Venture-Daily Digest+: Limited Partner's Not Taking New Commitment To Invest In VC Funds?

Welcome to Today’s Venture-Daily Digest+ Writeup
Thursday, Dec 21, 2023

Hey👋! It’s Thursday & Welcome to Today’s Venture-Daily Digest+: Your Deep Dive Venture Dose! Thanks for reading today’s Digest+ writeup.

In today’s writeup we will deep dive into “What Limited Partners (LPs) Think about today’s VC Market” and their strategy to invest in the VC Funds. This writeup will be more helpful to VC Partners, VC Professionals and even founders to get idea on how limited partner make investment decision in VC firms. Let’s deep dive into it -

👉 Some Interesting Points From The Conversation:

1. Funds that returned 3x+ typically have a dragon (an investment that returned the fund)

2. The historic maxim that you need to ride your winners all the way through, is getting a rethink, in light of the high multiples that are available to early stage investors when they sell to later stage investors

3. Interesting data points on breakages; the breakage between fund one and two is 50% (i.e., half don’t raise a second fund), by fund four, it is 17% (that is, only one in six funds reach fund four)

4. They typically except a seed fund to return 5x and a Series A fund to return 3x.

Why The Power Law Matters In Early Stage Venture Fund Outperformance ?

Me: Okay, so you’ve been an LP for many, many years and you have the chance now to call yourself up the night before your first day as an LP. Knowing what you do now, what would you advise yourself?

Limited Partner: I would say really understand the importance of the power law, which I know sounds like a bit of a nitty gritty and I’d gotten this advice from other LPs, which is the difference of having a power law defining company in your portfolio and the experience of that for the GP along with the entrepreneur really changes the understanding of how venture works and you really just can’t onesie twosies at <incomprehensible> performance. It’s hard to walk that until you really feel it and then you see these activities, you see the companies taking off. You see the difference in what it looks like to have that kind of a power driver in your portfolio.

Me: Got so many things to unpack from such a small segment – onesie twosie to <incomprehensible> outperformance? What do you mean by that?

Limited Partner: If you think of a growth stage portfolio, it’s not that one doesn’t want to have a power law company and have it return a) 100x and b) two to three times your fund. It’s just much harder when you have a large fund. So, a lot of those funds end up having a number of exits that end up adding up to driving performance. In an early stage fund, we’ve yet to see a fund that’s returned three or more X that does not have a company that’s returned at least one time the fund. And that’s what I mean by you can’t do the single and base hits like, oh, I got a two X on this deal, I got a three x in that deal. Those are all great to add to the portfolio, but if you don’t have a fund returner or a couple of half fund returners, we haven’t seen a fund that’s hit out performance.

LP Portfolio Construction

Me: Speaking of the importance of power laws within portfolios there, I often think that actually LPs are too diversified given the breadth of venture portfolios at 30 to 50 companies, most often if you have 10 managers, you have 300 to 500 underlying portfolio companies. I mean that’s a lot of diversification. Do you think that LP portfolios are too diversified or do you actually think that they’re not diversified enough given the importance of having just one of that as power law?

Limited Partner: LPs are like snowflakes. No two are the same. So, some people do like diversification. I know some LPs that specifically look at the overlaps or the lack of overlaps between their managers and what they really are trying to do is they cover the seed market for exactly this point and they want to make sure if they catch something if it happens. And then what the LP does is sort of a look through on the math and says, well what if I’m putting X dollars into this fund and they’re putting Y dollars into this company? What needs to be true for those companies to be productive on my side? And I know other people that say, hey, I think this area is really interesting so I’m fine if I’ve got two or three managers that invest in the same area and even in the same company because if they hit one it’s going to be that much more productive And it really comes down to how the LP wants to build their portfolio.

Me: Do you think about it in buckets? I see so many LPs that think about it through like, oh, I need early stage consumer, I need series A and B enterprise. Do you think about it through that bucket then?

Limited Partner: Well, we just do early stage, which in our definition that means we started out originally with Series A and we’ve now moved down into seed and pre-seed, so within that area we then look at what is the overall underlying distribution of companies that we have. We are proud venture geeks and we do publish some of our findings. So, last year we ran our consumer enterprise report and enterprise does tend to have more consistency of exits, but you get the big spikes in the consumer ones. So, if a Coinbase for example, you don’t get 10 of those at the same time historically, but you will get just more enterprise exits but lower typically exit size. Yes, but consumer can too. Again, if you do look at the returns, if you consider the facebooks, the coinbases, but they are fewer and farther between what we saw in 2020 to 2022. Again, you had the Coinbase, you had a couple more if you got out when Peloton stock was high, there were ways of making money but it’s not as consistent as the enterprise. So, we do want both in our portfolio but we’re conscious of the exit dynamics.

Are LPs Not Making Any New Commitments?

Me: I mean we’re going to get into lean in versus lean out. I want to start though from the top, because there is a a lot of negativity and doom and gloom, and no LPs are investing and this is the end. Is it true that no LPs are making new commitments? How do you think about that statement?

Limited Partner: That’s not true. I think LPs are being more selective and making new investments, but they’re absolutely making new investments. All the data’s not in yet, but it doesn’t look like the volume of dollars being invested this year into funds is anywhere near last year. Last year was a peak, so that’s not wildly surprising, but they’re still making investments.

Me: It’s the question if no new managers are raising though really. I mean there’s a huge withdrawal in terms of net new manager raisings. Yes, there are still some, but the amount that have come back to market has changed significantly, which might correlate to the reduction in dollars. You think that’s fair?

Limited Partner: I think it’s kind of all tied together, right? If the entrepreneurs are slowing down their fundraising so they can produce the metrics necessary to convince a GP to invest, then the GP is going to call less capital and then deploy their funds slower and then LPs are going to be slower. We saw numbers about 12 to 18 months, which is historically atypical. Usually it’s three years, so if now they’re lengthening back out to three years, yes, there’s fewer funds being raised and I think there’s a lot of we can get into this or not of people trying to figure out what is the health of the underlying companies, what’s really going on? And there’s so many things going about why LPs are slowing down. A lot of LPs also pre-spent future budgets, if that makes any sense. If you were raising a fund every 18 months and I thought you were raising every three years, I had two choices. Either I pull from future year’s budgets or I reduce my cheque so that I stay consistent in my deployment, even if you’re raising faster or I end up spending money or committing money earlier than I anticipated, and then right now given what’s going on in the markets, a lot of LPs are feeling liquidity strains. I wouldn’t say a crunch, but there’s different demands on those dollars.

Me: So, what you’re saying is that most actually just pulled forward dollars from the future. They didn’t reduce commitment size.

Limited Partner: People did both.

Me: And now they’re feeding the pain.

Limited Partner: Correct. Because you also, what you have at the same time is not only is people that are say existing established venture investors know that it can take 10 years for an exit to happen, that’s not a surprise…but if you’ve built a portfolio and you’ve got public and privates and other areas, you can manage your liquidity by taking money from other places as it comes in. But if the exit markets are generally shut for everybody, you’re not getting your private equities necessarily distributing capital. So, you can’t use that to make your capital calls either, and, you don’t want to sell your stock when it’s down if that’s not part of your strategy. So, there’s just a lot of varying things going on. They’re hitting budgets and a lot of LPs that manage endowments or foundations have an annual budget that they have to spend money on for whatever their business is. So, they still need to figure out how to make those payments.

Me: And like mandated outflows for scholarships, for university reimbursements or for educational grants or whatever.

LPs, Liquidity and Implications

Limited Partner: Correct. So, I’ve sat through multiple investment committee sessions with larger funds, larger LPs managing multiple funds who are looking at, well, how do you manage this? You also have liquidity profiles that you have to keep. You can’t be too illiquid because it violates their rules and just where are you going to clip your coupon so to speak?

Me: I’ve met quite a few endowments who are 35% plus <incomprehensible>. Where do you think it’s going to reasonable?

Limited Partner: So, it’s hard to give a common answer. I do know when a lot of endowments start looking at the L model <not clear what L means here, Liquidity?> and being willing to go very long on that. They shifted to that and maybe some people are rethinking it. I do know there are some managers, some LPs, sorry, when I say managers, who are like, we’re just going to have to pause for a bit while it rebalances, which also has its own dangers. I mean there is a very long history of looking at venture returns, which says if you’re not in the market, you just don’t know how to call the exit. So, you have to be consistent about committing, but if you have a bunch of existing managers who are still putting money in the ground, you could probably skip a year and still have money going in, just not be re-upping or making new investments.

Me: The hard thing is if you skip a year and you skip a year on the best managers, then they’re not going to take you back.

Limited Partner: Correct. That is one of the concerns.

Me: So, what do you do then?

Limited Partner: Everybody has to decide. Some people just make it work with a smaller cheque or they take it from somewhere else. Some LPs will say, we believe we can get back in later, some LPs have to exit.

Me: In terms of the liquidity problem, what do we think happens then? Because I take actually a longer view. I don’t think IPO windows will open for longer than people think.

Limited Partner: I thinks it’s back half of next year.

Me: You’ll see it in the update coming out this weekend, but it’s like Databricks, Stripe, it’s not going to be enough to actually crack open the IPO markets like we think it will be. I don’t think that’ll come out next year and so I think it’s going to be like H2 2025. So, what do we do then when liquidity is actually that far away?

Limited Partner: It’s going to be tough. I mean people will probably have to keep tightening their belts. I mean we’ve seen this before. It took a number of years post 2000, it did take about three years to correct and for venture to come back in and there was just a lot less money being committed to funds and so you’ll see a winnowing out, but you also as a fund manager, if you wanted to wait an extra two years before you raised, you can, but you can still manage your portfolio and wait until it develops and then come back.

Me: Do we think we’ll see strip sales? Do we think we’ll see selling fund positions? I’m seeing fund positions now being at 80% discount. I mean it’s a great time to be a buyer.

Limited Partner: Yes, we are seeing that coming together in the market. I think the challenge is exactly what you said. Somebody wants an 80% discount and the person selling might not want to sell at an 80% discount. So, I think the market still hasn’t fully corrected. I think we’re seeing the tip of the iceberg and if the market doesn’t come back, there could be a lot more and that is when, to your point about when endowments and foundations and other LPs have to make some really hard choices about what they keep in their portfolio and what they don’t.

Me: Do you think emerging managers who have maybe some really promising exciting early positions that they could sell but at a steep discount, should they sell them to get the DPI to raise the next funds or should they stay true hold them because they’re long-term winners, but then have TVPI not DPI?

Limited Partner: Well that is a tough question. Can we start with an easier one?

Me: Let’s say you have an open AI in your portfolio or an absolute kind of a home run, but you need DPI and actually to get that next cohort of LPs you need to do the sale.

Limited Partner: I bet some will, but again, to the point of it, if you can sell 10 or 20%, let’s say you got in what was OpenAI’s first round, but it was not a hundred billion, no, so whatever was some smaller number and if you could then sell in the a hundred billion dollars round and 50 extra money, 20 extra money, that doesn’t sound any different from what we’ve said in the past, which is that people sell into these high rounds and make money. That’s not illogical. It’s like anything on Twitter, if people say hold onto your winners, there’s usually a sub-bullet that’s not making its way out on Twitter. So, I think originally when a lot of that language was stated, it was because people were selling dramatically earlier. I’m going to make up numbers, but let’s say 200 million or 400 million versus 10 billion or 5 billion or even a billion, but the idea of taking some money off the table, those two are not diametrically opposed. And I’ve heard LPs that used to say, hold on to all your winners all the time are now saying, well, I meant that, but in context there are times when it could be useful (to take some money off the table).

❌ Not end, We have covered four topics from our discussion in this writeup. 

We will share other four topics like Capital signals, LP-GP communication, and the TVPI-DPI disconnect Fund sizing in today’s context, Startup Exits in Sunday’s venture-daily digest+ newsletter!

Stay tuned & keep eye on your inbox 👀.

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✍️Written By Sahil R | Venture Crew Team