All the energy for venture funds flows from LPs — the money goes from LPs to partners at funds, which in turn invest in startups. But since the number of IPOs and exits has started to dry up, the pressure is starting to rise on LPs, and Venture Investment Associates’ Chris Douvos knows it. And he made it abundantly clear to investors on a panel at TechCrunch Disrupt NY today.
“There’s this huge exit sphincter,” Douvos said. “So we’re pushing this capital out and we’re kind of feeding the snake, LPs give money to GPs, GPs give to startups, startups get liquid and it comes back to LPs and the cycle starts over again. When you’ve got this exit sphincter and the snake is getting packed fuller and fuller, it reminds me… for those of you familiar with the Wu Tang Clan there’s a song called Method Man where one of the methods of torture they talk about is, ‘I’m gonna sew your rectum shut and keep feeding you’, that’s what it’s like to be an LP today.”
That’s not too surprising on a take of the current state of the technology market. There have been a fraction of a fraction of the number of technology IPOs the market typically sees in the first part of the year. That means that liquidity for investors — and, in turn, LPs, has started to stall, and that means that funds might start looking at alternative asset classes.
“It used to be private companies would aspire to go public,” First Round Capital’s Josh Kopelman said on stage. “We’re at the rare moment in time it’s the opposite. The minor league ball players are getting paid far more than the MVP major league players. Until that works itself out in the market it’s gonna create a really challenging time for these companies valued in the private markets to realize anything in the public markets.”
Still, venture funds are still finding ways to raise new huge funds. Andreessen-Horowitz, for example, is talking to investors about raising $1.5 billion for its latest fund, and other funds have been able to raise hundreds of millions — if not billions — in new funds. Firms seem to have shifted to raising new funds every two years or so, which is also putting some pressure on LPs.
“All the energy comes from us, if the LPs stop showing up the trees will wither,” Douvos said. “That sounds grandiose, but one of the challenges is the pool of LP capital isn’t infinite, dollars going into VC compete at the institutions where these dollars come from against other asset classes what’s most attractive. One of the challenges venture faces is the furthest out money, they’re the longest option, and as a result there’s a lot of pressure.
While all this is happening, venture funds don’t actually look too bad on paper. In the past few years valuations have risen significantly, making funds look like they will have good returns — if they have the exits to back it up. And so far, those exits haven’t shown up, and LPs and funds of funds need those exits to show up in order to actualize their returns.
Still, there are buyers, like Apple, Facebook and Google. But those companies are looking for more strategic fits in terms of tech, talent, and filling holes, Kopelman said. And that means that companies that haven’t quite figured out their fundamentals, or the right way to value companies against comparables, that’s making it challenging for companies to figure out how to exactly value companies they may potentially acquire.
“There’s a high level of [M&A] activity, but I don’t know if there’s a high level of desire to pay prices divorced from fundamentals,” Union Square Ventures’ Andy Weissman said on stage. “It seems like there was more of that in the past, but it’s less now.”
While firms talk about a downturn, and dropping valuations, it isn’t anywhere close to what struck the market around 2001 and 2002, Kopelman said. “As the market’s gotten choppy over the last couple quarters, you have a whole generation of founders and funders who have never been through a downturn. If you’re been in the industry for the last 7 years you’ve seen straight up. I don’t think it’s ever as bad as people think it is.”
“One of their secrets of success has been getting off the bus one stop too early rather than one stop too late,” Douvos said. “But that takes courage, most investors lack courage. Once you say n to a fund, you’re forever in that GP’s bad graces.”