VCs under pressure - 'LPs are not happy'
Founders might think that VCs have an easy life. When markets are surging forwards they may be forgiven for thinking so. But right now, after an abrupt market correction, VCs are feeling the heat. Limited Partners (LPs), the investors in VC funds, are stepping back from new commitments. Fundraising by VC firms hit a nine-year low in 4Q22, according to the latest reports. VC fundraising dropped 65% in 4Q22 compared to 4Q21, with a mere $20.6B being raised. This is the lowest figure since 2013 and marks the largest disparity with the level of funding in the preceding three months since 2009. LPs invested in only 226 VC funds in 4Q22, the fewest for that time period since 2012. This is in sharp contrast to the peak of 620 VC funds in 4Q21. Factors such as inflation, extended effects of the pandemic, and overall market instability are all considered to have caused hesitation amongst investors and a pull back in funding for both startups and, now, VCs. But this is just the public face. Behind the scenes, tensions between VCs and LPs have been brewing for a while. We are now starting to get a taste for what's in store.
Respected VC, Gil Dibner of Angular Ventures, says in his blog this week that a lot of LPs are frustrated and unhappy with how VCs have been conducting themselves. This follows his earlier 10-point Twitter thread which started, "We talk to a fair number of LPs. If we connect the dots, it seems there is a huge explosion coming. Here's how it might unfold..." Dibner goes on to set out some of the worst habits that VCs adopted in the bull run up to 2021. The essence of his scathing analysis is that VCs have raised and deployed too much money, too quickly, and at ridiculous prices. "There are many funds out there that deployed THE ENTIRE FUND at peak valuations". Even those that held back reserves face a new problem: "Hold reserves for the messed up ones or make new investments that are much smaller and more rationally priced? Bad performance is already baked in...not an easy choice." Then the revelation that a lot of funds jacked up their fees well above the standard '2 & 20%' that ruled the industry for decades. "This means that NET DPIs are going to be even worse than they would have been had the funds not been greedy." Overall, this is a brutal assessment that lays bare some of the worst excesses of recent years.
As VCs have been pulling back in their deployment of funds into startups since early 2022, whilst still charging these big fees, Limited Partners are getting restless. Some funds may even have to consider returning capital to LPs. This is set to precipitate more pain as many VCs have really beefed up the size of their teams over recent years and they need the big fee base to carry these extra people. Slower deployment of capital means there is just a lot less for these bloated teams to do. The danger (for founders) is that these VCs will all want to look busy. Many will be taking meetings and pursuing discussions with founders knowing that there is very little prospect, if any, that they will invest. But amongst the noise, there is some relief: There is still a good number of really decent funds out there that kept their feet on the ground in recent times. They stuck to their knitting and didn't get (excessively) carried away with the market exuberance we all witnessed, especially in 2021. For the rest, expect a big shakeout as some funds are forced to return capital, cut costs, and employ a more disciplined approach. This will be very painful for some VCs and far from the much easier life many had become accustomed to.
Crossover investors play increasing role in Europe
Crossover investors such as Baillie Gifford, BlackRock, Tiger Global and Temasek have become key players in the tech ecosystem. 2021 was a marquee year, with crossover investors involved in $60B+ worth of VC deals, or 13% of global VC, according to a new report from Dealroom. These big hedge funds and asset managers are a special breed as they span both private and public markets. Typically investing in one of the last private market rounds before backing companies again at public listing and then post-IPO, these enormous funds started competing against better-known VC funds for deal flow as companies stayed private for longer in recent years. The impact: crossover-fund-backed startups started going public faster, more often, and at a higher market cap than peers without crossover backing. As markets turned in 2022, many in the VC community predicted that these so-called 'venture tourists' would simply withdraw from mainstream VC. Whilst activity levels have dropped back from the heights of 2021, what we are now seeing is a repositioning rather than a full retreat. Importantly, early stage investment has become a key thrust.
Until 2020, global crossover investors were mainly active in the US and Asia, allocating more than 80% of their investments into these two markets. However, from 2020 to 2022 investment allocations changed significantly. As the US proportion sank from 68% to 52% and for China from 13% to 2%, European allocation doubled from 9% to 18% - an all-time high. Crossover investors accounted for 8% of all VC funding by value in Europe in 2021, up from 1% only five years earlier. In 2022 their activity dropped back to 6%, but was still 1.6x higher than in 2020. As crossover investors increasingly turned to Europe, several have established European offices and on-the-ground teams. The UK is the favoured landing spot and as a result UK startups have raised the most VC funding from crossover investors, followed by Germany, Sweden and France. A big part of the value-add is that crossover investors can add global experience and network to IPO candidates. Almost 25% of the latest European tech listings were backed by crossover investors. These companies went public 50% faster, 2.3x more often and at 148% higher valuation compared to companies without a crossover investor.
Historically, crossover investors have been most active in later stages, with over 60% of the rounds happening at Series C+ from 2016-2020. Seed and Series A accounted for just 20% of global deal flow. But the tide is turning. Last year was characterised by two trends: crossover investors started to diversify their deal flow by increasing the focus on early-stage funding rounds. Almost a third (31%) of their venture cheques were for Seed to Series A startups in 2022. At the same time, they cut heavily on late-stage rounds (Series C+) due to the massive squeeze on valuations. This ability to invest across the venture stages could have significant implications for European businesses. Europe has a considerable late-stage funding gap compared to the US. The European share of global VC funding steadily decreases from early- to late-stage. While Europe thrives in startup creation it still lacks the ability to scale them up. This gap in late-stage funding is caused by a lack of specialised European late-stage investors with deep capital pools, which also contributes to the gap in public market value creation. Crossover investors can play an essential role in filling these gaps and supporting more private value transition to the public markets. Founders would love to see more of this.
What to expect from a lead investor
Lead investors play a crucial role in funding. As rounds are often syndicated, especially at Series A and beyond, the lead investor brings efficiency to the process by 'catalysing' the deal: They corral the new investors behind a set of terms (the Term Sheet) and, on behalf of the syndicate, negotiate these terms with the founder. The lead investor will usually put in around 50% of the cash, but this can vary depending on the number of syndicate members. Some investors will prefer to 'follow'. Followers may not have the investment firepower to lead nor might they have the resources (or even the expertise) to bring a deal together, which can be considerable. And if they are based on a different continent, they may prefer to have a local investor lead, simply for convenience. By looking at their investment history, founders should try to identify which of the investors they are targeting are likely to lead and which are more likely to follow. It shouldn't necessarily dictate the order in which investors are approached. A prospective lead investor may be more motivated to get behind a deal where several 'followers' have already expressed strong interest.
The lead investor can also smooth the due diligence (DD) process by minimising the degree of independent DD each investor needs to undertake. This can be a real bonus for founders as supporting investors through the DD process can be very time consuming. A competent lead can also reduce the friction that occurs between Term Sheet and the final Investment Agreement. This requires a strong grasp of legal matters (in the jurisdiction where the deal is being done) and the ability to appoint and manage the lawyers who will be responsible for the drafting. In deals where some syndicate members are based outside the UK, having a lead investor that has an established working relationship with a good UK law firm can be a huge benefit. Negotiating final agreements with overseas law firms or with a hastily appointed UK firm that may not be familiar with venture deals can, at the very least, create huge frustration. In some cases it can severely delay a closure - or even derail it.
Lead investors accrue an authority that comes with being the 'dealmaker', extending beyond that of a key shareholder and (most likely) board member. This combination provides a certain prestige or soft power that can be leveraged post-deal. Whilst all investors are owed the same duty, it's likely that the executives will be most responsive to those that have the greatest leverage. Some VCs will quickly try to position themselves as the prospective lead for this very reason. Provided they have a solid track record in this role and have the gravitas to act on behalf of other funds, founders should make the most of this capability. When building target investor lists, it is therefore important to ensure that potential lead investors are clearly identified and researched - then given priority treatment. This means identifying the specific partner who will lead the deal on behalf of the fund. Competent lead investors can be a huge asset. They can really smooth the process of dealmaking and make a founder's life a lot easier, both pre and post investment.
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