What LPs Really Think About Soaring VC Returns
Originally a thread on X/Twitter:
1/19: I asked a number of institutional LPs that invest in VC funds what they thought about the recent rise in exit valuations and if the resulting VC results were going to impact their view of managers and allocations. You might be surprised about what they said! Unpacked:
2/19: Theme #1: A significant number of VC funds are posting better than expected returns driven partially by companies in their portfolios going public in today’s crazy environment. The LPs have an interesting view of what this means/how it impacts their view of specific VCs.
3/19: Many funds that were forecasted to deliver 1.5X MOIC are going to end up as 3X+ MOIC funds due to today’s late stage private and public market valuations. They love the returns but care about how they were generated as much as the actual outcome.
4/19: One LP said they’re studying the top 20-30 IPOs and SPACs of the past 12 months to see who owns what with an eye forwards determining which managers got lucky and which ones repeatably have been able to find winners. Consistency trumps incremental returns.
5/19: Another LP pointed to the power law of venture and the truth that in investing luck can drive results. When they evaluate managers, much more goes into their assessment than returns. Some vintages will be kind to all managers but very few can perform when the tide is out.
6/19: One LP observed that some managers generate extraordinary returns backing marginal businesses that ultimately don’t hold up well over time post acquisition or as public companies.
7/19: Selling marginal companies to strategic buyers or public market investors at inflated prices factors into this LP’s assessment of their managers because it’s difficult to generate consistent returns as a carnival barker.
8/19: Another LP stated that they’re pretty discerning and can tell when a VC routinely backs companies that build mouse traps that are enduring and sustainable. Liquidity generated when a company is still figuring things out is not the same as liquidity from a great company.
9/19: The best VC managers routinely back companies that a typical public market investor would want to hold onto for a long time because they are obviously good businesses. Good managers spot good businesses when they’re still private.
10/19: Theme #2: There’s always been a disconnect between public and private valuations but it’s unusual how today’s public market investors are willing to pay more than private market investors.
11/19: One LP believes that public market investors have flipped to become more long-term oriented than private market investors. 2020 and 2021 results are being overlooked if a business will accelerate post pandemic (typically digital/software businesses).
12/19: Public tech valuations look crazy relative to 2021 and 2022 numbers, but certain companies’ growth rates can start to look attractive in 2023/2024. Paying today for 2023/2024 results is very long term focused relative to historical norms.
13/19: The big unknown is whether the public markets are being rational because “how high is up” is so much higher than was ever expected. The biggest companies are worth $1-$2 Trillion! Great companies can now be worth $100B+ when in the past these were $20-$30B outcomes.
14/19: If true then valuations in the private markets are a bargain and everyone should be bidding up the best companies with the most potential. With a right hand tail that’s longer than ever before, it fundamentally changes the return profile of private market investing.
15/19: Theme 3: Public markets liquidity is returning capital to LPs. They want to recycle the money in Privates but mainly into established managers. LPs are interested in finding emerging managers but the bar is high because the top-tier established managers are doing well.
16/19: Early stage funds are coming back to market with opportunity/growth funds and many are requiring LPs to take their pro-rata between the funds. Late stage funds are deploying money quickly and passing the hat for more. These factors are sucking up excess capital quickly.
17/19: Some of the “raise more capital” behavior is driven by VCs’ desire to defend ownership in their winners. Many managers believe that the risk/return trade-off in their best companies is amazing in every single private round.
18/19: More capital is also needed by fund managers given the increases in average round size. Growth is being valued over profitability and growing quickly requires additional investment to be put behind customer acquisition efforts
19/19: The TL;DR: All VCs should assume their LPs have great BS detectors. They want to back managers with repeatable strategies over lucky managers. They trust the best managers will navigate today’s market well and seek to put more money in the hands of those they believe in.
(Feel free to share with your favorite VC fund and pull them into the conversation!)