Follow me @samirkaji for my random, sometimes relevant thoughts on the world of early stage venture and start-ups.

Recently, I received an email from a seed fund manager inquiring about current Limited Partner appetite for investing in new seed fund managers. The query was in response to a declaration made by someone closely connected to LP’s that the current fundraising environment for venture is worse than what we saw following the housing bubble collapse of 2008.

I’m not sure I fully agree with the statement when juxtaposing 2009 with today’s macro environment. Even with the recent public equities sell-off, the Dow is 3.5X larger than during Q1 2009. The current unemployment rate of 4% is less than half of what it was in 2009, and economic fundamentals appear to be robust. And with four consecutive years of $30B raised by US venture funds, it appears to be a very strong fundraising market for venture.

However, putting aside these macro fundamentals, I do believe that the statement has merit within the emerging manager circuit, and for many new firms (particularly unproven Micro-VC’s) raising in 2018, the chill may be similar to what all of venture faced in 2009 and 2010.

So why do I think that this will be the case?

Many Limited Partners made their Emerging Manager bets during 2013–2016.

As shown by the chart below from May 2017, 480 sub-$100MM fund I offerings were raised between January 2013 and December 2016. 

During this time, both family offices and institutional investors (Fund of Funds, Endowments, and Foundations) actively invested in new emerging manager funds in hopes of landing an early spot with the next First Round Capital, True Ventures, or Felicis Ventures — note that many LP’s have had active emerging manager mandates over the past 5 years. However, beginning in early 2017, I’ve observed large masses of institutional LP’s recasting strategy and becoming content with simply following on to the bets they made in 13’-16’, and only opportunistically adding new names (often only 1–2 names/year). With many existing Micro-VC firms coming back to market in 2018, a significant portion of institutional allocation is already be spoken for.

Higher opportunity cost

For most new managers without existing and transferable investing track records, the family office market has served as the primary source of capital.Aside from the difficulty of finding family offices that are allocating into venture funds (most do not publish investing strategies publicly), the bar for meaningful allocations ($2MM+) has dramatically moved upward in recent quarters.

Much of this reality centers on rising opportunity costs, both with other venture investment opportunities and other asset classes. On the former, Preqin pegged nearly 600 1st time funds in market globally in their recent report. This level of competition ensures that securing family office capital remains tough as the difficulty of comparing managers and picking a select few is at an all-time high.

Further complicating matters today is the rising opportunity cost against other asset classes. As of last week, tax-exempt government bonds hit a four year high, with many investors believing that the recent tax reform and an expected rising interest environment will push bond pricing even higher, offering a very attractive economic option for yield starved investors — many of which in recent years have had to increase risk capital allocations to generate reasonable outcomes.

Additionally, other risk capital opportunities like crypto could further push risk capital away from investing in venture funds, particularly unproven ones.As such, venture managers must realize the decision matrix for LP’s is much more complex than whether they believe a certain manager is interesting or may do well.

Liquidity, liquidity, liquidity

Despite the massive increase in dollars flowing into venture capital backed companies in recent years, the exit environment is decidedly tepid. 2017 marked the 3rd consecutive year of declining exits, much of which can be attributed to companies staying private longer due large supplies of late stage capital (hello, Softbank). However, the net result is less recyclable capital in the system.

Fortunately, a string of bellwether exits (AirBnB, Uber, Lyft, Palantir, etc.) could quickly cure venture liquidity issues by bringing dollars back to LP’s, opening the gates for companies sitting on the sidelines, and providing the market with more public acquirers.

As a wrap-up, I do think a fundraising winter of sorts is coming for new fund managers that do not have attributable and relevant track records. We also believe that it will difficult for firms that are coming back to market with fund II offerings at amounts that are significantly scaled from the prior fund as it is unlikely that early portfolio mark-ups will provide enough market validation to counteract the headwinds listed above.

On the positive side, the majority of large LP’s agree with the view that we are just entering into a sustained golden age of innovation, led by transformative technological advances that should occur across every industry vertical.

Instead of fretting or avoiding fundraising, it’s just important for managers to actively recalibrate expectations on fund targets, time and energy spent fundraising, and required strength of fund fundamentals.

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