This past week was a busy week for LPs (those who invest in VC funds) and GPs (those who deploy said funds) to meet and mingle in the Bay Area with a few big events going on. I like to write about what I learn from the LP side because I have found most founders don’t know what LPs think, and I find it useful myself as I’m learning to invest on my own. I couldn’t capture everything from the week, but I wanted to write down what struck me most. While Monday through Thursday were intense and packed with meetings all over the Bay, I finally had a chance to reflect on all those coffees, panels, fireside chats, and hallway conversations across the annual meetings, conferences, and summits I attended this week. (A special thanks to friends Michael and Graham from Cendana, friends at Silicon Valley Bank, and Alastair Goldfisher for inviting me to participate. The notes below are culled from conversations from the events, but I don’t want to attribute them to anyone specific as it should be the ideas that permeate in this case — not “who” shared them.)
From the GP Perspective:
1/ More Funding Checkpoints: It used to be founders would raise first from friends & family and then seed investors, and then finally the institutions who would do a Series A on the smaller side. Now founders have pre-seed, then seed, then an extension, finally get to A, but then maybe A-prime or A-1. This could be construed as more capital efficiency (deploying cash at the right points on the risk curve and empowering founders to minimize dilution impact) or entirely inefficient (spending lots of time being evaluated and having notes stack too high against founders at conversion). I tend to err on the side of viewing this as inefficient, but perhaps this is the uncertainty we all have to navigate through given the explosion in new company formation and era of cheap money.
2/ Syndicate Risk: Many seed GPs talked about how the explosion of smaller firms and more names on the cap tables can cause myriad problems, especially for seed leads — leaking information, proliferation of bad advice, heavy pro-rata duties, misalignment of fund objectives given broadening LP base, and so forth. On the other hand, at the very earliest stages of company formation, it would make sense that the risk is spread out (from a financial point of view), though from the founder point of view, what is best here? It’s an open question and I don’t know the answer (yet).
3/ Smaller or Longer: Exits are smaller than they have been versus 5-10 years ago (though some of the exits are HUGE, but concentrated across a few events), and companies are staying private longer — fewer meaningful exits cut off the oxygen for funds, naturally, as most companies never get to IPO; longer holding periods for private stocks mean LPs and the GPs have to hold and work longer to see liquidity, and this can impact the pace of an investor, and indirectly slow down investors from investing if they haven’t seen liquidity to show back to LPs who could keep reinvesting. (Most are hoping some of their companies get scooped up in M&A if a wave of consolidation should be so lucky to appear.)
From the LP Perspective:
1/ Getting Out: I have been to many of these events now over the last two years in an effort to learn. Never before had I heard the LPs across the board talking about exits — finding managers who know “how to get out,” creating stronger incentives for managers to find exits. As noted earlier on previous posts, managers are often not in control of when liquidity can arrive, and in larger outcome cases, investors without enough control can actually see liquidity slip away because the company owners do not want to sell. (I posed this conundrum to an LP who used to be a VC, and he remarked that his technique to control for this was to invest in firms where the GPs often coinvest together as a means of grabbing control back at the board level around such decisions.)
2/ Chasing Alpha and Avoiding Risk: One LP remarked to me that he gets his “3x” from growth funds, where GPs are making fewer, more targeted bets, looking at tons of data. Therefore, in early-stage, he needs to see 5x, but most funds are just gunning for 3x. Here, they chase Alpha, but of course, so many funds are now bigger, and it’s easier for LPs (especially the larger ones) to park large amounts of money with experienced managers (one reason why spinouts are coveted) who won’t lose the entire farm. We may see the same behavior play out across VC firms according to size, where the smaller funds are more comfortable with taking on greater risk given the return expectations versus larger funds who have really grind it out to return such high values.
3/ Incredible Shifting Sands Underneath Traditional VC: With more funding “checkpoints,” the number of startups and VC firms continuing to increase, the returns coming in (but concentrated), and people slowly leaving traditional VC, LPs see tons of opportunities to find and partner with smaller or newer firms and find new ones that can scale and perhaps not get too big. We now see dozens of firms which started as smaller seed firms now managing well over $100M in a fund and taking on the new Series A; now seed firms are looking for traction and data to analyze; now pre-seed is actually a category that institutional LPs have added to their lexicon; and, perhaps most important, the next crop of founders aren’t as swayed or in awe of the larger institutional VC brands that many LPs have admired for years. And, new LPs are in the mix too — it is not clear which models and vehicles and managers will build the best flytraps to catch the next big outcomes. It’s all up for grabs.