Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued growth with the emerging manager landscape.
As we move into month three of the COVID-19 outbreak, the impact on the global economy has been unmistakable, and arguably the most significant since the US came out of the last recession. Conferences have been cancelled (SXSW!), business travel has nearly grinded to a halt, companies such as Amazon and Twitter have asked workers to stay away from the office, and the public markets have encountered massive turbulence.
Historically speaking, private early stage 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 far too early to understand the medium to long term effects of the virus on the private capital markets, companies (see Sequoia’s latest cautionary piece) and venture funds must start planning for a potential new reality.
Over the last decade, the emerging manager ecosystem has gone from infancy to early maturity with over 1,000 firms having been formed since 2009 (and according to Preqin, there are 1,023 firms in market right now for a new fund).
So what should emerging managers, the super majority whom are seed focused, expect when fundraising in 2020?
A few items:
- Family office allocation disruption — In our late 2018 emerging manager survey, we 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’s). Over the last 5 years, we’ve seen family offices as incredibly active (albeit opaque) participants in emerging fund allocations and in co-investments. While there certainly remain a large contingent of family offices with long histories of being as durable investors across market cycles, a material number of family offices just began investing in venture during the post-2009 period of economic prosperity. We should expect those in this latter group, particularly those whose family wealth has been generated from areas outside of tech, to retrench to varying degrees while waiting for some semblance of true macro visibility. I don’t believe that the paradigm has shifted completely from yield chasing to liquidity hoarding, but 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. With business travel partially suspended for many (also reducing the number of serendipitous touch points at industry events) coupled with general Macro anxiety, I’d recommend managers, particularly those with Fund I/II offerings to plan for an 18+ month cycle from initial fundraising launch. There will always be exceptions, chiefly those that are spin-outs from larger funds.
- Soft commits — Soft commitments are verbal (or over email) commitments by LPs who have yet to sign formal fund subscription documents. These commits have always been a bit capricious in even the best markets, and we generally advise fund managers to haircut soft-commits by 30%-50% when planning a close. Especially for those with reliance on non-institutional LPs, I’d recommend haircutting soft commits by 50–70% when planning on closings.
- Institutional behavior — During the first 3–6 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 2 year fundraising cycles, larger fund sizes, and pre-emptive “shelf” raises (raising a fund before needing to activate, and often not going live with new fund for 3–9 months). While Q2/Q3 have historically been when many institutional allocators start actively meeting new groups, the travel slowdown may affect meetings in the short term, regardless of if managers are willing to travel. While Zoom calls help, it’s doubtful any institutional investors will be making commitments w/o several in-person meetings. I’d also expect those without active emerging manager mandates to be even more deliberate in 2020 (this is based on a handful of conversations I’ve had over the last couple of weeks).
- Fund II/III offerings — During the course of the last decade, many managers have successfully raised follow-on funds every 2–2.5 years, largely using mark-ups to demonstrate traction. As these metrics early in the fund’s life have shown little correlation to ultimate fund performance, we should expect LPs to heavily discount these numbers to wait for more portfolio seasoning before re-committing (both to determine how the portfolio weathers a less founder friendly valuation market in the coming quarters and to see if any liquidity is realized). I also think that managers will be asked to extend time between funds to 3 years, and encourage a slower deployment pace. Regardless, 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, things could shift dramatically if positive developments quickly occur with COVID-19 and the public markets rapidly stabilize. However, I think it’s unlikely based on the history of past pandemics and the current info we have on the contagion level (I’m definitely not purporting to be an expert of any type).
As a result, while managers certainly shouldn’t panic — As we all know, it’s wonderful place to have dry powder in uneven and anxious markets — a bit of conservatism and patience around fundraising targets, timeline, and process should be exercised.