Times are changing. Startups and VCs are facing tougher times, layoffs, down rounds and eroding valuations. However, already a record amount of money has gone into U.S. venture funds this year. As an LP (a limited partner, which is an investor in venture funds), am I seeing something others aren’t? Or am I just nuts?
I don’t think I’m nuts, but admittedly I may be a little biased. What I think we see shaping up is a year of “the haves and the have-nots.” I believe the first quarter of 2016 was a classic example of what happens when there is uncertainty in the overall market.
Experienced venture fund managers with existing LPs all fundraise at the same time, and LPs prioritize established managers and wait to work with newer, smaller funds later in the year.
Experience is invaluable
For example, of the 57 funds that closed last quarter, the gross majority of the money ended up in the hands of experienced managers like Accel, Battery, Founders Fund, General Catalyst, Index and Union Square Ventures. Moreover, the percentage of sub-$100 million funds dropped from 65 percent to 54 percent, which is the lowest it’s been since 2007. Also, funds greater than $500 million are disproportionately represented at 16 percent of all funds raised in Q1 2016, versus an annual Q1 average since Q1 2015 of closer to 10 percent.
Both VCs and LPs understand the value of having capital to invest at lower valuations. Further, the funds that have raised to date have strong market positions, track records and, in many cases, realized returns and experience weathering downturns. Obviously these are all factors LPs value, especially in an uncertain market like the one we face today.
The ugly denominator effect
With the bleak outlook, why are all the funds in the market? Well, some are raising based on their firms’ typical fundraising cycle, and others have accelerated their fundraising timeline to get ahead of any potential “denominator effect” — basically where a continued decline in the market affects LPs’ ability to invest.
LPs that invest in both public and private sectors often determine how much to allocate toward venture capital as a percentage of total assets; and the amount that gets invested in venture decreases if the value of their public assets decreases. As a result, venture funds that try to raise later might face the hard truth that money has dried up.
With the boom times calming down, knowing how your fund and your portfolio companies plan to navigate through this change is critical.
Based on the market activity in January and February, the ugly denominator effect appeared to be an impending inevitability. Although the market has rebounded, and the denominator fears dissipated, the net result of the stampede to fundraise early in the year could leave those funds yet to raise wondering if there’s any money left.
Beat the odds
The good news for you is that LPs with a dedicated venture program understand that smart investing requires investing in up and down markets alike — and allocate capital accordingly. As Alex Mittal of FundersClub noted in his recent blog post, great companies get founded in downturns as well as bull markets.
The same is true of venture funds. Andreessen Horowitz’ first fund was raised in 2009, and Lowercase Capital’s famous first fund in 2010 — both years when venture fundraising was under extreme pressure. Money from LPs dedicated to venture will still be there and notably, strong emerging managers can be “haves” alongside established managers. This is true even in uncertain markets.
Here are a few things I recommend to attract LPs and improve your odds of raising:
- Give advance notice: For any of you who plan on fundraising this year and haven’t told your LPs, do so now. We need the heads-up to plan for the upcoming year.
- Prep for diligence: Expect LPs to want to understand what is driving the underlying performance of your individual portfolio companies. We’ll ask you what your unrealized valuations are based on. Where do the revenues of your portfolio companies come from? Is it based on other startups that might get caught sideways trying to fundraise, or from companies that will still be able to pay their bills if the market dips? We want to know how you’re thinking about the next few years. With the boom times calming down, knowing how your fund and your portfolio companies plan to navigate through this change is critical.
- Leverage your LPs: If you have existing LPs, ask them for intros and to give you market feedback. Ask them what they are hearing from other LPs and who is actively allocating to new managers.
- Be patient: Can you slow your roll and fundraise in 2017? For funds still establishing track records, consider using 2016 to develop your portfolio companies, help them to raise their next rounds, and wait to fundraise yourself until early next year.