Nodem: liquidity for emerging market VCs

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.

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?

There are many good reasons to sell a stake outright. However it can create adverse selection issues - what do they know that we don’t?

Having LPs share in the upside tacitly means that the LP believes in the fund and we are aligned in wanting success: an extra level of assurance for Nodem.

Full LP-led transactions can also cause higher friction since both parties have to agree on a fixed price that is often at a sharp discount (in assets that are visibly high quality), due to the buyer/seller mismatch in EMs. In some circumstances, it can also damage an LP's relationship with a GP.

What if a GP wants liquidity for the fund as a whole? 

Same process, more or less. Say the GP raised a fund with 4x of residual value (the NAV is 4x original LP commitments) in year 11, with underlying companies still growing 20-30% YoY. LPs want liquidity to re-up in the latest vintage, but the market is unfavorable for the GP to sell companies on the secondary market. 

Nodem gives the GP cash today, which they immediately turn into cash distributions to LPs. Returns on the underlying funds are then shared between Nodem and the GP the same way they are in the LP scenario.

The terms of the deal are heavily negotiated, but the principle is always fast liquidity, low friction, and alignment around maximizing the value of the fund. Nodem is a reliable LP aligned with the underlying GP.

You call your geographical scope “Next Wave”, which includes the world minus the 10 legacy advanced economies (North America, Western Europe…). In short, EMs. You’ve excluded China from the play. Why?

I love China, speak Mandarin and believe in the next generation of Chinese VC managers. 

The truth is that there isn’t much appetite when it comes to selling the best Chinese assets. You are more likely to pick up a portfolio of dubious SaaS companies at discounts to frothy 2021 valuations. 

Even if the best assets were for sale, their secondary prices didn’t reflect the amount of risk a foreign investor takes when investing in China. International exit markets are limited, and it’s unclear when China’s IPO markets (particularly for “out-of-favor” sectors) will reignite.

Notice that I’m still bullish on China as a market. I just think it’s a tough place to find true bargain discounts in pre-existing private funds.

Lastly, Nodem’s ethos is to focus on EMs, which I’ve crisscrossed and deeply engaged with during my time at Sturgeon. What I’ve come to realize is that China isn’t an EM. It has more in common with the US in terms of market depth and technological sophistication: from AI to robotics.

Lastly, China is large enough to deserve 100% of an investor’s attention. You are either all-in on China, or not at all.

Nodem’s thesis relies on EM tech champions eventually exiting. Why are you so certain that will be the case? 

As mentioned, people in the VC space are due for a “duration reality check”. It takes a long time for outlier companies to undergo lucrative exits. Just look at Canva, Stripe…Unfortunately, that timeline is longer than the arbitrary 10-year fund life the VC industry has adopted. 

This is no different in EMs. It isn’t that EM tech companies can’t exit: Nubank, Kaspi, Tinkoff and Grab have proved they can do it on Western stock markets. Fawry and GoTo have proved they can go public locally, too. 

Many companies just need more time to achieve that exit at an acceptable multiple. It would be a shame for GPs and LPs to give up on that upside just because they have decided the fund would be 10 years long. Hence Nodem.

Do any particular tailwinds support Nodem’s thesis?

Two main ones. 

First, the valuations of EM tech startups have dropped since 2021. This is good, because it ushers in a more rational pricing environment for company acquirers. Paradoxically, Nodem’s worst-case scenario (for deployment) would be a bull market where valuation returned to 2021 levels, combined with abundant liquidity. 

One of the major reasons Nodem maintained a global investment mandate is that different markets will be more/less attractive at different times. Secondary markets are inherently cyclical, and our ability to rotate our investments into different markets during periods of relative distress turns a cyclical asset class into a non-cyclical one.

Second, the value of companies held in VC funds older than 10 years old is set to skyrocket as the 2015-2021 vintages mature. This will become an enormous asset class. 

What’s your contingency plan in the event of a bull market?

Part of the reason why we have a global mandate is to diversify our risk. Bull markets aren’t globally uniform, so being in multiple markets helps assuage a localized bull market. 

If markets are too hot and no deals make sense, the best course of action is to return money to investors before deploying it. That’s what the best and bravest GPs do. 

How does Nodem gauge the “exitability” of the stakes it’s investing in?

We look for multiple exit routes. It depends on the company. Generally, at the time we’re coming into the fray, the VC has already drawn up an exit strategy for their most promising companies. 

Part of Nodem’s due diligence is digging into the viability of these exit plans. Nodem is connected and in constant discussions with potential buyers in the public markets, PE firms and strategics to understand the appetite for given companies/sectors/regions.

Nodem will be overweighted in fintech for many reasons, not least that the sector has an obvious pool of acquirers. 

Wouldn’t EM PE players be Nodem’s competitors? 

Not really. Nodem is doing fund-level transactions, which many PE firms don’t have a mandate for. PE prefers to invest directly in companies. PE firms will become a major source of exits for mature VC-backed companies, but they aren’t competitors on the fund-level liquidity side.

In essence, we don’t have many competitors because there are not many pools of capital capable of making our style of investments. There are a small number of other EM secondaries players but they’re more interested in direct deals (buying out shares in underlying companies). 

Nodem is restructuring fund distribution waterfalls with existing LPs/GPs. This could be considered boring and complex to most. It also requires a different skillset, as we’re underwriting GPs as well as what are mature corporations (by the time we invest in “year 10” or so).

Nodem will also be used as a tool for larger asset managers to deploy in EMs. Our biggest challenge today is educating the market on the benefits of our solution. 

How do Nodem’s returns differ from a VC fund’s returns?

VC is a high risk, high reward "power law" asset class where +10x net returns are possible to the top few. When Nodem invests in a maturing fund, the standout companies are large and our underwriting is more akin to a PE shop. 

Nodem is looking to achieve lower multiples and faster paybacks that would ultimately drive a sustained and elevated IRR.

Do you have any fundraising advice for emerging managers?

Emerging managers sometimes forget that their fund is a product with a customer (LPs). Like any startup, they need to think strategically about their PMF and clearly articulate their value proposition to their target LP base. It is nearly impossible to be everything to everyone.

When they start, it’s best to optimize for investing over everything else. Scraping together $50k SPVs is a great start. Showing, not telling, is always better. If one cannot assemble smaller SPVs, maybe they should wait or reconsider launching a VC. Further, there is no advantage to targeting an unrealistic fund size: you can always agree with LPs to increase. 

It's difficult to fast forward the network that experience gives you. The LP network I’ve built through 12 years in the industry allowed Nodem to raise sufficient funds in a few weeks. 

I’d advise starting a fund when one feels they have a robust, trusted network of available capital allocators they can comfortably tap. 

The Realistic Optimist’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice.