‘Our money is 20 years old’: Limited partners face liquidity crunch at venture capital firms

These days, it’s not easy to be a limited partner investing in venture capital firms. “Limited partners” who fund venture capital firms face an asset class in flux: funds are twice as old as they used to be, emerging managers face life-or-death fundraising challenges, and billions of dollars are trapped in startups that may never justify their 2021 valuations.

Indeed, at a recent StrictlyVC panel in San Francisco, above the din of the raucous crowds gathered to watch, five prominent limited partners, representing endowments, funds of funds, and secondaries managing more than $100 billion combined, painted a striking picture of the current state of venture capital, even as they see areas of opportunity emerging through the disruption.

Perhaps the most surprising revelation is that venture funds are living much longer than anyone planned, which creates a host of problems for institutional investors.

“Conventional wisdom might have suggested 13-year-old funds,” said Adam Groscher, manager of the J. Paul Getty Trust, which manages $9.5 billion. “In our portfolio, we have funds that are 15, 18 or even 20 years old that still hold outstanding assets, blue-chip assets that we are happy to hold.” However, he said, “the asset class is much more liquid” than most people might imagine, based on the history of the industry.

This extended timeline forces limited partners to tear down and rebuild their allocation models. Lara Banks of Makena Capital, which manages $6 billion in private equity and venture capital, noted that her firm now designs the life of the fund for 18 years, with the majority of capital actually returning in years 16 to 18. Meanwhile, the J. Paul Getty Fund is actively reconsidering how much capital to deploy, leaning toward more conservative allocations to avoid overexposure.

The alternative is to manage active investment portfolios through secondary companies, a market that has become core infrastructure. “I think every limited company and every public company should be actively involved in the secondary market,” said Matt Hodan of Lexington Partners, one of the largest secondary firms with $80 billion under management. “If not, you are self-selecting what has become a core component of the liquidity model.”

Disengagement from Evaluation (Worse Than You Think)

The committee did not sugar coat one of the harsh truths about venture valuations, which is that there is often a large gap between what venture capitalists believe their portfolios are worth and what buyers will actually pay.

TechCrunch’s Marina Temkin, who moderated the panel, shared an extreme example from a recent conversation with a general partner at an investment firm: A portfolio company that was last valued at 20 times revenue was recently offered only 2 times revenue on the secondary market — a 90% discount.

Michael Kim, founder of Cendana Capital, which manages nearly $3 billion focused on seed and pre-seed funds, put this in context: “When someone like Lexington comes in and takes a real look at valuations, they may actually face 80% cuts on what they envision will be winners or near-winners,” he said, referring to the “messy middle” of venture-backed companies.

Kim described this “messy middle” as companies that are growing 10% to 15% with annual recurring revenues of $10 million to $100 million and whose valuations topped $1 billion during the 2021 boom. Meanwhile, private equity and public markets buyers are pricing similar enterprise software companies at only four to six times revenue.

The rise of artificial intelligence has made matters worse. Hodan explained that companies that chose “to preserve capital and be sustainable during recessions” saw their growth rates decline while “artificial intelligence spread and was overtaken by the market.”

“These companies are now in a very difficult position, where if they don’t adapt, they will face some very serious headwinds and possibly die.”

Desert Manager Emerging

For new fund managers, the current fundraising environment is particularly difficult, notes Kelly Fontaine of Cendana Capital, corroborating her statement with a startling statistic. “In the first half of this year, the Founders Fund raised 1.7 times the amount raised by all emerging managers,” she said. “In total, institutional managers raised eight times the amount raised by all emerging managers.”

Why? Because institutional LPs, which committed larger sums faster than ever to venture capital firms during the pandemic days, are now seeking quality instead, concentrating their dollars in large platform funds like Founders Fund, Sequoia, and General Catalyst.

“There are a lot of people, a lot of peer institutions that have been investing in projects for as long or longer, and have become over-exposed to the asset class,” Groscher explained. “These permanent pools of capital that they were known for are beginning to decline.”

The silver lining, according to Kim, is that the “tourism fund managers” who flooded the market in 2021 — for example, the VP at Google who decided to raise a $30 million fund because their friend did — have largely been “fired.”

Is venture even an asset class?

Unsurprisingly, the panel addressed Roelof Botha’s recent assertion at TechCrunch Disrupt that the project is not actually an asset class. They largely agreed, with some caveats.

“I’ve been saying for 15 years that enterprise is not an asset class,” Kim said. Unlike public stocks, where managers cluster within one standard deviation of a target return, things are widely dispersed in a venture. “The best managers significantly outperform all other managers.”

For institutions like the J. Paul Getty Trust, this kind of distraction has become a real headache. “Making plans around venture capital is very difficult because of the dispersion of returns,” Groscher said. The solution was exposure to platform funds that offered “some reliability and continuity of returns,” with an emerging manager program to generate alpha.

Banks offered a slightly different view, noting that the project’s role was evolving beyond just “a pinch of salt in the wallet.” For example, she said, Stripe’s exposure in Makena’s portfolio is actually a hedge against Visa, as Stripe could potentially use crypto bars to disrupt Visa’s business. (In other words, McKenna sees the project as a tool that can help manage disruption risk across the entire portfolio.)

Unload stock earlier

Another topic covered in the panel discussion was the normalization of general partner sales at bullish periods, not just at distressed prices.

“A third of our distributions last year came from secondary products, not discounts,” Fontaine said. “It was from the premium sale to the final round valuation.”

“If something is worth three times your capital, think about what you would have to do to make it six times your capital,” Fontaine explained. “If you sell at 20% off, how much will you get back out of the box?”

The discussion brought to mind a conversation TechCrunch had with veteran Bay Area pre-investment investor Charles Hudson in June, when he shared that investors in very young companies are increasingly having to think like private equity managers: optimizing cash returns rather than running houses.

At the time, Hudson said one of his limited partners asked him to do an exercise and calculate how much money Hudson would have made had he sold his shares in his portfolio companies in stages A, B and C instead of continuing on the journey. This analysis revealed that selling everything at the Series A stage didn’t work; The multiplier effect of staying in the best companies outweighs any benefits from cutting losses early. But Series B was different.

“You could have a fund worth 3x more if you sold everything at Level B,” Hudson said. “And I’m like, ‘Okay, that’s pretty good.’

It would certainly help if the stigma surrounding high school evaporated. “Ten years ago, if you were doing a high school study, the unspoken thing was: ‘We made a mistake,’” Kim said. “Today, secondaries are definitely part of the toolkit.”

How to raise in this environment (despite the headwinds)

For managers trying to raise capital, the committee provided support and tough advice. Kim recommended that new managers “reach out to as many family offices as possible,” describing them as “usually more sophisticated in terms of betting on a new manager.”

He also suggested pushing hard on co-investment opportunities, including offering no-fee, no-load co-investment rights as a way to attract interest from family offices.

The challenge for emerging managers, according to Kim, is that “it would be really difficult to convince a university institution or an institution like… [the J. Paul Getty Trust] To invest in your $50 million micro fund unless you are well-heeled — [meaning] “Maybe you are one of the founders of OpenAI.”

As for choosing a manager, the committee agreed that private networks no longer exist. “No one has a private network anymore,” Fontaine said emphatically. “If you’re a clear founder, even Sequoia will track you.”

Kim explained that Cendana relies on three aspects instead: a manager’s access to founders, his ability to choose the right founders, and most importantly, “hustle.”

“Networks and domain expertise have a shelf life,” Kim explained. “Unless you’re rushing to modernize those networks, expand those networks, you’re going to get left behind.”

As an example, Kim pointed to one of Cendana’s fund managers, Casey Caruso of Topology Ventures. Caruso, a former Google engineer, will “live in hacker houses for weeks to get to know the founders there. She’s technical, so she’ll actually compete with them in their little hackathons. And sometimes she’ll win.”

He contrasted this with “some 57-year-old fund manager who lives in Woodside. They wouldn’t have that kind of access to founders.”

As for important sectors and geographies, the consensus was that US AI and dynamism dominate at the moment, along with fund managers based in San Francisco, or at least, easily accessible.

However, the committee recognized traditional strength in other areas: biotechnology in Boston; fintech and cryptocurrencies in New York; Kim said the ecosystem in Israel “despite the current issues there.”

Banks added that she is confident that the consumer will have a new wave. “Pallet boxes have put that aside, so it looks like we’re ready for a new model,” she said.