As the COVID-19 pandemic continues, the impact on the global economy has been widespread. The U.S. is likely at the start of the most significant economic slowdown since the 2008 recession. Major conferences like South by Southwest have been canceled; business travel has nearly ground to a halt; cities are ordering non-essential workers to shelter in place; and the public markets have encountered massive turbulence.
The negative impacts on private early-stage markets may take longer to play out. Historically, private markets lag behind public markets by 12-24 months, and capital pullback typically occurs only after a sustained period of extreme volatility or downward-shifting movement. And while it is too early to predict the longer-term effects of the coronavirus on the private capital markets, companies and venture funds must start planning for a potential new reality. (For more, see Sequoia’s latest cautionary piece.)
Over the last decade, the micro venture capital ecosystem has gone from infancy to early maturity, with over 1,000 firms having been formed since 2009 (and according to a report by Preqin and First Republic, there are now 1,023 firms in the market for a new fund).
So what should emerging managers — the majority of which are seed-focused — expect when fundraising in 2020? Consider the following potential effects on firms looking to micro VCs for funding in the near future.
Family office allocation disruption
First Republic’s late 2018 emerging manager survey found that 67% of the capital allocated to Fund I offerings were from family offices and high net worth individuals (53% for Fund II, and just under 50% for Fund III). Over the last five years, family offices have become active (albeit opaque) participants in emerging fund allocations and in co-investments.
While there is certainly a large contingent of family offices with long histories of remaining durable investors across market cycles, a significant number of family offices just began investing in venture during the post-2009 period of economic prosperity. Those new to the scene are likely to retrench somewhat, while waiting for a semblance of true macro visibility. That’s particularly true for those whose family wealth has been generated from areas outside of tech.
Takeaway: While it’s unlikely the paradigm for family offices has shifted completely from yield-chasing to liquidity-hoarding, the pendulum is certainly swinging.
Protracted fundraising cycles
From 2016 to 2019, the average time to fundraise for micro VC firms dropped from 20 months to 16 months. That’s likely to increase, with business travel partially suspended for many (also reducing the number of serendipitous touchpoints at industry events), coupled with general macro anxiety.
Takeaway: In this new environment, managers, particularly those with Fund I/II offerings, may need to plan for an 18+ month cycle from the initial fundraising launch. There will always be exceptions, chiefly those that are spin-outs from larger funds.
Soft commitments are verbal (or email) commitments by limited partners who have yet to sign formal fund subscription documents. These commits have always been a bit capricious in even the best markets, and fund managers are generally wise to haircut soft commits by 30% to 50% when planning a close.
Takeaway: Especially for those with reliance on non-institutional LPs, it may now be necessary to haircut soft commits by 50% to 70% when planning on closing.
During the first three to six months of most calendar years, many institutional venture LPs are buried with re-ups from existing managers in their portfolio. This has been even more compounded in recent years with many firms following two-year fundraising cycles, larger fund sizes and preemptive “shelf” raises (raising a fund before needing to activate, and often not going live with a new fund for three to nine months). While the second and third quarters have historically been when many institutional allocators start actively meeting new groups, the travel slowdown may affect meetings in the short term, regardless of whether managers are willing to travel.
Takeaway: As long as travel restrictions and social distancing are in place, it’s doubtful any institutional investors will be making commitments without in-person meetings. Those without active emerging manager mandates may be even more deliberate in 2020.
Fund II/III offerings
Over the last decade, many managers have successfully raised follow-on funds every 2–2.5 years, largely using markups to demonstrate traction. As these metrics early in the fund’s life have shown little correlation to ultimate fund performance, LPs are likely to heavily discount these numbers to wait for more portfolio seasoning before recommitting. This serves a dual purpose of determining how the portfolio weathers a less founder-friendly valuation market in the coming quarters and evaluating if any liquidity is realized.
Takeaway: Regardless of timeline, the path toward a Fund II or Fund III (especially one that has a big step up in fund size) will be more difficult than years past.
Of course, the environment could shift dramatically if the trajectory of COVID-19 shifts in a more positive direction and the public markets rapidly stabilize. But that seems unlikely at this point, based on the history of past pandemics and current information on contagion levels.
As a result, while managers certainly shouldn’t panic — as we all know, it’s advisable to have dry powder in uneven and anxious markets — a bit of conservatism and patience around fundraising targets, timeline and process should be exercised.