Michael Cardamone is CEO and Managing Partner at Forum Ventures.
In recent conversations with venture capital professionals, one thing is abundantly clear: This current market is a profoundly challenging time to be fundraising as an emerging manager. As the market turned down last year, the percentage of limited partner dollars going into emerging funds decreased, a trend that appears to be continuing into 2023. Many LPs are either refraining from investing in the VC asset class entirely or, in a “flight to safety,” are focused only on investing in “brand name” funds. This leads to a concentration of LP capital in the same big funds that have been around for decades, despite their recent vintages likely struggling as the market and private valuations majorly reset.
As the CEO and managing partner of an emerging fund, I see first-hand from conversations with LPs and other emerging managers some of the misconceptions around investing in emerging funds, and while fears are understandable, there’s a lot to be gained from investing in small, early-stage funds—especially right now.
What can we learn from the data?
I recently spoke with a foundation whose board insisted on investing in the brand-name funds, despite the chief information officer acknowledging that he thought “alpha” in the venture asset class was in small emerging fund managers.
As the saying goes, nobody gets fired for buying IBM. Understandably, in a down market, some LPs are pulling back from the asset class entirely or not adding new managers at all. Foundations and endowment funds are often constrained by the denominator effect. Family offices and high-net-worth individuals understandably have angst around investing in VC funds in this market, especially if they felt burned on deals done during the extremely high valuations of previous years.
It’s true that established funds generally carry a lower risk profile. LPs usually don’t risk losing their investments and will often opt to invest in well-established funds that they have long-standing relationships with. These funds have built trust over decades, but it’s hard to return large percentages on these large funds.
Some experts argue that VC funds investing during and after a recession has historically outperformed funds investing leading up to a recession. In my experience, there are a lot of factors that lead to this, especially for early-stage funds, including lower entry prices at initial investments, companies scaling into what will likely be the next bull market and more talent available in the market. Additionally, if you look at the top 10 performing funds per vintage year, the majority are new or developing funds. As I see it, it’s simply easier to generate outsized returns as a smaller fund. I think this will end up being a great vintage for the venture asset class, and small, emerging funds will be the major driver of outsized returns given they are higher risk, higher reward for LPs.
Why don’t LPs lean more into small emerging funds, given the data?
So, why are investors so hesitant to invest in smaller funds? There are often emotional and structural barriers that keep LPs from investing in emerging managers. As I said, bigger funds usually have more experience and have built up trust over decades, so LPs feel safer, especially during turbulent economic times. Additionally, it takes just as much work, or more, to underwrite an investment in a small emerging manager than it does to invest in a large, established fund; but you can’t deploy nearly as much capital into the small fund. If you are an LP managing a lot of capital, it’s harder to justify making 20 small investments into emerging managers to deploy the same amount of capital you could deploy into a large, established fund.
What are some ways LPs can assuage their fears?
The fear is understandable, but when interest rates are high like they are today, small, emerging managers, in my opinion, give LPs the best chance to meaningfully outperform less risky, liquid investments. The key is honing in on a process to properly underwrite these smaller funds. Here are a few tips.
Backchannel with founders who have worked with those funds.
A VC fund needs to be able to source, make good investing decisions, and then “win” the right to invest if there are other investors at the table trying to invest as well. By backchanneling with founders, LPs can get a sense of why a VC fund “wins” deals and whether that founder would choose to work with them again and/or refer other founders to them.
Talk to other general partners in the ecosystem who have co-invested.
Again, this gives LPs a sense of whether other funds are likely to pull the VC fund they are evaluating into deals, which helps with sourcing and validates whether they are a value add to partners for the company they have co-invested in.
Look at follow-on funding and commercial progress.
Examine both follow-on funding from previous portfolio companies plus the commercial progress of those same companies since the initial investment. Traditionally, LPs have put a lot of emphasis on the quality of follow-on funders in each of a VC fund’s portfolios as a way to underwrite the quality of each underlying company. In an environment where the time in between rounds is expanding quite a bit, LPs should also look at the revenue growth and progress of key companies in the fund’s portfolio to get a sense of how they are doing since the fund invested.
In order to solve the structural problems mentioned above, it will require a mindset shift and likely an increase in the team size. There are early signs of some of the large, multi-stage funds downsizing their funds in this new market, and I think it’s inevitable that some of the new seed funds will struggle to raise their next fund and end up leaving the market. I think these two trends, plus the data mentioned above, will lead to more LP dollars eventually flowing into the small, emerging managers that can persist through this market, build a great track record and provide an amazing founder experience. Those LPs will likely be rewarded for doing so.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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