Today, it is not easy to be a limited partner investing in venture capital firms. LPs who fund VCs face an asset class in flux: funds have nearly twice the lifespan of old, emerging managers face life-or-death fundraising challenges, and billions of dollars are trapped in startups that may never justify their valuations in 2021.
Indeed, at a recent StrictlyVC panel in San Francisco, over the hum of the raucous crowd that had gathered to watch, five prominent LPs, representing endowments, fund-of-funds and spin-offs managing more than $100 billion combined, painted a stunning picture of the current state of venture capital and the current state of opportunity.
Perhaps the most striking revelation was that venture funds live much longer than planned, creating a host of problems for institutional investors.
“Conventional wisdom might suggest 13-year funds,” said Adam Grosher, director at the J. Paul Getty Trust, which manages $9.5 billion. “In our own portfolio, we have funds that are 15, 18, even 20 years old that are still holding marquee assets, blue chip assets that we will be happy to hold.” However, the “asset class is simply much more illiquid” than most would imagine based on the industry’s history, he said.
This extended timeline forces LPs to duplicate and rebuild their allocation models. Lara Banks of Makena Capital, which manages $6 billion in private equity and venture capital, noted that her firm is now modeling an 18-year capital life, with most of the capital actually returning in years 16 to 18. Meanwhile, the J. Paul Getty Trust is actively reviewing how much capital to deploy, leaning toward more conservative positions.
The alternative is active portfolio management through secondaries, a market that has become essential infrastructure. “I think every LP and every GP should be actively involved in the secondary market,” said Matt Hodan of Lexington Partners, one of the largest secondary firms with $80 billion under management. “If not, you’re self-selecting from what has become a key component of the liquidity paradigm.”
The valuation disconnect (it’s worse than you think)
The panel did not reveal one of the hard truths about venture valuations, which is that there is often a huge gap between the value of VCs’ portfolios and what buyers will actually pay.
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TechCrunch’s Marina Temkin, who moderated the panel, shared a chilling example from a recent conversation with a general partner at a venture firm: A holding company last valued at 20x revenue was recently offered for just 2x revenue in the secondary market — a 90% discount.
Michael Kim, founder of Cendana Capital, which has nearly $3 billion under management focused on start-up and seed funds, put this in context: “When someone like Lexington comes in and takes a real look at valuations, they may actually be facing an 80% reduction in what they perceive their winners or runners-up to be ‘said to be in the middle of.’ business-backed companies.
Kim described this “messy middle” as businesses growing 10% to 15% with annual recurring revenue of $10 million to $100 million that had billion-dollar valuations during the 2021 boom. Meanwhile, private equity buyers and public markets are valuing similar enterprise software companies at just four to six times revenue.
The rise of artificial intelligence has made things worse. Companies that chose to “conserve capital and sustain through a recession” have seen their growth rates suffer while “AI has caught on and the market has overtaken it,” Hodan explained.
“These companies are now in this really difficult position where if they don’t adapt, they’re going to face very serious headwinds and maybe die.”
The popup admin desert
For new fund managers, the current fundraising environment is particularly rough, observed Kelli Fontaine of Cendana Capital, underscoring her statement with a startling statistic. “In the first half of this year, Founders Fund raised 1.7 times the amount of all emerging managers,” he said. “Total established managers raised eight times the amount of all emerging managers.”
Why? Because institutional LPs that were deploying larger sums faster than ever to VCs during the pandemic days are now looking for quality, pooling their dollars in big platform funds like Founders Fund, Sequoia and General Catalyst.
“There are a lot of people, a lot of peer institutions that have invested in businesses as much as we have or more, and they became overexposed to the asset class,” Grosher explained. “These eternal reservoirs of capital that they were known for started to retreat.”
Makena Capital’s Banks acknowledged that while her firm has held the number of new managers steady at one to four per year (with just two this year), the “dollars we’ve used in the Founders Fund are larger than what we’ve deployed on the emerging manager side.”
The silver lining, according to Kim, is that the “tourist fund managers” who flooded the market in 2021 — for example, the Google VP who decided to raise a $30 million fund because their friend did — have largely been “washed out.”
Is venture even an asset class?
As expected, the panel took note of Roelof Botha’s recent claim at TechCrunch Disrupt that the venture is not actually an asset class. They largely agreed, with some caveats.
“I’ve said for 15 years that venture is not an asset class,” Kim said. Unlike public stocks, where managers cluster within one standard deviation of a target return, things are widely dispersed in businesses. “The best managers significantly outperform all other managers.”
For institutions like the J. Paul Getty Trust, this kind of sprawl has become a real headache. “It’s quite difficult to make plans around venture capital because of the dispersion of returns,” Grosher said. The solution was exposure to platform funds that provide “some reliability and persistence of returns,” at levels with an emerging manager program to generate alpha.
Banks offered a slightly different view, suggesting that the role of the business is evolving beyond just being “a little salt in the portfolio.” He said, for example, that Stripe’s exposure to Makena’s portfolio actually acts as a hedge against Visa, as Stripe could potentially use crypto rails to disrupt Visa’s business. (In other words, Makena sees the venture as a tool to manage the risk of disruption across the portfolio.)
Stock unloading earlier
Another topic of discussion on the panel was the normalization of GP sales in up cycles, not just in unfavorable prices.
“One-third of our distributions last year came from secondary companies and were not from sales,” Fontaine said. “It was from selling at a premium to the last round of valuation.”
“If something is worth three times your fund, think about what it has to do to make it six times your fund,” Fontaine explained. “If you sell 20% off, how much of the capital will you get back?”
The conversation brought to mind a conversation TechCrunch had with veteran Bay Area investor Charles Hudson in June, when he shared that investors in very young companies are being forced to think more like private equity managers: optimizing for cash returns instead of in-house.
At the time, Hudson said one of his LPs asked him to do an exercise and calculate how much money Hudson would have made if he had sold his shares in his portfolio companies in stages A, B and C instead of holding on for the ride. This analysis revealed that selling everything at the Series A stage did not work. the compounding effect of staying in the best companies offset any benefit from early loss reduction. But the Series Bs were different.
“You could have 3x cash if you sold everything to B,” Hudson said. “And I’m like, ‘Well, that’s pretty good.’
It certainly helps that the stigma surrounding minors has evaporated. “Ten years ago, if you did a sub, the buzzword was ‘we did it wrong,'” Kim said. “Today, subs are definitely part of the toolbox.”
How to grow in this environment (despite the headwinds)
For managers trying to raise capital, the committee offered tough love and advice. Kim advised new managers to “network in as many family offices as possible” and described them as “usually more cutting-edge when it comes to betting on a new manager.”
He also suggested we push hard for co-investment opportunities, including offering no-fee co-investment rights as a way to get family offices interested.
The challenge for emerging managers, according to Kim, is that “it will be very difficult to convince a university institution or an institution like [the J. Paul Getty Trust] invest your little $50 million fund unless you’re extremely skilled — [meaning] maybe you’re a co-founder of OpenAI.”
When it came to manager selection, the panel was unanimous: Proprietary networks are no more. “No one has a proprietary network anymore,” Fontaine said flatly. “If you’re a legible founder, even Sequoia will watch you.”
Kim explained that Cendana indexes three aspects: a manager’s access to founders, their ability to pick the right founders and, critically, “hustle.”
“Network and domain expertise has a lifetime,” Kim explained. “Unless you’re trying to renew those networks, expand those networks, you’re going to be left behind.”
As an example, Kim pointed to one of Cendana’s fund managers, Casey Caruso of Topology Ventures. Caruso, a former engineer at Google, will go live in hacker houses for weeks to meet the founders there. “It’s technical, so it will compete with them in their little hackathons. And sometimes it wins.”
He contrasts this with “some 57-year-old fund manager who lives in Woodside. They’re not going to have that kind of access to the founders.”
As for which sectors and geographies matter, the consensus was that AI and US dynamism dominate right now, along with fund managers based in San Francisco, or at least with easy access to it.
That said, the committee recognized a traditional strength in other areas: biotech in Boston. fintech and crypto in New York. and Israel’s ecosystem “despite the current issues there,” Kim said.
Banks added that she is confident that the consumer will have a new wave. “Platform funds have put it on the sidelines, so it looks like we’re ripe for a new paradigm,” he said.
