State of the LP Market w/ Beezer Clarkson, Partner at Sapphire Ventures
I.e. here's how money is flowing through the ecosystem to startups
A lot of conversation amongst VCs today is centered around what is happening with LP capital. Limited Partners (LPs) are the key partners that enable VCs, Private Equity Funds, Hedge Funds, Infrastructure Funds and much more to invest in founders, public companies, and real assets. The capital comes from many sources such as foundations, endowments, pension plans, fund of funds, corporate balance sheets, family offices, and more. When capital invested into funds becomes scarce, it correspondingly has an effect on the amount of startups that can be funded as well.
To give us an overview on the current State of the LP market, we have the pleasure today of hearing directly from Beezer Clarkson, Partner at Sapphire Partners and Board Member of the NVCA. Beezer has over 20 years of investing experience and has evangelized the #OpenLP movement, which aims to bring transparency to the entire venture ecosystem (LPs → GPs → founders) through many thought leaders and voices in the industry, including her team at Sapphire Partners. I could not be more excited for readers to learn from Beezer today in this post.
I’m going to start with a broader question. What should GPs know about the current state of the LP market?
At the risk of stating the obvious, the LP world in many ways looks very different from a year ago, even six months ago. While we have seen a series of very large venture funds raised already this year – bringing the total raised north of $100BN for the second consecutive year – many LPs’ budgets have changed given the state of the public markets and the potential state of their private holdings.
This change is playing out in a few ways. LPs are still allocating - hence the fundraising year to date – but we expect that many institutional LPs were likely already tapped out by the end of Q1, given the number of existing venture managers that either raised in Q1 or told their LPs they were coming back this year. Remember, while this year has seen a significantly less active IPO market and a lot less liquidity back to LPs in general, the last few years prior saw many record return statistics. I would assume LPs re-upping to existing managers this year and are re-committing to venture managers who have returned capital recently as LPs have faith these same managers will know how to successfully weather a downturn.
An open question, of course, is how many venture firms will raise in the second half of this year. I’m hearing many GPs are slowing their investment pace both because of the market , as well as the reason they don’t want to have to come back to their LP base this year. While I hate being the bearer of not-so-optimistic news, my instinct says that for those venture managers who have not yet institutionalized their LP base and are still developing their portfolios - so have some TVPI but less (or no) DPI. This will be a much tougher market to raise in for multiple reasons. LPs may have either allocated their funds this year or are under liquidity pressure themselves, and it could be they’re sorting for venture managers they feel understand how to manage in down markets as well as up markets. Because we just had nearly a decade-long bull market, many venture managers have not invested in a downturn - which is not to say they won’t be able to successfully - but I believe VCs should be mindful that LPs will want to understand how they plan to successfully manage a portfolio through a downturn with no prior experience.
Can you describe portfolio allocation and how that is affected at times of major changes. For example, some folks bring up the “denominator effect” saying that as value has fallen in various assets, allocations to stuff like venture or private equity can become “overallocated”. Is that happening now and if so, why does it matter? Is the way to correct this overallocation simply to slow down investing or to increase investments in another area as a counterweight?
From my experience, LPs and VCs are alike in that both strategically think through how they want to invest their capital. For certain LPs who invest in a range of assets this can mean a certain % for venture, another % for PE (buy outs, growth equity, etc), then another % for public managers (stocks, bonds or both), real estate, etc. (e.g. 40% public equities, 20% private equity, 10% real assets, etc).
Over the last couple of years, we’ve seen many VCs raise a new fund every 1-2 years, or even multiple times in one year – much faster than the historical 3-4 years – and sometimes raising bigger funds and/or multiple funds at once (e.g. early + opp or growth fund). This meant many LPs going into this year were already at or over their target allocation to venture.
As we have also seen, many public equity markets are significantly down from recent highs. For example, if venture was supposed to be 15% of your portfolio, but that was including public positions that are now down 50-70%, your ‘denominator’ – or the size of your total portfolio – just shrank. As the private market valuations generally do not get re-priced as quickly as the public markets, it would follow that your 15% in venture probably looks much larger now (perhaps 20-25% or more).
That is the denominator effect: your denominator shrinks so your (in this case) venture allocation looks larger than before, which can then force LPs to cut back on putting new dollars to work into venture funds, including existing managers.
Another important aspect of portfolio management that LPs should consider is liquidity. LPs can use liquidity to re-invest in venture funds or to meet other obligations of their portfolio. As an example, many foundations must give away a certain amount of capital per year, or endowments might have school associated expenses to fund, etc. If an LP is already over-allocated to venture and there is no or very little liquidity coming back this year, that puts further stress on the system.
Within the venture bucket, how do market downturns like this affect specifically the mix of the venture allocation? Does capital for certain stages of funds diminish (early stage, growth, late stage), does the LP strategy change at all?
Depends on the LP of course, but for many of the institutional LPs that I know, when they set their venture allocation strategy, they’re accounting for the entire course of being an LP (which can be a multi-decade experience), and they assume upfront there will be bear and bull markets.
Sapphire Partners, for example, focuses on investing in primarily early stage venture funds. That focus doesn’t change in up or down markets, it is what we do :)
This may be a dumb question but is there risk of LP capital significantly drying up given the slower pace of distributions?
While I don’t foresee LP capital drying up en masse for venture, I do know multiple LPs who are rethinking their budgets based on revised cash flow modeling assuming exits they had thought were coming this year will take longer.
LPs also take into account how much exposure they have to a sector or a firm as part of their own portfolio. For example, if a fund is back fundraising on an annual basis instead of every two or three years, LPs might cut their check into each individual fund raised. However, over the course of those three years, that LP may have the same overall allocation as if they did one bigger allocation into one three year fund.
A lot of VCs are telling their companies to favor capital efficiency during this time rather than growth. The common advice is to extend runway as much as possible. What is the equivalent advice that you would recommend to GPs?
Yes. Many GPs were on average raising funds much faster over the last couple of years and deploying more rapidly (say in 1 year instead of 3+). While not one answer works for every situation, in general, LPs we know are supportive of VCs slowing down and going back to more historical norms of investing a fund over multiple years – keeping the bar very high for new investments as well as follow-on’s.
When you are looking to invest in GPs, what specifically are you looking for? Does this change at all during market downturns?
We look for who we believe will be exceptional early-stage investors, which can take a variety of forms: single GPs, first time funds, established multi-partner firms, generalist or thematic. This doesn’t change during a market downturn.
Any other areas that we didn’t cover that you think are important for GPs, Founders, or other constituents to know?
This is a really good time to develop stronger relationships with your LP. Most limited partners aren’t surprised by slowing growth due to the macro-economic climate, but they still appreciate clear communication about what is happening in your portfolio. As down rounds become more common, LPs appreciate GPs who demonstrate and communicate a clear understanding of how their portfolio companies are positioned and where there is risk. At a minimum, this means having a solid understanding of burn rate, cash runway and supporting logic for current valuations. Let your LPs know what your perspective is on your companies’ ability to fundraise, which are hitting their metrics vs those that may be in a tougher situation, and companies that must raise this year vs those that have a year (or two) to continue to build the business before raising again. Communicate this proactively to your LPs as well as what this market means for your current pacing.
Some stuff I really enjoyed reading this week:
If there’s one podcast you listen to, do this one with Peter Attia. He has several more comprehensive podcasts that dive into the science behind it, but in this pod he explains in plain terms how to increase our longevity through 1. exercise (certain types especially) 2. sleep 3. diet 4. stress 5. chemicals put in body
This premium blog post by Hhhypergrowth on enterprise companies & products best positioned for Federal spend is a goldmine of info on how infra is adopted into federal customers, highly recommend subscribing: https://hhhypergrowth.com/premium-federal-update-3/
Liberty’s newsletter is a must-subscribe as well. The coverage on Cloudflare’s Q2 earnings and how they adjusted from productivity messaging to cost & ROI messaging to continue to win customers in this environment is great
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