Venture capital, like most other asset classes in the past year, was characterized by uncertainty. Institutional and individual investors alike witnessed the breakdown of the 60/40 portfolio, a sharp slowdown in secondary transactions, a virtual cessation of IPOs, cratering of the crypto markets and declining late-stage deal valuations. All this paired with rising rate uncertainty, volatility, and other global macroeconomic conditions and risks led to extensive opacity and ample debate around all assets, including venture capital.
In the venture industry, the last few years have been some of the most robust fundraising years for fund managers on record. $154 billion was committed to VC funds in 2021; $93 billion in 2020; and an estimated $163 billion for 2022. That’s over $400 billion in just three years. Viewed in conjunction with declining public markets, some investors are worried about over-allocation to private assets for limited partner (LP) portfolios.
Yet despite these milestone fundraising years, emerging managers have simultaneously fallen behind. In recent quarters, emerging managers (including first time funds) took less than 15% of capital raised (versus ~33% in 2021). And given the market declines of 2022, there is concern that emerging managers will experience continued fundraising challenges in 2023.
In light of this uncertainty, First Republic collaborated with the team behind Different Funds to dive into the state of today’s emerging manager fundraising reality. This article sheds light on how general partners (GPs) are thinking about fundraising tactics and strategies over the coming year. It also incorporates LP perspectives, offering additional color.
We surveyed several hundred venture capital partners on their fundraising plans and market perspectives. We received over 80 responses to the survey, which are analyzed below. Survey emphasis was placed on emerging managers, though we also received responses from established firms as well. (See below for respondent breakdown). We also interviewed several general partners (GPs) and family offices to incorporate qualitative perspectives and commentary. This article highlights some of the most interesting findings for both GPs and LPs alike.
Emerging venture capitalists (VCs) are walking a balance with the current fundraising environment: About half are staying the course, while the other half are adjusting their tactics and strategies to address fundraising risks and concerns. Anecdotally, we hear that more established managers (Funds 2 and 3) are having an easier time fundraising in large part due to existing relationships and years of conversations, while first-time funds are struggling more than normal.
The primary tone among GPs is cautious confidence, which is in line with the required GP mindset: One must have confidence in oneself and their strategy to place long-term, high-risk bets. Yet it’s worth bearing in mind that most emerging managers are under 40 and literally have never experienced an economic downturn like this in their investment careers. They may not realize how bumpy this ride can be.
On the LP appetite side, it seems that family offices are the one fundraising bright spot for VCs: Many are still deploying and taking first conversations. While individual LPs are more likely to take a “wait and see” approach, and institutional LPs (which are rare for first-time funds to begin with) are commonly declining new conversations outright.
The long time frames of venture funds mitigate certain concerns that LPs may have for assets with shorter time frames and durations. In general, LPs view private investments as “uncorrelated” to public markets and allocate deliberately according to risk and performance goals. For LPs that have capacity to deploy and understand venture, they know that maintaining exposure across vintages and searching for the next great managers are core to portfolio construction.
LP potential — Family offices are the ideal target
We asked respondents to tell us which type of LP they thought would be most receptive to their next fundraise. Emerging managers largely report family offices as their primary target (46%). This coincides with verbal reinforcement from interviews (more on this below), noting that family offices are the most reliable sources of capital in the current market. That said, a sizable portion anticipate institutional investors to be most receptive, with more established managers more likely to prioritize institutions — likely due to existing relationships and years of cultivation. Of course, GPs also know that institutional LPs are a must-have as they size up their assets under management (AUM), while high net worth individuals and smaller LPs are often priced out of larger funds.
LP diligence processes are becoming more intensive
In bearish market cycles, it stands to reason that LPs may become more careful with capital deployments and more intensive with due diligence of prospective funds, despite weak economic cycles historically correlating with stronger VC vintages and valuation. Survey data on this topic bears out this trend. Over half of respondents agree that LP diligence processes have been longer/more intensive this year as compared to 2021; fewer than 10% disagree with that statement. There’s clearly broad consensus among emerging managers that LPs are exercising greater caution before allocating to funds in the new climate. Managers also frequently report that these new diligence processes are longer/more deliberate than what they’d experienced pre-pandemic.
How GPs Are Responding
50% of GPs are staying the course with their fundraising plans
Despite all the macro shifts that occurred last year, half of VCs report they’re making no changes to their fundraising plans. Roughly 17% of emerging managers report they’re accelerating a final close for a fund they have in-market, suggesting they anticipate the coming year will be worse for fundraising than 2021. About a fifth of VCs are delaying fundraising their next fund (with Fund 2 the most likely to delay), with a similar proportion slowing their investment pace to stretch out existing capital. Only 11% of VCs are leaning into syndicating individual deals and focusing on smaller capital raises, and these are overwhelmingly GPs raising their first fund.
In an uncertain market, LPs often tighten their belts, re-ups are not guaranteed and the bar for new relationships becomes even higher. This data leads me to think that GPs are not adjusting their plans based off what they are hearing from LPs just yet.”
ERIN HARKLESS MOORE
INVESTMENTS DIRECTOR, PIVOTAL VENTURES
When looking at responses segmented by LP types that dominate a GP’s fund or network, there are a few differences. Namely, VCs who report they raise primarily from individual investors and family offices are more likely than those raising primarily from institutional LPs to be undeterred in their fundraising plans by current market conditions. VCs raising primarily from institutional LPs, on the other hand, are more likely to delay their next flagship fund, but significantly less likely to be slowing their investment pace.
This mirrors what we’ve heard from interviews in the course of our research. Several funds have noted that some institutional LPs are pulling back on their venture activities, particularly for any commitments to new managers. Comments such as “we’re overcommitted,” “we’re only re-upping with existing managers” and “come back to us in 18 months” are becoming more common. Individual high net worth investors are, increasingly risk averse as well.
Family offices, in contrast, are continuing to deploy capital and are actively seeking to add new managers as well. In fact, some funds report that family offices are increasing their commitments on subsequent funds and driving the capital raise.
Logically, this makes sense, as family offices generally have different time horizons and performance mandates than institutions. Given lower performance in other asset classes, an endowment or pension may currently be overallocated to venture and must strive to meet its portfolio construction goals (i.e., the denominator effect). Family offices have greater flexibility and generally recognize it’s important to maintain exposure to different vintages, especially when underlying deal valuations become more friendly and create opportunities for more outsized returns.
MANAGING PARTNER, E14 FUND
Increases in fund size are the expected norm
It appears GPs are not only confident they can continue forward with existing fundraising plans but are also bullish on their ability to collect larger amounts of capital from more LPs: 70% of VCs plan to increase their next fund size, 56% plan to raise from a larger roster of investors, 65% plan to increase the average check size from each investor, and 59% think they will accomplish this on similar or faster timelines than their last capital raise.
This bullish outlook may largely result from GPs’ understanding that they’re raising for long-term vehicles that, in theory, may be sheltered from short-term market fluctuations and have historically outperformed public equities as an asset class. LPs actively watching their portfolios decline in value may feel differently.
Also, given that many emerging managers launch their VC firms with multi-year plans for growing into established managers, those reporting their next fund will “stay the same” in size or number of investors may actually reflect a more pessimistic outlook than the neutral stance it appears to reflect. For a Fund 3, acknowledging that their Fund 4 might be the same $100 million size of their existing fund, rather than the $150 million or $200 million set out in their fundraising plans at founding, displays a pragmatic shift in strategy. (And while some GPs find their fund size “sweet spot” and stay there, it’s more common for emerging GPs to scale their fund sizes with experience.)
And it’s clear that while GPs are mostly bullish on fund size and LP participation, their confidence wanes with respect to fundraising timelines: 41% expect their timelines to be longer than with their last fund. Fund IIIs looking toward their fourth fund and GPs raising their first fund are the most concerned on timelines, with over 50% of them expecting timelines to extend.
Terms to remain mostly static, with hurdle rates unchanged or nonexistent despite a rising interest rate environment
Terms are one fulcrum that managers have to incentivize LPs to participate in a fund. While the 2/20 fee strategy is the industry norm, other terms like hurdle rates and GP commits can be more flexible. But based on survey responses, the vast majority of VCs have no plans to adjust the terms of their funds to provide greater incentive for LPs to allocate.
In fact, the term most reported to change is investment minimums — 35% intend to increase the minimum check they’re willing to accept from LPs. This reflects a group of GPs that actually expects they can be more selective in LP participation for their next fund, rather than less.
This increase could reflect the portion of emerging managers who plan to shift from individual to institutional LPs for their subsequent fund (a natural progression as firms become more established). But given many of these VCs have reported they plan to raise much of their capital from family offices, this doesn’t necessarily seem to be the case.
It’s also interesting that about 10% of respondents anticipate they’ll raise their next fund with more GP-favorable terms. With increased management fees, increased carry and decreased GP commit, GPs should carefully consider whether they really want to lean into less favorable terms for LPs and higher minimums, as it could have negative consequences:
VICE PRESIDENT, VERDIS INVESTMENT MANAGEMENT
GP commits are a bit more of a complex topic. Those likely to decrease their GP commit are GPs raising their first, second and third funds, while those raising fourth funds and beyond are either staying the same or increasing their commits. The ability to maintain commits through funds is dependent on prior fund liquidity, which may be slow in coming, thus necessitating frank discussions with LPs on subsequent funds:
As for GPs lowering their GP commit, I believe it’s important to understand the ‘why.’ One example scenario may be a firm that is raising a larger fund, so the total GP commit dollars may be larger, but the percentage is smaller to maintain the alignment goal. There may be other scenarios where I would also want to better understand the underlying reasons — for example, if a GP is raising fund III or IV and hasn’t had significant liquidity yet and started out with a high GP commit in fund I — then that can be financially challenging for a GP to maintain.”
PARTNER, SAPPHIRE VENTURES
Lastly, the absence of VCs changing their hurdle rates is especially noteworthy in the current high interest rate environment. In a market where the risk-free rate is approaching 5% annually, it might be expected that GPs need to promise LPs a greater internal rate of return (IRR) before they start collecting carry. Yet VC funds are typically decade-long vehicles and, currently, the inverted yield curve shows the market expects long-term interest rates to decline. Given the long duration of venture as an asset class, it’s likely that GPs see no need to match what they believe is a temporary jump in interest rates. If rates remain high over a longer period, it will be interesting to see if GPs relent and begin to increase hurdles.
Despite confidence in the survey results, GPs still have a wide range of concerns as we enter 2023.
As a final part of the survey, we asked respondents to tell us what concerned them most about raising their current or next funds. While there were obvious themes to the concerns (see below), responses varied widely. Some GPs expressed worries about transitioning from high net worth individual raises to an institutional-driven strategy. Others mentioned concerns that many LPs have left the market temporarily. One GP raised the specter of LP defaults (which certainly occurred during the 2008 Global Financial Crisis and sowed chaos within some firms).
Overall, the most commonly expressed fears and concerns as we head into 2023 from the survey were:
- Long and slow fundraising time frames
- Limited, weak or delayed performance metrics due to fewer up-rounds, existing portfolio companies delaying their next capital raises and a closed IPO window
- LPs not adding new managers and/or ignoring emerging managers
- LP liquidity concerns and LP hesitance to back more illiquid assets
- Overallocations to venture and the denominator effect, particularly for institutions
— Anonymous GP
“I'm concerned that LP diligence will be exclusively focused on metrics that don’t bear out any meaningful results until after year 5 or 6 in the life cycle of the fund.”
The nature of venture capital requires conviction and confidence in the face of uncertainty. While GPs and LPs alike seek to perform due diligence about the entrepreneurs and managers they invest in, only so much can be known … and the long durations of the asset class create ample opportunities for surprises and disruption.
Accordingly, despite broad declines across financial markets over the last year, it’s perhaps no surprise that half of our surveyed VCs remain confident with no plans to change their fundraising strategies for their next investment vehicles. Early data suggests this confidence may be reasonably placed, as 2022 was in fact a banner year for VC fundraising (though emerging managers took a declining share of capital).
Still, over 40% of respondents expect fundraising timelines to lengthen in 2023. And over 75% recognize specific concerns and risks they’re monitoring as they relate to LP fundraising. In tandem, many LPs are carefully evaluating their overall portfolios and assessing their liquidity needs.
Given that venture fundraising typically takes around 18 months, GPs may want to bear in mind the possibility that we may be at the beginning of a fundraising winter for private assets. While LPs generally recognize the importance of maintaining exposure across vintages, liquidity and portfolio imbalances often drive decisions. The fact that emerging managers are also rapidly declining in their share of overall capital commitments also suggests that LPs are moving more toward established funds and the “usual” suspects. And even industry leaders are feeling the pressure, as evidenced by Sequoia Capital’s recent announcement that it’s reducing management fees on new funds.
As we head into 2023, we suggest GPs keep a few things front of mind: Look to truly differentiate your firm and thesis from others in the market; strive to support your existing portfolio to improve medium-term outcomes; and maintain or improve the terms that you offer your LPs.
About the Contributors
Leslie Jump: A founder of Different Funds, Leslie has experience as a GP, an LP and an entrepreneur. She brings a full-stack perspective to the venture landscape. She’s worked with and advised hundreds of GPs and LPs, while leading the creation of some of the venture industry’s most sought-after research and data.
Mack Kolarich: A founder of Different Funds, Mack has done due diligence on and advised hundreds of VC firms and supported institutional LPs on their private asset selection, sourcing and portfolio strategies. He’s conducted both public and proprietary research across the venture stack, looking at everything from fund terms to deck design to sector evaluations to performance and beyond.
Jacob Tasto: A founding analyst of Different Funds, Jacob has built some of the industry’s most robust venture data sets while conducting groundbreaking research. His analysis has led to novel articles and reports across venture capital, SPVs, deep tech and other private assets.
The views and opinions of the third parties quoted in this article are not necessarily those of First Republic Bank and should not be relied upon as such. The content of this publication is for information purposes only and should not be considered as legal, financial, accounting or tax advice, nor as an investment recommendation or an endorsement of any investment fund. First Republic Bank makes no representations, warranties or other guarantees of any kind as to the accuracy, completeness or timeliness of the information provided in this publication. You should consult with your own professional advisors to fully understand and evaluate the information provided in this publication before making any decision that could affect the legal or financial health of you or your business.