In today’s Finshots, we explain why the concept of continuation funds are becoming popular in the venture capital world.

But before we begin, if you're someone who loves to keep tabs on what's happening in the world of business and finance, then hit subscribe if you haven't already. If you’re already a subscriber or you’re reading this on the app, you can just go ahead and read the story.


The Story

Here is a simple way to think about the model of a Venture Capital firm.

  1. Raise money from investors by telling them about the opportunity to invest in hard-to-access private companies.
  2. Find exciting young startups that spin a great story of potential growth and invest in them.
  3. Wait for a long time. Typically, it takes 5+ years to sell these portfolio companies at a higher valuation — either to another investor or in an IPO. Then, deduct hefty fees and return the monies to the investors.

Repeat the cycle.

But sometimes, things go wrong. The economic environment turns ugly and exiting companies at lofty valuations can be hard. The startups make losses so an IPO is out of the question. Big investors vanish as they turn cautious and wait for better times and clarity to emerge.

I mean, India was a classic example of this in 2022. Foreign venture capital interest in Indian tech startups had fallen by 40%. Only 8 tech companies chose to IPO during the second half of the year compared to nearly 24 tech companies during the previous year.

The struggle for an exit was real.

Now if you’re a VC firm stuck in this situation, it means you can’t find an exit at the right price and the investors start knocking on your doors demanding that their investments be returned. After all, you did promise to make good on the promise in 5 years. And you know that while investors might forgive a slightly lower return, they’ll punish you if you fail to return money on time. Word will spread and no one will want to invest in your funds again.

That’s when you’re struck by a brainwave. You simply launch another fund.

Yup!

You raise fresh money from a bunch of investors — call it Fund B. And instead of scouting for a new idea, you just stick all that money into buying out the existing portfolio from Fund A. That way, you get to return cash to the old set of investors and they won’t complain anymore. And the new investors will get to own a portfolio that you claim will be a multibagger.

This, folks, is what’s known in the industry as a continuation fund. And VCs are flocking towards this exit strategy.

Here’s the Financial Times over the weekend:

One of Silicon Valley’s most prominent venture capital firms, Lightspeed Venture Partners, is seeking to use a private equity-style structure [continuation fund] to sell $1bn worth of start-up stakes and free up cash to return to investors.

And in the past 5 years, continuation funds have risen from a $5 billion industry to well over $70 billion today.

But it’s not all kosher. As the strategy gets popular, investors are pointing out the problems too.

For starters, there might be a pricing or valuation problem.

Research firm Raymond James crunched the numbers and found something shocking. Say a VC had initially valued a startup in its portfolio at $100. But when it launched a continuation fund to buy out this stake in the startup, it would sell it at say $90. In fact, 42% of continuation fund deals happen at a lower valuation.

So you could say that the older set of investors are being short-changed quite often.

Now you could argue that the investor could choose to remain an investor in the new fund too. They could hope that the market environment soon changes and they get better exits. But that simply means they get locked in for another 5+ years without knowing the end outcome anyway.

It also raises another question — of fees.

Let’s say the VC fund invests $10 million across 10 companies. There are two ways they make money. They charge an annual management fee of around 2% on $10 million for all the operational activity and salaries they need to pay their staff. And then, over time the portfolio value grows to a neat $1 billion. Now when they sell this portfolio and make an exit, they’ll charge a performance fee of 20% on these profits. Think of this as a bonus for their business smarts.

It’s the famous 2 and 20 model.

But what if you could sell this $1 billion portfolio to yourself?

Then it’s a bonanza. See, when you exit the portfolio, you can’t charge a management fee anymore because someone else has bought it. But now, your new fund can continue to charge the 2% fee. And this time, you can charge it on the entire value of $1 billion.

That’s quite a finance bro move, eh?

And when you finally exit it for good from Fund B, you’ll probably get to charge another 20% performance fee too.

Finally, you could even make the argument that it’s an easy way for the VC firm to extend the life of dud investments. It can palm off these startups to its new fund. And it will only have to worry about the consequences of the decision later i.e. when 10 years later, it’s time to exit investments in Fund B.

Think of it as ‘evergreening’ bad investments. Just like how banks keep lending to companies that are on the verge of defaulting on their loans. It’s simply a way to push the bad news for another day.

And that’s why some folks in the asset management world are likening this to a pyramid scheme. You know, where you use fresh money from new investors to pay out old investors. Just that there is an actual underlying business in the case of a VC firm.

So it’s actually more of a game of financial music chairs, no?

Anyway, it’s still early days for continuation funds. We don’t know what the end outcome will be yet. We don’t know if regulators will clamp down on this burgeoning industry. We don’t know if investors will protest against them and ask for better structures.

But for now, you know the good, bad, and ugly of this new VC playbook.

Until then…

Don't forget to share this article on WhatsApp, LinkedIn, and X (formerly Twitter).

📢Finshots is now on WhatsApp Channels. Click here to follow us and get your daily financial fix in just 3 minutes.



Why Millennials Should Buy Term Life Insurance‌

Nearly 83% of Indian millennials don't have term life insurance!!!

The reason?

Well, some think it's too expensive. Others haven't even heard of it. And the rest fear spam calls and the misselling of insurance products.

But a term policy is crucial for nearly every Indian household. When you buy a term insurance product, you pay a small fee every year to protect your downside.

And in the event of your passing, the insurance company pays out a large sum of money to your family or your loved ones. In fact, if you're young, you can get a policy with 1 Cr+ cover at a nominal premium of just 10k a year.

But who can you trust with buying a term plan?

Well, the gentleman who left the above review- spoke to our team at Ditto.

With Ditto, you get access to:

  1. Spam-free advice guarantee
  2. 100% free consultation from the industry's top insurance experts
  3. 24/7 assistance when filing a claim from our support team

You too can talk to Ditto's advisors now, by clicking the link here