This year will likely be a sore spot for venture returns. While we haven’t seen drastic down rounds or sensationalized startup shutdowns yet, if the market continues on its downward trend, it feels all but inevitable.
While some firms can shrug off a bad vintage or two — thank you, management fees — poor performance hits their investors (limited partners, or LPs) the hardest. But despite the fairly certain future performance hit, institutional LPs like to play the long investing game. Because of that, they aren’t generally a very reactive bunch.
So I was surprised to see that the Fairfax County Employees’ Retirement System told Insider in May it was putting a pause on new venture relationships — while interestingly still investing in crypto — while the New York State Teachers’ Retirement System voted in August to cut their venture allocation by five percentage points for next year.
The pair of news items made me curious if this particular downturn was actually enough to sway LPs from their historic investing norms, but according to LP consultants, these two venture backers are most likely outliers. The consultants said even if things get much worse before they get better, LPs have more reasons than not to stay the course.
Fundraising data from this year backs this up. According to PitchBook, venture capital firms raised $121.5 billion in the first half of 2022. Kari Harris, an attorney at Mintz law firm, which is focused on firm fundraising, told TechCrunch it seemed institutional LPs have been slower but still active. She added that firms definitely still have the upper hand as far as fund terms go, which signals the market is still strong.
For one thing, some LPs have learned their lesson from being too reactive in the past. Joshua Beers, a principal and head of private equity at consultant NEPC, told TechCrunch that some investors got spooked and retracted in the last financial crisis, but that decision didn’t turn out well for them.
“Those that left the market in 2009 likely lost out on some really great performance,” Beers said. “I think there are definitely some LPs that are thoughtful of that now and really want that vintage-year diversification.”
By “vintage-year diversification,” Beers is referring to the investing practice of backing funds every year so that a portfolio won’t be too tainted from a bad year — like this one is shaping up to be.
Beers added that choosing to sit out this year, especially if a fund series an LP has been traditionally investing in comes to market, may sour relationships with good managers and impact future potential to invest with them.
“If you have to invest less, do it, but don’t sit out,” he said. “Even if you have to halve your commitment to protect your allocation. The other challenge with venture in particular, if you were to forgo a fund series, that almost prohibits you from getting back in at a later time.”
He added that the money most impacted by the current downturn is what was already invested, not the money that would be going in now, so investors should stay committed to their pacing plans and vintage diversification strategies.
John Coelho, a partner at consultant StepStone Group, agreed.
“Venture is a long-term asset class,” Coelho told TechCrunch. “We advise our clients to steadily commit and not to go all-in in one year and out the next year.”
But even if you ignore all of the sentiment about portfolio diversification and consistent pacing, Coelho and Beers both said that LPs should keep investing in this market because it will likely pay off.
“When there is a dislocation or stock market correction, the vintage years that come right after those events have been among the best vintage years,” Coelho said. “That’s when there is less capital, valuations are down. There are not [as many] copycat-type founders.”
Beers added that while early-stage venture funds have been the most compelling place for LPs to house their money in a quest for the strongest returns, this environment could create new opportunities for smart bets in late-stage funds.
When late-stage writedowns really start to proliferate — which he predicted could begin as early as September — funds will be able to get into solid late-stage companies that were maybe too expensive to be worth investing in last year. This could open a new avenue of funds for LPs.
If some non-institutional investors pull back — which seems more likely as some are just in the asset class opportunistically — institutional LPs may have additional opportunities and should absolutely stand firm.
“Venture may not lead the way for the next 10 years,” Coelho said. “The opportunities are out there, even despite the challenges in the market. There are still compelling opportunities at every part of the venture spectrum.”
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