The Goldilocks Zone: Finding Value in Venture & Growth Secondaries | Ep. 42

Show V/O:

This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify, or wherever you get your podcast to make sure you don't miss an episode. Here is your host, Tony Davidow.

Tony:

Welcome to the latest episode of the Alternative Allocations podcast series. I'm thrilled to be joined today by Matt Hodan of Lexington Partners. Welcome, Matt.

Matt:

Hey, Tony. It's great to be here. Thanks for having me.

Tony:

Well, Matt, I want to just start with your background. You have a very unique perspective and I think it helps shape the way that you look at the world. So if you can, just share a little bit about your background and then we'll get into the opportunity set for today.

Matt:

Yeah, happy to. Just by way of introduction, Matt Hodan, as you said, a partner at Lexington. I've been at Lexington now for nearly 16 years. I'm based in our Menlo Park office and I co-lead our investment activities and venture and growth. I've built most of my career here at Lexington. I did have a stint as an entrepreneur prior to joining Lexington, founded a company backed by Y-Combinator and raised a bit of angel capital before we ultimately sold.

And prior to that, spent some time as a private equity investor at GenStar Capital and started my career with back when in investment banking in New York.

Tony:

And I think that's helpful because, again, I think you have a different vantage point and look at the world differently. I do want to come back and also revisit the fact that I think being in Menlo Park is a real advantage for the space that you operate in. But let us kind of start off with the macro big picture.

And that is that we're starting to see green shoots and attractive opportunities in the venture and growth area, an area that I think candidly has been a bit challenging for the last couple of years. How do you see the market opportunity and what is starting to change that has really provided all these great opportunities that we've been talking about recently?

Matt:

Sure. We're seeing a significant opportunity in venture and growth today. I think it's important to frame that opportunity by looking back at the asset class over time and how it has performed.

Venture and growth has been a strong long-term asset class for investors to be invested in. And I think those who have made it a permanent allocation, and their portfolios have been rewarded for doing so, based on our various benchmarks that are out there. It's among the highest performing asset classes across private equity. It stacks up very well to buyout to real estate to credit. That's kind of the historical lens. So, I think from a starting point, it's an asset class you want to be invested in.

But today, we're seeing just an incredible opportunity driven by a number of forces that are shaping the venture and growth market. And then really, that market has changed a lot over the years. One of the principal forces has been companies are staying private longer.

We're just seeing a long-term secular trend of companies choosing to stay private. If you look back to the late 90s, early 2000s, the average company exited around seven years post-investment. Fast forward to the 2010s, closer to nine years. We're in the 2020s now and the story is still being written, but it's clear that companies are staying private even longer.

So I think 10 years plus, that's being driven by founders and CEOs who have realized it's better to grow a company in the private markets. Private markets have the ability to reward a longer-term mindset. And I think the investors in the private markets really are attuned and prefer that longer-term mindset.

Whereas in the public markets, the company can be punished for operational volatility, quarter to quarter. And so it really promotes the shorter-term thinking, shorter-term quarter to quarter mindset of growing a business. And I think we all know building businesses just never a straight line. So it's hard to succeed as a growth asset in the public markets.

And the private markets have adapted to support companies growing to much more significant scale as private companies. I think the OpenAI round that we saw raised earlier this year at over 120 billion, the capital raised, is really a testament to how far we've come.

That would have been unheard of 10 years ago. And the fact that the private markets can support a company well into the trillions valuation with capital raises that are in the 100 plus billion scale shows that you can grow a business to a really significant level while remaining private.

Tony:

It is interesting to see the evolution in particular. I do remember the dot-com bubble. And I think a lot of advisors still have a perspective of those young companies who went to the market, weren't really prepared for it. A lot of the companies failed. And we fast forward to today and the perfect example, as you were describing, is looking at a company like SpaceX, which is a 24-year-old company.

But I think as you pointed out, Elon Musk had the flexibility to raise capital in the private markets, had the freedom to manage for the long run, which I think is the only way that companies survive. And that ultimately goes public 24 years after its founding at a $2 trillion valuation. So to me, it kind of punctuates that point that the private market opportunities are very different today than they were 10 years ago or 20 years ago.

And it's a reflection of what's happening in the overall ecosystem. So to us, certainly, it's very exciting. Matt, if you could have love to pick up on that point, which is, if we now look at the high-profile names like the SpaceX and the Anthropics and the OpenAIs, and they certainly get most of the attention, are there areas when you look at venture that you're seeing opportunities, maybe outside of those high-profile names, and not named specific, but more sectors and opportunities?

Matt:

It's interesting. Those companies get most of the press. And I think there's broad awareness of the incredible journey that those companies have had and incredible level of value creation those companies have experienced.

They're really the example of what's possible in the market, but they've already arrived. Today, those companies are the consensus bets. I think everybody recognizes that these are high-quality companies that are getting quite close to an exit event, be the most likely an IPO for each of them.

If we’re doing our jobs right, we're really focused on building exposure into the tier one venture-backed assets of today, but also building exposure into tier one venture-backed assets of tomorrow. And so what we're spending most of our energy focused on, what are the next Anthropics, the next OpenAIs, the next SpaceXs, the next Databricks, pick your company and build exposure into those companies over multiple investments, multiple years, and tracking them and building conviction over time. So the end goal is to have a portfolio that is diversified that has exposure to these really high-quality brand name businesses that everyone agrees are great assets to own, but to build an exposure at an earlier point in their development when the valuations are more grounded and when there's more time for value compounding to occur on the private markets.

And to maybe address your question in a more broad sense, what we are seeing in venture and growth is an incredibly sizable asset class with an incredibly fragmented universe of companies at various stages of their development in various sectors or sub-sectors within venture and growth and within different segments of the economy. There are phenomenal companies being built in many different areas across the landscape. I think if your aperture is just the five or six logos that are making the front page of the Wall Street Journal, you're missing the bigger picture opportunity.

When you step back, you compare the quality of the companies that are available in the private markets, growth-oriented companies specifically, to the quality of the growth-oriented companies that are available in the public markets, there’s no contest. It's very clear that the private market companies are more interesting investments.

They have higher growth rates typically. They have better unit economics oftentimes often chasing large market opportunities. With companies staying private longer, some of these companies are even achieving greater scale as private companies than the public comparitives.

So there's a real opportunity to invest in the venture and growth ecosystem through a diversified strategy at an attachment point that's early enough in a company's development that are able to participate in that value creation over multiple years. That's really attractive.

Tony:

We wholeheartedly agree. We think there's just incredible opportunities. This changing dynamic we and others in the industry have been referring to as this convergence of public and private, we need to rethink how we categorize the opportunity set.

I think one of the unique things with what you and your team at Lexington are doing, though, is you're actually buying secondary opportunities. How does a secondary market source opportunities in venture and growth? And why is that an effective way of getting exposure across the landscape?

Matt:

I think it's important to recognize the secondary market, even for venture and growth specifically is not a monolithic thing. It's not homogenous. It's a very sizable market with a spectrum of different types of assets, different types of transactions, different scale of opportunities.

We, as one of the largest investors in venture and growth secondary is globally, and given our extensive history of investing in this asset class and the relationships and access and information that that history has provided us, we really focus on the highest end of the market, the largest transactions with the most institutional counterparties, really more curated capital solutions that solve a problem or meet a specific need of the seller.

What that means is that we're underwriting diversified portfolios of assets. These tend to be portfolios of interests in venture and growth funds. Each of those funds often has many underlying venture and growth companies.

In one transaction, we may be acquiring exposure to hundreds of underlying companies. And so you can imagine the complexity and the underwriting motion that's required to make sense of that and to be thoughtful about pricing that portfolio. We have the systems and the infrastructure and the relationships and the information access to be able to do that effectively and on a deal timeline.

That segment to the market is an incredible attachment point. It allows us to really curate exposure to what I like to call the Goldilocks zone of value creation. It's after companies have found product market fit and are now on the scaling phase of their development.

But before they get to that very late stage, maybe a year or so before an IPO or an M&A event where in the latest stages, you're faced with more valuation and exit environment risk. By investing in this Goldilocks zone, we avoid much of the cost and risk and duration associated with early stage venture investing, while also avoiding much of the valuation and exit environment risk that comes with very late stage investing. And we're able to curate a diversified portfolio by buying exposure through transactions that have inherent diversification, as I was describing earlier, and really curating each of those transactions around the underlying companies that we think are the tier one venture backed assets of tomorrow.

Tony:

Yeah, and it sounds similar to the broader secondary story that we often talk about, which is you're buying those assets at a later stage. You're getting that built in diversification. But it does beg for you need to have a deep network.

And I know that that is something you pride yourself on. And of course, there's an advantage being in Menlo Park, where so many of these opportunities are sourced, maybe talk a little bit about why that's so important to you and how you're in fact sourcing opportunities.

Matt:

Lexington has had a focus on investing in venture and growth equity really since the early years of the firm developed back in the mid-90s. It's been a core component of Lexington's broader investment strategy over the years. And in fact, the second office Lexington ever opened was the office here in Menlo Park.

We've grown of course over the years and it's become a larger portion of the overall program. And we've grown with the market. It's been a very important focus of our firm for decades. Having a team based here really means that we are part of the ecosystem. So having that team based here is a huge strength and differentiator that we've invested a lot in over the years and growing. As far as sourcing goes, we're in a very fortunate position of being one of the largest investors in this asset class and having a reputation for being a sought-out counterparty for sellers, both on the LP side but also on the GP partner side for secondaries. And what that means is that we really don't need to do a lot of outbound sourcing.

We see organically pretty much every sizable secondary opportunity that is brought to market inbound to us because of that great inflow of opportunities and extremely wide top of funnel that we're able to be very selective and identifying the best secondary opportunities. Having been at this for as long as we have, we have developed many hundreds of relationships with sponsors in the ecosystem, venture capitalists, growth equity managers at all levels, whether it's seed, early stage, mid-stage, late stage, you name it. And of course, we also have relationships with many even buyout sponsors given Lexington's broader focus on private equity.

For all of these relationships, we see tremendous organic deal flow that's not intermediated. We usually are hearing about opportunities from sponsors and from our network before an intermediary is brought in. Now, of course, granted, given the size of the investments that we focus on, it's very common to have an intermediary ultimately be brought in to help manage the transaction.

And that's a good thing. That's something we advocate for.

Tony:

Matt, let us get out of here on this question. And that is we're sitting here late in 2026. We've had a fairly volatile year with a lot of uncertainty.

As we peer into 2027, it certainly looks like the PE ecosystem is looking much more attractive. We've talked a little bit about those high-profile IPOs, but we're starting to see more green shoots. We anticipate more IPOs coming to the market, big and small.

We anticipate more M&A activity. Doesn't that bode well for the broader opportunity set? And as you're looking out in the future, what are you seeing? Are you seeing the same sort of green shoots that we are?

Matt:

Yeah, it's interesting. Private equity broadly has been a very rewarding asset class for a while now for investors. And I think that has continued to be the case, in large part, because of some fundamental forces that exist that drive that asset class.

Being able to grow a business without the public market scrutiny, being able to have investors have a longer-term mindset, being able to attract capital at scale to support growth initiatives, and just really disciplined management with investors that are focused on driving value creation, not just in the quarterly board meeting, but between those board meetings and partnering with these companies to drive value. You see all of those dynamics on the buyout side also apply to the venture and growth ecosystem, where I spend most of my time.

The opportunity set that I see in venture and growth looking ahead is extremely interesting. We are at a pivotal point in the evolution of venture and growth, where it has become not just a cottage industry backing really early stage businesses that then go public and achieve most of their growth in the public markets, but rather now a well-established sizable industry that drives innovation-driven growth and value creation for an extremely long period of time and an extremely long period of company development.

And that's all in support of this broader market environment that we're in where we're seeing technology transformation occur thanks in large part to artificial intelligence and the potential of that technology. And so when I look ahead and I think about what does that mean for investors that are trying to capture value creation and their portfolio, this is an incredibly interesting time to be an investor.

You're getting in at the ground level on a new transformational technology that is AI at a relatively early point in the development of that technology. And you have the ability now to get diversified exposure to growth and transformation driven by that technology through venture and growth. And that's in part through the companies that are developing the technologies, but it's also through backing companies that are now adopting this new technology to drive more value creation through new product, new services, more growth, maybe expansion at a new geography, even using AI as a tool to accelerate the value creation in their businesses, all of which we see taking place across the venture and growth ecosystem. And I would contend that the venture and growth companies are exceptionally well positioned to adapt, it’s almost inherent in the ethos of being a venture and growth company, that you have adaptability. These companies have embraced this new technology.

And as we look at what we're seeing in the market, most of the companies that are not native AI companies are using AI in a way to accelerate performance. Some are facing headwinds and it will be painful for certain companies, but by and large, it's been a positive force.

Tony:

Matt, thank you so much. I think this is great. You've certainly painted a very rosy picture for the opportunity set in venture and growth. And I think for all the investors out there, what an exciting time and an opportunity to hopefully own the next SpaceX, Anthropic and OpenAI. So very timely discussion.

We share your enthusiasm. We'll be releasing our private market outlook shortly. And this will be one of the themes that we delve into in a fair amount of detail.

So as always, thank you to our guest, Matt Hodan of Lexington Partners. Terrific guest today. Thank you to all of our listeners who have been loyal and have followed us as we begin our fourth season here on the Alternative Allocations podcast. And as always, if you have ideas, please feel free to reach out to us and let us know about topics and themes that would be of interest to you.

I thank you all and thanks again, Matt, so much.

Matt:

Thank you, Tony. It was great to join you.

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