The State of VC
It's Mixed
On Valentine’s Day, I listened to a presentation on the VC business by Juniper Square. It was interesting. A lot of the time, these things are bullshit but this one actually had some actionable information in it so it was really helpful for me.
Valuations got crushed in 2022, no surprise. What’s interesting is the Limited Partner (LP) appetite for funds. If you are an experienced investor with a long track record and a history of funds, you have no problem raising capital for a fund. It might take a bit longer as institutional LPs go slower but you can raise it.
Institutional LPs are walking a tightrope. If an existing manager wants to raise a new fund, they don’t want to wind up on the outside looking in by lowering their allocation to that fund. At the same time, they might not be excited about putting money in a fund today and might try to get the fund to slow down their fundraising.
If you are an emerging manager, the environment is brutal.
They can’t get institutional capital but can get it from family offices and high-net-worth (HNW) people. But, those people might press on the terms they invest in. The other trend is that companies, family offices, and HNW people are really worried about the reputational risk of being in a fund. They don’t want to be on the front page of the news saying that they are an investor in your fund. Many want to be in “ESG” funds because socially it looks good even though it will wind up as a crappy investment.
I have blogged about ESG in the past. I would short-sell every climate fund or ESG-focused fund harder than Jimmy Chanos shorts stocks if I could. Give it five years, there will be a dearth of returns there and the LPs would have been better off sending money to charity.
This is no change from the institutional side, even though the stats show emerging managers often have outsize returns compared to existing funds. Much of that statistic is due to the fact emerging managers assume a lot more risk and generally invest earlier than big institutional funds. They get a lot of bang for their buck given the check size. Emerging managers have to get to their fourth or fifth fund to be able to raise from institutional capital. It’s been that way for years.
The big change is the calculation of reputational risk. If you are on the OLFAC list, you will have a hard time. Given most dollars that are allocated to venture capital are managed by people that trend liberal or very liberal, conservatives will have a much harder problem raising money than liberals since the current environment is toxic for conservatives. Again, out-of-the-closet conservatives have had a hard time raising money for funds in Silicon Valley and points beyond for a while. Today, discrimination is more overt.
If you are an emerging manager who is out of the closet conservative, you will need to raise from conservative limited partners. In the webinar, they didn’t say the quiet part out loud, it was inferred.
No one wants to be on a capitalization table of a company that blows up like an FTX. These kinds of people do not seek to be in the news. They like to be in the backroom.
When we think about venture debt, the market is very different than venture equity. Venture debt is loans made to existing venture-backed companies with $10MM per year in top-line revenue that have gone through three to four raises. The key component of venture debt is the cost is cheaper, and founders hang on to equity. The razor’s edge is if you can’t pay it, the costs become very very expensive.
Instead of risky credit strategies, money is flowing to private credit strategies. Post-2008, private credit performed better than stocks.
Fixed-income bonds are not attractive right now with higher rates and higher inflation. Public stocks are struggling. Valuations are getting compressed in private equity markets and in venture investments. Real estate values are struggling with higher rates and the wake of Covid. That’s increasing demand for private credit strategies by 10x.
Demand for VC-backed IPOs is down by 90%. That’s a huge hangover on the VC market. Demand is down due to public markets and the Fed. No one knows what sort of company can break the dam, or when the dam will break. IPOs are on hold for now. There are headwinds in the short run because VCs have raised a record amount of capital in the last few years. There is a record amount of dry powder right now. They are waiting to deploy it.
From the entrepreneur's perspective, they might be able to do a debt round instead of the traditional financing round from a VC since VCs don’t want to give them the valuation they want. The subjective point made was all this has to flush through the system and the thought is that it will take another 6-9 months to work its way through the system.
One thing they didn’t talk about was the appetite from both entrepreneurs and venture capital funds for inside rounds. Inside rounds can be difficult. But, in this environment, they might be necessary.
My friend and late-stage VC Tom Lovarro had an excellent tweet storm about the state of financing that illustrates some disconnects with good advice for entrepreneurs.
Another thing they are seeing is that early-stage companies are not getting hit as hard as later-stage companies. When a later-stage company doesn’t hit its numbers, the pain is much more significant.
Funds have to report to their Limited Partners. How fast should they ratchet valuations down? It’s a very difficult question. At our fund which was a seed stage fund, we never really aggressively raised them. If the company did another round, we’d value it at the post-money of that round. No money raise, no bump in valuation and if the company is struggling, we took them down.
Limited Partners have to value their holdings and report to their stakeholders. They rely on timely and true valuations from the GPs they funded.
No one sees the stock market rally so far this year as anything but a dead cat bounce. They don’t see a fundamental reason for the market to be this high. They don’t think the Covid candy and Fed candy the market received have worked their way through the market.
Diligence on both funds and investments into startups is taking more time. No one has fear of missing out anymore. People are acting more rationally. This is a fallout from FTX’s crash, but also other high-profile blowups in the Valley like WeWork and Theranos.
Risk management and operational tightness are in vogue. How you manage risk as a fund manager, and the internal operations of the fund are important. I think that lends credence to using a platform like Carta to help with audits, and reporting to investors. We used Carta in our fund, and we are investors via an acquisition of Vauban.
I think it’s easier to handle the operations part. It’s much more difficult to translate how you measure and calculate risk as a fund manager.
The one thing to bear in mind during this environment, risk awareness is heightened. Monetary risk, market risk, and reputational risk. It’s easy for anyone to say no. They won’t lose their job if they say no. They will lose it if they say yes, and everything becomes a SNAFU afterward.
Personally, I think once valuations are tamed, there will be a golden time to invest. I think we are in a technological renaissance of sorts that will see gains in all kinds of industries we have never seen before. If I were running a fund today, I’d be beating the bushes looking for deals.
One conversation I always had with entrepreneurs was about valuation. I explained the hard math around it and the expected returns. I also explained why valuation was a strategy just like marketing or development operations. Corporate finance is about math, but it’s a strategy just like anything else and you want the momentum to build all the way until exit.
Venture returns have been much better than regular stock market returns or bond market returns. They should be because the risk is higher. But, the heightened risk in everything is making the entire industry slow down and I think that is actually a good thing. I just wish they’d figure out ways to allocate capital better to emerging managers who were conservative politically. They don’t have to change, so they won’t.
I predict a backlash against woke fund VC fund managers based on the invisible hand. In my area (procurement/finance/supply chain tech) the best returns have been from individuals and funds without a political agenda. I'm having more discussions with those I know in the field on this. More Jews, especially, are waking up to the fact that woke is essentially an anti-Semitic agenda (thank you David Bernstein). The classical liberal / liberal backlash is coming (I would not call it a conservative backlash). But personally, I have avoided funds recently which I know have a progressive bias or put DEI or ESG agenda above a real investment thesis. As one factor, no problem (e.g, Vista -- which is more PE than VC of course, but still 100% tech). But if politics (and woke is politics) are part of the main overall investment dining thesis/menu, as you point out, you might as well shoot your returns in the foot.
Very insightful piece particularly the comments about conservative fund managers. But as an entrepreneur I can I can tell you that I’m fielding more inbound investment calls now that I ever have before. Some are looking for “pre extinction” deals but many are not. I just find it interesting.