These days, it is not easy to be a limited partner who invests in venture capital firms. The LPs who fund VCs are confronting an asset class in flux. Funds now have nearly twice the lifespan they used to, emerging managers face life-or-death fundraising challenges, and billions of dollars sit trapped in startups that may never justify their 2021 valuations.
At a recent StrictlyVC panel in San Francisco, five prominent LPs, representing endowments, fund-of-funds, and secondaries firms managing over one hundred billion dollars combined, painted a surprising picture of venture capital’s current state, even as they see areas of opportunity emerging from the upheaval.
Perhaps the most striking revelation was that venture funds are living far longer than anyone planned for, creating a raft of problems for institutional investors. Conventional wisdom may have suggested 13-year-old funds, said Adam Grosher, a director at the J. Paul Getty Trust, which manages 9.5 billion dollars. In their own portfolio, they have funds that are 15, 18, even 20 years old that still hold marquee assets, blue-chip assets that they would be happy to hold. Still, he noted the asset class is just a lot more illiquid than most might imagine based on the history of the industry.
This extended timeline is forcing LPs to rebuild their allocation models. Lara Banks of Makena Capital, which manages 6 billion dollars in private equity and venture capital, noted her firm now models an 18-year fund life, with the majority of capital actually returning in years 16 through 18. The J. Paul Getty Trust is actively revisiting how much capital to deploy, leaning toward more conservative allocations to avoid overexposure.
The alternative is active portfolio management through secondaries, a market that has become essential infrastructure. Matt Hodan of Lexington Partners, one of the largest secondaries firms with 80 billion dollars under management, stated that every LP and every GP should be actively engaging with the secondary market. He said that if you are not, you are self-selecting out of what has become a core component of the liquidity paradigm.
The panel did not sugarcoat one of the harsh truths about venture valuations, which is that there is often a huge gap between what VCs think their portfolios are worth and what buyers will actually pay. TechCrunch’s Marina Temkin, who moderated the panel, shared a jarring example from a recent conversation with a general partner at a venture firm. A portfolio company last valued at 20 times revenue was recently offered just 2 times revenue in the secondary market, a 90 percent discount.
Michael Kim, founder of Cendana Capital, which has nearly 3 billion dollars under management focused on seed and pre-seed funds, put this into context. He said that when a firm like Lexington comes in and puts a real look on valuations, they may be actually facing 80 percent markdowns on what they perceive that their winners or semi-winners were going to be, referring to the messy middle of venture-backed companies.
Kim described this messy middle as businesses that are growing at 10 to 15 percent with 10 million to 100 million dollars in annual recurring revenue that had billion-dollar-plus valuations during the 2021 boom. Meanwhile, private equity buyers and public markets are pricing similar enterprise software companies at just four to six times revenue.
The rise of AI has made things worse. Companies that chose to preserve capital and sustain through a downturn saw their growth rates suffer while AI caught on and the market moved past it, Hodan explained. These companies are now in this really tricky position where if they do not adapt, they are going to face some very serious headwinds and maybe die.
For new fund managers, the current fundraising environment is especially rough, observed Kelli Fontaine of Cendana Capital. She underscored her statement with a stunning statistic, noting that in the first half of this year, Founders Fund raised 1.7 times the amount of all emerging managers. Established managers in total raised eight times the amount of all emerging managers.
The reason is that institutional LPs who committed larger sums faster than ever to VCs during the pandemic are now seeking quality instead, concentrating their dollars with large platform funds like Founders Fund, Sequoia and General Catalyst. Grosher explained that many peer institutions that have been investing in venture as long as they have or longer became overexposed to the asset class. These perpetual pools of capital that they were known for, they started pulling back.
Banks of Makena Capital acknowledged that while her firm has kept the number of new managers steady at one to four per year, with just two this year, the dollars that they deployed in Founders Fund is larger than they have deployed in the emerging manager side. The silver lining, according to Kim, is that the tourist fund managers who flooded the market in 2021 have largely been flushed out.
Unsurprisingly, the panel took up the recent assertion that venture is not really an asset class. They largely agreed, with some caveats. Kim said he has been saying for 15 years that venture is not an asset class. Unlike public equities, where managers cluster within one standard deviation of a target return, things are widely dispersed in venture. The best managers significantly outperform all the other managers.
For institutions like the J. Paul Getty Trust, that kind of dispersion has become a real headache. Grosher said it is quite challenging to make plans around venture capital because of the dispersion of returns. The solution has been exposure to platform funds that provide some reliability and persistence of returns, layered with an emerging manager program to generate alpha.
Banks offered a slightly different view, suggesting that venture’s role is evolving beyond just being a little bit of salt on the portfolio. She said, for example, that Stripe exposure in Makena’s portfolio actually serves as a hedge against Visa, since Stripe could potentially use crypto rails to disrupt Visa’s business. In other words, Makena sees venture as a tool for managing disruption risk across the entire portfolio.
Another theme of the panel discussion was the normalization of GPs selling into up rounds, not just at distressed prices. Fontaine said a third of their distributions last year came from secondaries, and it was not from discounts. It was from selling at premiums to the last round valuation.
Fontaine explained that if something is worth three times your fund, you should think about what it needs to do to become six times your fund. If you sold 20 percent off, consider how much of the fund you are going to return.
The discussion recalled a conversation with veteran Bay Area pre-seed investor Charles Hudson back in June, when he shared that investors in very young companies are being forced to think increasingly like private equity managers, optimizing for cash returns instead of home runs. At the time, Hudson said one of his own LPs had asked him to run an exercise and calculate how much money he would have made had he sold his shares in his portfolio companies at the A, B and C stages instead of holding on for the ride.
That analysis revealed that selling everything at the Series A stage did not work; the compounding effect of staying in the best companies outweighed any benefits from cutting losses early. But Series Bs were different. Hudson said you could have a north of 3x fund if you sold everything at the B, which he considered pretty good.
It certainly helps that the stigma around secondaries has evaporated. Kim said that 10 years ago, if you were doing a secondary, the unspoken thing was that you made a mistake. Today, secondaries are most definitely part of the toolkit.
For managers attempting to raise capital, the panel offered tough love and advice. Kim recommended that new managers network to as many family offices as possible, describing them as typically more cutting edge in terms of taking a bet on a new manager. He also suggested pushing hard on co-investment opportunities, including offering fee-free, no-carry co-investment rights as a way to get family offices interested.
The challenge for emerging managers, per Kim, is that it is going to be really hard to convince a university endowment or a foundation like the J. Paul Getty Trust to invest in your little 50 million dollar fund unless you are super pedigreed, meaning maybe you are a co-founder of OpenAI.
As for manager selection, the panel was unanimous that proprietary networks no longer exist. Fontaine said flatly that nobody has a proprietary network anymore. If you are a legible founder, even Sequoia is going to be tracking you.
Kim explained that Cendana indexes on three aspects instead: a manager’s access to founders, their ability to pick the right founders, and, critically, hustle. He said networks and domain expertise have a shelf life. Unless you are hustling to refresh those networks, to expand those networks, you are going to be left behind.
As an example, Kim pointed to one of Cendana’s fund managers, Casey Caruso of Topology Ventures. Caruso, formerly an engineer at Google, will go live in hacker houses for weeks to get to know the founders there. She is technical, so she will actually compete with them in their little hackathons, and sometimes she wins. He contrasted this with some 57-year-old fund manager living in Woodside, stating they are not going to have that kind of access to founders.
As for which sectors and geographies matter, the consensus was that AI and American dynamism dominate right now, along with fund managers who are based in San Francisco or, at least, have easy access to it. That said, the panel acknowledged traditional strength in other regions, such as biotech in Boston, fintech and crypto in New York, and Israel’s ecosystem notwithstanding the current issues there, said Kim.
Banks added that she is confident that consumer will have a new wave. She said platform funds have kind of put that to the side, so it feels like they are ripe for a new paradigm.