What will Venture Investing Become?

For the past month, we have been reaching out to our broad, extended network, speaking to everyone we can find who works in and around venture capital (VC) investing. We have been trying to get a sense of the best ways to get capital directed towards the many promising Deep Tech companies we come across. In the dozens of conversations we have had – with VCs, Limited Partners (LPs, the funds who invest in venture funds), CEOs and family offices – the tone can best be described as extremely gloomy. From all this we are reaching the conclusion that the entire venture market is about to change in some fairly profound ways.

We think we are seeing the merging of the tail end of two major trends. The shorter trend started in the midst of the pandemic when money was extremely cheap and the whole world seemed to be racing online. Money flowed into any start-up that seemed to be riding that wave. Many of the largest VCs raised massive funds which they plowed into all the hottest deals of the moment, launching valuations into uncharted territory, and leaving little LP capital for the long tail of smaller firms. That all went into reverse in 2023 when interest rates started to go up. Money was suddenly not so cheap, and why take venture risks when cash was earning 5% in the bank. On top of that the IPO window slammed shut, so exits slowed to a trickle. As a result, VCs stopped returning funds to LPs. The most common refrain we hear from LPs today is that they have not seen any DPI (Distributions to Paid In Capital, i.e. cash returns) in a very long time. The big funds are sitting on overpriced investments in companies that are now struggling. On paper the LPs are all over-allocated to venture based on those 2022 numbers, but the big funds have not marked their portfolio to market values. If they did, the LPs would likely be grossly underweight to venture, but in a way that means lots of people would get fired. Until this logjam is resolved, raising LP capital is almost impossible. And that resolution probably will not come until interest rates in the US have moved down.

The other major trend in the market is the growth of venture firms over the past 15 years, and the fact that these are all entirely invested in software companies. For the past decade investing in software companies was an obvious path for a whole bunch of reasons. Combined with low interest rates and a lack of returns elsewhere, a lot of new venture firms entered the market. But these were a very different type of investor than we traditionally associate with venture capitalists. We were amazed to see deals closed in weeks, with no diligence other than a review of the companies’ growth metrics (CAAC, LTV, conversion, etc.). Many firms took what was effectively a purely quantitive approach to venture investing, that made it very hard for anyone offering a new technology to get the attention of a large swathe of investors. We do not mean to be critical of the people doing this investing, it is just that the whole market skewed too far in this direction.

We think these two trends have are now coming towards their end stage. It is hard to think that we are going back to the heady days of the late teens and early 20’s. This likely means that many more firms are going to close down, with funds lingering on long after their intended lifetime but staffed only by a skeleton crew. There are already many signs of this. Of the small and mid-sized funds we spoke with a large number are not even bothering to speak to LPs right now, let alone seeking to raise new funds, no matter how good their returns.

Of course it is not all doom and gloom. Two areas are still attracting LP dollars – AI and secondaries. The former should need no explanation, it is just a hot area. The secondaries market remains interesting because so many companies are staying private longer that this is one of the only ways for outside investors to participate. The problem is that both of these areas are incredibly narrow, maybe they can generate good returns but they are not enough to prop up the whole venture complex.

So if the old model has reached its end game, what is going to come next? The answer to that is not entirely clear.

One clear trend is that there is a growing divergence between the biggest dozen or so firms and everyone else. The big funds still command the most attention from LPs. There will likely be some shake up there as true returns start to emerge, but their position as a whole is unlikely to shift.

But at the same time, there is growing frustration among investors with the traditional model. Many LPs are starting to question the value of paying 2% & 20% fees. We have seen firsthand a strong desire from all sorts of investors to do invest directly alongside the funds, or without them entirely. It has gotten very easy to set up Special Purpose Vehicles (SPV), legal shells for aggregating disparate funds into an investment in a single company. Almost everyone we spoke with suggested this as the best path forward for grouping venture investments. LPs like this because there are no recurring 2% management fees, and no VC dictating when funds are returned. This approach makes it very hard for investors to build institutional funds with truly long-term capabilities. As such, we are not sure if this wave of SPV investing will last beyond the next round of interest rate cuts.

That being said, it is clear to us that the old model is not coming back.