VC Liquidity Crisis: Limited Partners Confront Venture Capital Funds

The Evolving Landscape for Venture Capital Limited Partners

Currently, investing as a limited partner (LP) in venture capital firms presents considerable challenges. Those funding venture capitalists – the LPs – are navigating an asset class undergoing significant transformation. Funds now have lifespans approaching double their historical norms.

Furthermore, new fund managers are encountering critical hurdles in securing necessary capital. Billions of dollars remain invested in startups whose valuations, inflated during 2021, may never be realized.

Insights from Industry Leaders

A recent panel discussion hosted by StrictlyVC in San Francisco revealed a surprising assessment of the venture capital environment. Five prominent LPs, collectively overseeing over $100 billion in assets across endowments, fund-of-funds, and secondaries firms, highlighted both the difficulties and emerging opportunities within the sector.

A key takeaway was the unexpectedly prolonged lifespan of venture funds, which is generating a series of complications for institutional investors.

Extended Fund Lifespans and Illiquidity

“The traditional expectation might have been funds lasting 13 years,” stated Adam Grosher, a director at the J. Paul Getty Trust, responsible for managing $9.5 billion in assets. “However, within our portfolio, we have funds that are 15, 18, and even 20 years old, still holding significant, high-quality assets that we are content to continue holding.”

Despite this, he emphasized that the asset class is considerably more illiquid than commonly perceived, given the industry’s historical performance.

Revisiting Allocation Models

This extended timeframe is compelling LPs to reassess and reconstruct their capital allocation strategies. Lara Banks of Makena Capital, which manages $6 billion in private equity and venture capital, explained that her firm now models an 18-year fund life.

She noted that the majority of capital returns are now anticipated in years 16 through 18. Concurrently, the J. Paul Getty Trust is proactively evaluating the amount of capital to deploy, favoring more conservative allocations to mitigate potential overexposure.

The Rise of the Secondaries Market

Active portfolio management through the secondaries market is becoming increasingly vital. “I believe both LPs and GPs should be actively participating in the secondary market,” asserted Matt Hodan of Lexington Partners, a leading secondaries firm with $80 billion in assets under management.

He added that failing to do so effectively excludes participants from a core element of the current liquidity landscape.

Key Considerations for LPs

Fund Lifespan: Venture funds are lasting significantly longer than historically expected.
Illiquidity: The asset class is proving to be more illiquid than previously understood.
Allocation Strategy: LPs are adjusting their capital deployment models to account for extended timelines.
Secondaries Market: Active engagement with the secondaries market is now essential for liquidity.

The Widening Valuation Discrepancy

A recent discussion highlighted a significant and often underestimated issue within venture capital: the considerable difference between portfolio valuations as assessed by VCs and the prices ultimately accepted by potential acquirers.

Marina Temkin of TechCrunch, who led the panel, presented a striking illustration. A company previously valued at 20 times its revenue received a secondary market offer of only 2 times revenue – representing a substantial 90% reduction in perceived worth.

Michael Kim, of Cendana Capital, managing close to $3 billion in seed and pre-seed investments, elaborated on this point. He stated that when firms like Lexington conduct thorough valuation assessments, markdowns of up to 80% can occur, even for companies initially considered successful or promising.

Kim characterized this situation as affecting companies in the “messy middle” – those experiencing growth of 10% to 15% with annual recurring revenue between $10 million and $100 million. These businesses often held valuations exceeding $1 billion during the peak of 2021.

However, private equity firms and public markets currently value comparable enterprise software companies at a multiple of only four to six times revenue.

The emergence of AI has further exacerbated this problem. Businesses that prioritized capital preservation during economic downturns experienced slowed growth, while AI advancements rapidly reshaped the market landscape.

As Hodan explained, these companies now face a critical juncture. Failure to adapt to the changing environment could lead to significant challenges and potential failure.

The Challenging Fundraising Landscape for New Fund Managers

The present fundraising climate presents significant hurdles for emerging fund managers, as noted by Kelli Fontaine from Cendana Capital. This observation is supported by compelling data. During the first six months of the year, Founders Fund secured 1.7 times the capital raised by all emerging managers collectively.

Furthermore, established managers as a whole garnered eight times the investment received by all emerging managers.

Reasons for the Shift in Investment

This trend stems from a change in strategy among institutional Limited Partners (LPs). Having rapidly allocated substantial capital to venture capital firms during the peak of the pandemic, LPs are now prioritizing quality and focusing their investments on large, well-established platforms such as Founders Fund, Sequoia, and General Catalyst.

As Grosher clarified, many long-term investors became overexposed to the venture asset class. Consequently, these institutions with perpetual capital pools have begun to reduce their commitments.

A Positive Outcome: The Departure of Transient Managers

Despite the difficulties, Kim highlights a positive development. The influx of “tourist fund managers” – individuals who entered the market in 2021 based on anecdotal success, such as a Google VP launching a $30 million fund – has largely subsided.

These less experienced managers have, for the most part, been removed from the competitive landscape.

Key Takeaways

Emerging managers face a significantly more challenging fundraising environment.
Institutional LPs are consolidating investments with established platform funds.
Overexposure to the asset class has led to a pullback from some perpetual capital pools.
The market has seen a reduction in transient fund managers.

The Classification of Venture Capital as an Asset Class

The discussion centered around Roelof Botha’s claim, made at TechCrunch Disrupt, questioning whether venture capital truly qualifies as a distinct asset class. The panel members generally concurred with this perspective, though acknowledging certain nuances.

Kim stated he has maintained for fifteen years that venture capital doesn't fit the traditional definition of an asset class. Unlike publicly traded stocks, where fund performance tends to be concentrated around a specific return target, venture capital exhibits a much wider range of outcomes. “Top-performing venture managers achieve returns that far exceed those of their peers.”

This wide variation in returns presents difficulties for institutions such as the J. Paul Getty Trust. Grosher explained that forecasting with venture capital is problematic due to the unpredictable nature of its returns. Their approach involves investing in platform funds, which offer greater consistency, combined with a program focused on emerging managers to seek higher returns.

Banks presented a differing viewpoint, noting that venture capital’s function within a portfolio is changing. It’s moving beyond simply being a minor component. For instance, Makena’s investment in Stripe acts as a counterbalance to their Visa holdings, as Stripe’s potential use of cryptocurrency technology could challenge Visa’s dominance.

Essentially, Makena views venture capital as a strategic instrument for mitigating the risks associated with broader portfolio disruption. It’s a tool to proactively manage potential challenges to existing investments.

Understanding Return Dispersion

The core issue highlighted was the significant dispersion of returns within the venture capital landscape. This means that the performance of different venture funds can vary dramatically.

Traditional asset classes, like public equities, demonstrate a tighter clustering of returns around the average. Venture capital, however, is characterized by a few exceptional successes that drive overall performance, alongside a substantial number of investments that yield lower or even negative returns.

Venture Capital as a Strategic Tool

The panel also discussed the evolving role of venture capital beyond pure financial return. It’s increasingly seen as a way to gain exposure to innovative companies and technologies.

This strategic exposure can provide benefits beyond direct financial gains, such as hedging against disruption or gaining insights into emerging trends. The example of Stripe and Visa illustrates this point effectively.

Strategic Hedging: Venture investments can offset risks in traditional holdings.
Innovation Exposure: Access to cutting-edge technologies and business models.
Disruption Management: Proactive mitigation of potential threats to existing investments.

Early Share Liquidation Trends

A key point raised during the panel discussion centered on the increasing acceptance of General Partners (GPs) selling equity in up-rounds, rather than solely when companies face financial difficulties.

Fontaine noted that a significant portion of their distributions stemmed from secondary sales, and importantly, these weren’t driven by discounted prices. Instead, sales occurred at values exceeding the previous round’s valuation.

The potential for returns was also highlighted. “Consider a scenario where an investment is valued at three times the fund size,” Fontaine stated. “What level of growth is required to reach six times the fund size?” He then posed a question: “If a 20% stake were sold at a discount, what proportion of the fund would be returned to investors?”

This discussion echoed a conversation TechCrunch had with Charles Hudson, a seasoned pre-seed investor based in the Bay Area, earlier in June. Hudson explained that investors in early-stage ventures are now compelled to adopt a mindset similar to that of private equity firms, prioritizing cash returns over solely pursuing exponential growth.

Hudson recounted an instance where one of his Limited Partners (LPs) requested a detailed analysis. This analysis calculated potential returns had Hudson liquidated his holdings in portfolio companies at the Series A, B, and C funding stages, instead of maintaining long-term positions.

The results indicated that selling all shares at the Series A stage proved suboptimal; the compounding gains from retaining ownership in successful companies surpassed the advantages of early exits. However, the Series B stage presented a different outcome.

“A fund return exceeding 3x could have been realized by selling all holdings at the Series B stage,” Hudson observed. “And that’s a very attractive result.”

The diminishing stigma associated with secondary transactions is a contributing factor. Kim commented, “A decade ago, engaging in a secondary sale carried an implicit admission of error.” Today, however, secondaries are firmly established as a standard investment strategy.

Navigating Capital Acquisition in a Challenging Landscape

For fund managers seeking capital, the discussion centered on pragmatic strategies and candid assessments. Kim advised aspiring managers to actively cultivate relationships with as many family offices as feasible, highlighting their inclination towards innovative ventures and willingness to invest in emerging talent.

He further proposed aggressively pursuing co-investment opportunities, even to the extent of offering fee-free and carry-free arrangements to attract family office participation.

According to Kim, a significant hurdle for new managers lies in securing investment from established institutions. Convincing a university endowment or a foundation, such as the J. Paul Getty Trust, to allocate funds to a smaller, $50 million fund requires exceptional credentials – often comparable to being a co-founder of a prominent company like OpenAI.

The Evolution of Manager Selection

The panel unanimously agreed that the era of exclusive proprietary networks is over. Fontaine asserted that even highly visible founders are now tracked by major venture capital firms like Sequoia.

Kim detailed Cendana’s evaluation framework, which prioritizes a manager’s access to founders, their skill in identifying promising ventures, and, crucially, their demonstrated “hustle.”

He emphasized that relying solely on existing networks and domain expertise is insufficient. Continuous effort to expand and refresh these connections is vital to remain competitive.

Demonstrating Initiative and Access

Kim cited Casey Caruso of Topology Ventures as an example of proactive engagement. Caruso, a former Google engineer, immerses herself in the startup community, even participating in hackathons to connect with founders firsthand and showcase her technical abilities.

This approach was contrasted with that of more established managers lacking such direct access to emerging talent.

Key Sectors and Geographic Focus

The prevailing sentiment was that artificial intelligence (AI) and the overall dynamism of the American market currently hold the most promise. Fund managers based in San Francisco, or with convenient access to the region, are particularly well-positioned.

However, the panel also acknowledged the continued strength of specific ecosystems: biotech in Boston, fintech and crypto in New York, and Israel’s tech sector, despite ongoing challenges.

Banks expressed optimism regarding a potential resurgence in consumer-focused investments, suggesting that the current focus on platform funds has created an opportunity for a new investment paradigm.