These days, it's not easy to become a limited partner investing in a venture capital firm. LPs that fund VCs face a liquid asset class. Fund lives are nearly twice as long as before, emerging managers face life-or-death financing challenges, and billions of dollars remain locked up in startups that may never justify their 2021 valuations.
Indeed, at a recent StrictlyVC panel in San Francisco, five prominent LPs representing endowments, funds of funds, and secondary firms that manage more than $100 billion collectively painted an alarming picture of the current state of venture capital, arguing that an area of opportunity is emerging from the chaos, despite the din of the raucous crowd that had gathered to watch.
Perhaps the most shocking revelation was that venture funds have lived much longer than anyone had planned, creating a lot of problems for institutional investors.
“Conventional wisdom might have suggested a 13-year-old fund,” said Adam Glossier, director of the $9.5 billion J. Paul Getty Trust. “In our own portfolio, we have funds that are 15, 18, even 20 years old, and we still have key assets, blue-chip assets that we would want to own.” Still, “the asset class is much less liquid” than many would imagine based on the history of the industry, he said.
This extended timeline is forcing LPs to dismantle and rebuild their allocation models. Lara Banks of Makena Capital, which manages $6 billion in private equity and venture capital, noted that her firm currently models an 18-year fund life, with most of the capital actually coming back in 16 to 18 years. The J. Paul Getty Trust, on the other hand, is actively reviewing its investments and leaning toward a more conservative allocation to avoid overexposure.
The alternative is active portfolio management through secondaries, a market that has become an essential infrastructure. “I think every LP and every GP should be actively involved in the secondary market,” said Matt Hordan of Lexington Partners, one of the largest distribution firms with $80 billion under management. “If you don’t, you are choosing between what has become a core element of the liquidity paradigm.”
Discrepancy in evaluation (worse than expected)
The panel did not politely explain one of the hard truths about venture valuations: that there is often a wide gap between what VCs think their portfolios are worth and what buyers actually pay.
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TechCrunch's Marina Temkin, who moderated the panel, shared an unpleasant example from a recent conversation with a general partner of a venture firm. In other words, a portfolio company that was previously valued at 20x earnings was recently offered on the secondary market at a discount of just 2x earnings, or 90%.
Michael Kim, founder of Cendana Capital, which manages nearly $3 billion in seed and pre-seed funds, puts this into context: “When someone like Lexington comes in and takes a hard look at valuations, they may be facing an 80% discount from what they perceive is actually going to be a winner or runner-up,” he said, referring to the “messy middle ground” of venture-backed companies.
Kim described this “messy middle ground” as companies that are growing at 10% to 15%, have annual recurring revenue of $10 million to $100 million, and were valued at more than $1 billion during the 2021 boom. Meanwhile, private equity buyers and the public market are pricing similar enterprise software companies at just four to six times earnings.
The rise of AI has made the situation even worse. Hodan explained that companies that chose to “preserve capital and persist through a downturn” experienced lower growth rates while “AI took hold and the market got over it.”
“These companies are in a very difficult position right now and if they don't adapt they will face very serious headwinds and possibly disappear.”
Emerging Manager's Desert
Cendana Capital's Kelli Fontaine says the current fundraising environment is particularly tough for new fund managers, and punctuates her remarks with a surprising statistic. “In the first half of this year, Founders Funds raised 1.7 times more money than all emerging managers,” she said. “Incumbent business owners collectively raised eight times more capital than all emerging business owners.”
why? That's because institutional LPs, which pumped large amounts of money into VCs at unprecedented rates during the pandemic's go-go days, are now looking for quality instead, concentrating their money in big platform funds like Founders Fund, Sequoia, and General Catalyst.
“There are a lot of people and peer institutions that have been doing venture investing as much or more than we have, and they have become overly exposed to this asset class,” Glossier explained. “They started withdrawing the eternal pool of capital that they were known for.”
Makena Capital's Banks acknowledged that while her firm has stabilized the number of new managers at one to four per year (only two this year), “we're putting more money into founders funds than we're putting into the emerging manager side.”
The silver lining, Kim said, is that the “tourist fund managers” who flooded the market in 2021 — such as the Google vice president who decided to raise $30 million on the recommendation of a friend — have been largely “wiped out.”
Are venture businesses also an asset class?
Unsurprisingly, the panel picked up on Roelof Botha's recent argument at TechCrunch Disrupt that venture companies aren't actually an asset class. They largely agreed, with some caveats.
“I've been saying for 15 years that venture is not an asset class,” Kim said. Unlike public equities, where managers are concentrated within one standard deviation of a target return, conditions in venture are widely dispersed. “Good managers perform far better than all other managers.”
For institutions like the J. Paul Getty Trust, this type of dispersal is a major headache. “It's very difficult to plan around venture capital because the revenue is so dispersed,” Grosher said. The solution is exposure to platform funds that offer “a degree of reliability and sustainable returns” layered with emerging manager programs to generate alpha.
Banks took a slightly different view, suggesting that the role of ventures is evolving beyond just “adding a little salt to the portfolio.” For example, she said Stripe's exposure in Makena's portfolio actually acts as a hedge against Visa because Stripe could use crypto rails to interfere with Visa's business. (In other words, Makena views venture as a tool for managing disruption risk across a portfolio.)
Pre-unload shares
Another theme of the panel discussion was the normalization of selling GPs at up-rounds, as well as at distressed prices.
“A third of last year's distributions came from secondary distribution, not from discounts,” Fontaine said. “It went from selling at a premium to final round valuation.”
“If something is worth three times the money, think about what you need to do to make it six times the money,” Fontaine explained. “If I sell it at 20% off, how much money will I get back?”
The discussion reminded me of a conversation TechCrunch had with veteran Bay Area pre-seed investor Charles Hudson in June. At the time, he said investors in very young companies are increasingly being forced to think like private equity managers, looking to optimize cash returns rather than home runs.
At the time, Mr. Hudson said one of his LPs asked him to calculate how much profit Hudson could make if it sold shares in portfolio companies at the A, B and C stages instead of staying on board. That analysis revealed that selling everything at the Series A stage doesn't work. The compounding effect of staying with the best companies outweighs the benefits of cutting losses early. But Series B was different.
“If you sell everything at B, you could get more than three times the fund,” Hudson said. “And I thought, 'Well, that's pretty good.'”
It certainly helps that the prejudice against derivative works has faded. “Ten years ago, if you were in the secondary, the implicit understanding was, 'We made a mistake,'” Kim said. “The secondary is definitely part of the toolkit right now.”
How to grow in this environment (despite headwinds)
The committee offered tough love and advice to business owners looking to raise capital. Kim encouraged new managers to “network with as many family offices as possible,” saying they are “generally more cutting edge in terms of betting on new managers.”
He also suggested aggressively promoting co-investment opportunities, such as offering fee-free, no-carry co-investment rights, as a way to attract family offices.
The challenge for up-and-coming executives, according to Kim, is that “it's going to be very difficult to convince university endowments and foundations like this.” [the J. Paul Getty Trust] Unless you have a very strong pedigree, you can't invest in a fund that's only $50 million. [meaning] Maybe you're a co-founder of OpenAI. ”
When it came to choosing an administrator, the committee was unanimous that the proprietary network would no longer exist. “No one has their own network anymore,” Fontaine said flatly. “If you're a legible founder, even Sequoia will track you down.”
Kim explained that Cendana measures three aspects. These are management's access to founders, their ability to select the right founders, and, importantly, their effort.
“Network and domain expertise has a shelf life,” Kim explained. “If we don't work hard to modernize and expand these networks, we will be left behind.”
As an example, Kim pointed to Casey Caruso of Topology Ventures, one of Cendana's fund managers. Caruso, a former Google engineer, will be living at Hacker House for several weeks to get to know its founders. “She's so good at her craft that she actually competes with them in little hackathons. And sometimes she wins.”
He contrasted this with “a 57-year-old fund manager who lives in Woodside. They wouldn't have that kind of access to the founders.”
As for which sectors and regions are important, the consensus was that AI and American dynamism currently prevail, with fund managers based in, or at least easily accessible, San Francisco.
That said, the committee acknowledged traditional strengths in other regions. Boston Biotechnology. Fintech and cryptocurrencies in New York. And the Israeli ecosystem is “despite the current problems there,” Kim said.
Banks added that he believes there will be a new wave of consumers. “Platform funds have put that aside, so I feel like it's ripe for a new paradigm,” she said.