary sale

In a secondary, an investor acquires your stake in one or more of your portfolio companies. The advantage is that it’s an exit – it gets the investment off your books and frees up your bandwidth, which are objectives for some CVCs. If those are your objectives, this option works well. The disadvantages are that the mothership will take a substantial writedown given the prevailing secondary discounts. And you’ll lose the strategic insights from the portfolio company that made you invest in the first place – along with the financial upside.

4. Strip sale

The awkwardly named strip sale is an increasingly popular option for CVCs. This is essentially a profit participation where a new investor pays up front for a share of future profits that the CVC’s portfolio generates. Unlike a secondary sale, the CVC keeps its stake in the portfolio companies; the only change from the status quo is that the CVC takes on a new financial partner who will share in some of the upside. So the CVC keeps its ownership and governance; it keeps it strategic insights; and it keeps upside. And critically, because it’s not a “pricing event,” there is typically no writedown. For many CVCs this is the most attractive option.  

What are CVCs’ prospects for generating liquidity on attractive terms?

They’re pretty good, actually.

We’re specialists in advising corporate venture arms on their liquidity options, and on executing them as a registered broker-dealer.

We see growing interest from external investors as they become more aware that CVC portfolios have a financially attractive profile, making them appealing to the abundant capital on the sidelines (more on that below). Specifically, investors are becoming more aware of:

• The attractive exits CVCs have delivered relative to conventional VC funds, with more exits and fewer wipeouts than conventional VCs;
• The large footprint CVCs have relative to the overall venture market, with more than 60% of last year’s venture deals including a CVC; and
• The increasing prioritisation of financial returns by CVCs.

There’s also more capital than ever chasing secondary and strip sale investments, with total fundraising by investors in such vehicles surging by 180% in 2023, surpassing the combined total of fundraising in 2021 and 2022. Near-term dedicated available capital for such investments is forecast to hit a new record of $255 billion, around 2.3x the trailing investment volume.

Plus, pricing on venture secondaries has now remained steady for two straight years, making buyers and sellers more willing to accept current valuations without remaining on the sidelines waiting for the market to move. That’s driving a narrowing of bid-ask spreads, which facilitates deals getting done. And the portion of total investment that’s going to venture capital (as opposed to private equity and other strategies) is up 50%, from 8% of the total, to 12% of the total.

How should you prepare for a strip sale?

Key considerations to prepare, and best practices for a successful outcome:

1. Determine your strategic objectives.

Understand what’s most important to you, because it will drive transaction structure. If generating liquidity is the overriding directive, a secondary sale may be best. You take your check from the acquirer, and you take your lumps in terms of writedowns and the loss of the investee company relationships. However, if you also care about preserving your portfolio company relationships and avoiding writedowns, you would be better advised to pursue a strip sale – while understanding that because you retain some equity upside, that the total check size will be smaller in a strip sale.

2. Set internal expectations.

Generating liquidity is complex and time consuming. It takes months, not weeks, so ensure the mothership understands the timeline. And with strip sales, it’s critical for the mothership to understand the structure, because the “headline number” on a transaction is easy to misunderstand: in a successful strip sale, a new investor might pay $40m up front for a share of profits in a portfolio marked at $100m. But if the mothership misunderstands this to mean that you just took a 60% haircut, they’ll be unhappy (speaking of career risk). It’s critical that the mothership understands that in a strip sale, this outcome means you put $40 million in your pocket, and that you kept some of the upside in the portfolio, while sharing some of it with a new investor. (And if the portfolio performs, you should get your full $100m out, and perhaps more.)

3. Get your story together.

Remember you are raising capital from a third party investor motivated exclusively by financial incentives. The strategic objectives that may have driven your initial investment are not particularly relevant to the new investor.  You will need to articulate your story about the attractiveness of your investments – and about your CVC team’s track record – in financial terms, not strategic terms.

4. Think about the communications strategy with your portfolio companies.

Depending on the terms of your NDAs and transaction documents, you may not be obligated to disclose a strip sale to your portfolio companies, but you may decide to communicate with them anyway. Doing so in a way that clearly communicates that you’re bringing on a financial partner that will further enhance access to financial resources while keeping the relationship otherwise unchanged is critical. Otherwise, a poorly thought-through communications strategy could result in alarm or strained relationships at the portfolio company level.

5. Assemble a war room.

These transactions are complex and challenging. They’ll require you to assemble a war room of trusted advisors including attorneys, accountants and investment bankers. Ensuring you have the right team, experienced in the different flavours of liquidity, how best to take them to market, and which new investors to approach, is essential.

With CVCs achieving attractive investment performance and motivated to seek liquidity without waiting for the IPO market to open up – and with masses of dry powder from investors who increasingly understand the appeal of CVC portfolios – we believe CVCs will see historic growth in outside investors providing liquidity for their portfolios.

Laurence Levi is a partner with VO2 Partners, a registered broker-dealer focused on delivering superior outcomes for corporate venture arms and other institutional investors.