Last week we ranted a bit about the changes coming the Venture Capital industry, and that seemed to have struck a bit of a nerve. This is apparently a topic on the minds of a lot of our readers. Almost everyone asked some version of “What comes next?”. Here we would like to be a bit more prescriptive in looking at what has gone wrong and then use that to think through the answer to that question.
From where we sit, the industry faces two problems: a lack of diversification that has built up over years and a widening gap between the top 20 or so firms and everyone else. We have written a lot about that first problem going back to this piece from 2019. In that year, we participated in over 100 VC pitches for our various clients. This was jarring – everyone asked the same set of questions and everyone seemed intensely focused on the purely quantitative metrics of our companies’ businesses. We almost never encountered a deep technical question, and for those companies that had businesses for which growth was not readily quantifiable (i.e. everything in hardware) we were quickly met with glazed eyes and a marked drop in interest. As we keep saying, 60% of future technology industry revenue will come from new technologies and hardware, an area that has attracted only 10% of venture dollars over the past decade. The world probably does not need anymore CRM companies, and while everyone would love to find the next Snowflake, that space is looking pretty crowded right now too. There is a clear opportunity for future VCs to move outside of traditional B2B SaaS into other areas – yes, AI, but plenty of others.
The other problem is that the largest funds are effectively sucking up a disproportionate share of LP dollars. This was incredibly pronounced in 2022, but that was just the tail end of a trend that had been building up for years. Maybe the world only needs a few handfuls of institutional VCs, but those firms themselves are changing. They have largely gotten so big that they have had to move beyond venture investing into broad-based “asset management”, or as one of our commenters put it “glorified mutual funds”. That last is a bit hyperbolic, but there is clearly a blurring of VC, private equity and late stage or secondary funds. Those may be great business models, but we would think that means a diminishing return profile and too much concentration for an industry that depends on new ideas for growth.
So where does the lead? To be clear, we are not entirely sure. This whole series of posts is our attempt to chart that new course.
For starters, it seems likely that the largest firms will continue to grow. They have deep wells of capital and strong brand names. Both LPs and start-ups will search them out. They will likely continue to charge healthy fees, above and beyond the traditional 2% and 20%. When the current logjam breaks, one or two of these will likely implode, but the rest will continue to thrive.
Below this top tier, there are hundreds of funds. Our sense is that those with domain expertise will thrive. They long ago learned how to tap into non-traditional pools of capital and have track records to build upon. We see this in video gaming and digital content, AI, and a few other areas. But beyond them there is a large, undifferentiated pool of investors who we think are going to struggle. Their current funds likely have a lot of over-priced deals in them and will struggle to generate returns good enough to raise their next fund. Some will struggle along and eke out a living. Our anecdotal data suggests hundreds of firms are already winding down in some way. Many of these will get absorbed into larger funds. If 2001-2003 is any guide, a few of these funds will shrink down to one person nursing the last portfolio constituents into the sunset. And many wore will just close shop.
At the bottom of the pyramid, there is a healthy-ish and growing pool of early stage funds. This is a hodgepodge of former executives with healthy personal exits which they are now turning towards a more structured form of angel investing. There are also a number of highly nimble investors with a real passion for their field – building accelerators and funding platforms. We see this in deep tech and AI and medical devices and a host of other fields. But these funds face two problems. First, they are going to have a hard time raising their next funds until interest rates fall meaningfully. We know a half dozen of these funds and they are clearly biding their time – they have enough work to do now maintaining their portfolio, but recognize that it will take a few years before they can really start growing them again. The other problem is more pernicious. These funds are heavily weighted towards early stage deals, they are simply not large enough to meaningfully participate beyond Series A. But if the number of larger funds shrinks who will be there to fund those Series B, C & D deals?
Currently, almost no one can raise an actual fund – AI and secondaries are the exception, but no one else. This holds for existing funds, and starting a new fund now is impossible. This will not change any time soon. First, interest rates have to fall, and our guess is that means more than two cuts in the US. Then LPs and other pools of capital will have to re-discover their risk appetites. And that will take a another year.
Another path forward that is becoming increasingly popular is Special Purpose Vehicles (SPVs) – single purpose entities that aggregate funds for a single investment. SPVs are structured so that the ‘manager’ only collects a percentage of the return, so 0% & 20% instead of 2% & 20%. These are viable now because as much as everyone is risk averse, there is still a desire among the big capital pools to invest in the venture class. All the high net worth individuals, family offices, sovereign wealth funds and others have capital to invest in deals, but they want to do this directly without institutional VCs as an intermediary. This trend has been growing for years, but is now really the only way that many deals can get done.
The approach has many problems. First, it presents exactly the type of concentrated risk that past LPs sought to avoid by having VCs and their portfolio math. The big LPs probably feel they can manage their portfolio risk better than any outsider and want to do away with the VCs fee structures. There are plenty of smaller LPs who cannot do this at meaningful scale and so will be cut out of the venture class entirely. From where we sit another major problem is that the SPV approach does not scale well. Each deal brings a heavy administrative load and at some point it becomes too difficult for an individual to manage. True, there are some good software platforms out there that help with this, but those lessen the administrative load they do not remove it entirely. A bigger issue is that without the 2% operating fees, no one can build a sustainable firm, one that could over time develop real domain expertise and dig deep enough into the technology to find the most exciting companies.
So the question then becomes – if SPVs are the current path, can someone string together enough of them to generate returns attractive enough to merit a chance to raise a larger fund down the road when risk appetites return? That seems likely, but it could take three or four years to happen. And what will funds look like then? Will the biggest LPs be so comfortable with SPVs that they will see no reason to return to the traditional model? Probably not, but it is possible.
We are stuck in the middle of this, so this post has a somewhat gloomy tone. That being said, all of what is happening now is part of a healthy cycle – creative destruction was overdue in the space for a long time. Eventually, the cycle will turn upward again, and we are very curious to see what new form the industry will take on then.
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