Nodem: liquidity for emerging market VCs
Alex Branton's new fund tackles EM VCs' liquidity clog.
This interview was conducted and edited by Timothy Motte.
Biography
Alex Branton is the founder of Nodem, a new fund freeing up liquidity for LPs and GPs investing in emerging markets.
Prior to Nodem, Alex was a partner at Sturgeon Capital and previously an investor at Cambridge Associates.
What problem is Nodem solving?
For the past decade, VCs in emerging markets (EMs) have enjoyed a sharp increase in LP funding, culminating in a 2021 peak. While billions in value have been created, liquidity has been hard to come by.
Many funds are nearing the end of their fund life and need to return capital to their LPs. Unfortunately, many of the companies they’ve invested in haven’t been acquired or gone public just yet. This creates a structural blockage, a clog, which hampers the flow of new money into the asset class.
This creates a conundrum. Maturing funds need to return capital to LPs, but GPs want to avoid accepting sharp discounts for their fast-growing winners just for the sake of liquidity.
Further, whilst LPs need liquidity to re-up, they want to maintain exposure to the fund's performing companies.
The whole situation isn’t abnormal, per se. EM or not, there is a significant mismatch in the arbitrary length of VC funds (10 years) and the practical reality of how long outlier businesses take to exit (more than 10 years).
EM VCs face a problem that VCs in developed markets (DMs) have already faced. However, EM VCs don’t have access to the liquidity solutions DM VCs have access to.
Hence Nodem.
Why are these funds taking longer than expected?
Those raising VC funds deferred to the industry standard 10 (+2) year fund lengths, designed for a pre-2010s era where that exit timeline was proven.
That has changed. It will be 15 years on average before most funds are close to fully realized. It just takes a longer time for many companies to scale and exit - true of both EM and DM.
In EMs, a generation of new LPs entered VC with limited vintage year diversification and an expectation of substantial flows within 5-10 years. It’s taking longer than planned. A significant duration reality check is in order, which is now hampering fresh reinvestment into our ecosystems.
How have other, more developed geographies solved this issue?
The US saw its first wave of major secondaries players emerge in the 1990s. These firms had multiple ways of providing VCs with liquidity: buying out LPs directly (LP-stakes), selling off underperforming assets and migrating performing ones to a new fund (GP-led, continuation funds) or NAV financing (lending the GP money, with the fund’s assets as collateral).
In DMs, such solutions exist both for private equity (PE) and VC funds. With time, secondaries have gone from a cottage industry to an established one. Today, intermediaries such as Evercore have branches dedicated to those transactions. More intermediaries means more liquidity, facilitating secondary transactions.
It’s interesting to note that the biggest VC secondary players emerged out of periods of turbulence, such as Industry Ventures (post dot-com bubble) and Gsquared (post 2008 financial crisis).
Don’t EM VCs have access to similar liquidity solutions?
EMs lack VC secondary players because existing global ones aren’t interested, and local ones don’t exist.
The size of EM secondary transactions are too small for most DM secondaries actors. They are also hard to accurately price from afar. They have enough sizable deal-flow to play with at home.
Locally, EM VC secondaries don’t exist because there hasn't been an acute need for them until now. As more and more EM VCs hit their 10-year marks, the need for secondaries is being felt for the first time.
RO insights: LPs' denominator problem
Why would LPs absolutely want liquidity at the end of the fund? If the fund performs, why not keep one’s stake until the underlying companies exit?
Here’s how Alexander Covello, another secondaries specialist, explained it to the Realistic Optimist:
“
LPs could want to offload their positions, even in good VCs, for several reasons.
First, many LPs are institutional investors (pension funds, endowments, etc…) and increasingly struggle to see the pertinence of tech. Especially in light of enticing, juicy interest rates. Tech made sense in 2021 when lending money returned nothing, but that isn’t the case anymore. Between a tech-focused VC stake and high yield T-Bills, opting for the latter can make sense.
Another reason is the “denominator effect”. Think of it this way: you lead a pension fund and your strategy sets a 12% maximum allocation to private equities (of which VC is a part of). For some reason, the value of your public equities (such as your Apple stock) drops.
Assuming the value of your private equities stay the same, this mechanically means your % allocated to private equity rises, since it now represents a larger portion of your pie. If that % surpasses your maximum allocation threshold, you might have to offload some of it. Hence the need for an LP-stake maneuver.
The increasing variety of VC LPs increases the variety of risk profiles. This means these LPs might have different exit strategies. This opens the door for alternatives to cash out on VC investments, and secondaries are one of them.
“
Excerpt from the pertinence of VC secondaries, from the Realistic Optimist
How does Nodem solve this?
Imagine you’re an LP in an Indonesian VC. The fund is 10 years old and contains 5, non-exited, local tech champions that continue to grow +30% year-over-year (YOY). You invested $1M, which is now worth $5M.
As an LP, you need some liquidity back, but you also want to maintain an upside in the fund’s companies, to cash out when they exit. One option would be to sell your entire stake in the fund. However, this would imply selling it at a sharp discount (if you can find a buyer) and haggling over the worth of the stake. You also wouldn’t keep an upside in the event of future exits.
Nodem offers something different. Say you need $1M of liquidity. Nodem will give you that in cash immediately. In doing so, Nodem becomes a senior recipient of the next flows from your stake (via preferred equity).
As companies from the fund start exiting, Nodem will get its capital back plus a preferred return. After this, you (the LP) get underlying proceeds until you are "caught up" to a pre-agreed level. Remaining distributions are then split between you and Nodem, in your favor.
As an LP, you get “cash today” and upside optionality.
What if an LP wants to sell Nodem its entire stake?