As much of the world shelters in place, nearly every client conversation we have with our venture capital fund clients comes around to some version of the questions "what are you seeing" and "will all of this impact our fund raising plans". We acknowledge the lack of clarity, at present, regarding the eventual duration and depth of the global health pandemic, and the associated impact on financial markets. Nonetheless, as we are now several months into these events, we thought it timely to provide our observations, initial in nature as they may be, regarding the present market for venture capital fund raising.
As background, our commentary here is based on interactions with hundreds of venture capital firms, all differently positioned. The punch line of the situation is that the impact of COVID-19 on fund raising will inevitably interrelate with a manager's particular attributes: investment area of focus, geography, size, performance, LP base, investment team composition and location, amount of dry powder and proximity to natural fund raising time, and cash position of portfolio companies, among others. In addition, further developments in coming weeks and months in regard to macroeconomic conditions are also likely to factor into fund raising outcomes, particularly in respect of the potential association of the public markets' performance with ability and desire of institutions to commit to private investments (the "denominator effect"). The snapshot from our seat at the table looks something like this:
Timing of Fund Raising
As the pandemic unfolded, managers were in various stages of fund raising: some were in market already, some were soon to be, some had plans to go out later in 2020 and others had no such near term plans at all. Those that were already in market and on their way to their targets were best positioned to proceed and, with rare exception and not surprisingly, those deals have had the desired outcome for the sponsor.
As to funds being offered by established sponsors that were about to launch as the pandemic unfolded, in general we have seen more of them continue unabated, perhaps with slight adjustments to timing or target capital amounts. We are heartened to have seen some major closings including a billion dollar plus "one and done" a few weeks into U.S. shelter in place orders, and we are likewise enthusiastic about the near-term 2020 pipeline. We are not hearing from essentially any prominent managers in important investment sectors that they are making major changes to near-term 2020 fund raising plans, though in select cases minor changes might include small modifications to timing or the holding of an additional closing to accommodate latecomers with logistical delays due to the pandemic.
Where established funds were scheduled to launch later in 2020, a demand for a closer look at unfunded reserves and the adequacy of current capital for continued operations may arise, and managers are often being asked by LPs to be transparent and to disclose a thesis as to why additional capital is needed in the planned time frame. These managers may need to focus on explaining how they are working with portfolio companies to manage cash flow (thus indirectly reducing pressure on fund raising until a later time). Where there is a chance to push fund raising out in time to where there might be more clarity, not only regarding the course of the pandemic but also on valuations, that has been the preferred choice of some managers; however in at least a few cases managers are electing to accelerate fund raising based on cash needs or in some cases a view that it is better to go out before there might be even more uncertainty in financial markets. Interestingly, we note that some projects have also sprung to life on theses that are tied directly to an intent to capitalize on market dislocations (e.g., overcorrections) or with conviction based on anticipated lower valuations in future rounds of outstanding private companies. This is a new trend in our experience likely tied to "lessons learned" following the previous global financial crisis.
While the sample is more scattered, we sense hesitancy and are discussing various types of changes in plans among pure "emerging" managers who were in process or planning initial funds in the history of their franchises. We've had a number of related discussions tapping into our prior experiences in down markets and how emerging managers successfully or unsuccessfully navigated those choppy waters to meet their fund raising goals and LP base construction. At a minimum, some of the family offices or high net worth individuals that might have been the target audiences for emerging manager deals are reassessing their programs, and "go slow" orders do seem to be cropping up in some instances. On the other hand, we have already successfully closed first time funds during shelter in places times, including funds that were oversubscribed and engaged in cutbacks. So while the situation for emerging managers is not a "nuclear winter" by any means, in some cases there is evidence of more caution on behalf of investors and the need on the part of managers to proceed thoughtfully.
Market Segment and Past Performance
Drilling in slightly deeper, for funds about to be in market as the pandemic was declared, the investment area of focus, construction and dynamics of the management team as well as performance (as always) have seemed most pertinent to the outcome. The pandemic for now has arguably created "winners and losers" at the portfolio level; those managers focused on areas such as ed-tech, health care, remote enterprise, online entertainment, semiconductors, online communications and other similarly related sectors have in our recent experience mostly been encouraged by investors to go ahead with fund raising especially where there is any potential for a delay to leave the firm with inadequate dry powder for any period of time.
On the other end of the spectrum, managers focusing or overweight in consumer discretionary, retail, travel, hospitality, offline entertainment and the like have faced resistance in some cases, particularly where there is any perception that additional capital would be used to support distressed companies. Notably, more venture managers are technology and life sciences focused, as compared to retail and consumer, and inasmuch, the industry may prove somewhat resilient to current macroeconomic events.
The LPs' Point of View
Our observation from an LP standpoint has been that, in general, investors are continuing to go ahead with their process for deals that were significantly advanced (for example, where on-site due diligence had already been completed). Many of them appear to have taken note, looking back to 2008 and the aftermath of the financial crisis, of the value of having dry powder to make investments as purchase price multiples level off and then drop during times of crisis. Savvy firms we work with are highlighting this. For example, a prominent Silicon Valley venture manager recently highlighted at their annual meeting, held online, that they continued to invest at an ordinary if not heightened pace through the 2001 and 2008 down cycles and investors were very much better off for it.
Regarding deals scheduled to go out later in 2020, it remains to be seen if on-site due diligence will be successfully replaced by remote due diligence, to the extent global travel does not resume in the near term, and if not, how that impacts fund raising. With that said, as we witness fund managers pivot fairly successfully to remote operations, as well as to remote investor relations (i.e., web-based annual and LPAC meetings, etc.), it seems promising that a mere lack of travel will not itself have a materially detrimental impact on fund raising later this year, especially for those firms that have been nimble enough to efficiently and effectively migrate their flow of work to remote. One key for LPs will likely be whether they have already "been in business" with the particular fund sponsor in prior funds, or at least have had an in person visit with the team prior to the current lockdown on in person meetings, providing additional headwind for emerging managers as well as a potential headwind for established managers looking to increase their LP roster.
Another trend to point out is that the industry, pre-pandemic, has been responding to a landscape where private companies stay private and require support longer, as borne out by the formation and use of a myriad of SPVs and top-up funds to capture late stage investments in portfolio winners. We have not seen that currently abate, and if anything, some managers that may have done one-off SPVs in the past (especially where their focus is on in-demand market sectors), or may have simply let later stage opportunities go to others, may take this as a chance to launch a growth fund product. Accordingly, there is the potential for a convergence of views and motivations: LPs understand the impact of the 2008 downturn on valuations and want access to these opportunities; and GPs have access to allocations in these sorts of deals and want to capitalize on that. Multiple products we are working on that are either in market now or coming to market soon will offer top-up fund vehicles to capture this perceived opportunity, and in general we think the trend of strategically raised SPVs and top-up funds is very likely to continue, if not expand.
A further observation relates to the "denominator effect". During the global financial crisis, many LPs significantly curtailed their investments in private funds as they became overweight as public markets fell. Commitments were cancelled and relationships were pruned. Our perception was that in many cases this was quite formulaic and rigid. While we have seen a small handful of institutions back out of recent deals specifically citing being overweight in privates, we are encouraged and hopeful that the rigidity of the position held in 2008 may have shifted. It would seem that taking into account post-2008 IRRs in the space, this is savvy. Many LPs have indicated to managers we work with that they now have greater, in some cases much greater, ability based on internal policy to break target limits where there is public market stress, so as to be positioned to capitalize on the potential for favorable private valuations moving ahead. We think this is healthy, and are glad to hear it. This evolving area deserves continued focus.
Finally, we have been watching developments as they relate to geography. Of the hundreds of venture firms we represent, somewhere around 15% of them are Asia-based. These firms and especially mainland China firms are a cycle ahead of U.S. firms, in the sense that their shelter in place orders came sooner, and have for now been lifted. We watch with interest the trend lines as these firms get back to business, at least for the time being. The initial observations are promising, in the sense that the return to work flows, and the resumption of investing if not fund raising, seem to us for now like a "V shaped bottom". This area deserves continued monitoring and we intend to watch Asia venture capital fund trends for potential signals about the U.S. market.
Advice to Managers
Our general advice to venture capital fund managers who are thinking about fund raising plans for 2020 or beyond is to assess your own unique situation, and talk to your investors. We have found that sometimes managers have assumed LPs would desire a fund raising freeze only to discover through analysis and discussion that, in fact, LPs wanted the manager to push ahead, if not also accelerate and/or create extra opportunities for later-stage deals. This is clearly not what every manager will discover on thoughtful diligence with their LPs, however it is important now more than ever to spend time having these detailed and honest conversations with LPs and formulating strategies around what is learned from them.
We are aware of a small number of prominent managers that are in frank conversation with their well-known investors, and highly institutional limited partners in certain of these cases have agreed to particular timing with respect to current or future fund raising plans, including delays in planned fund raising, made feasible by ready dry powder in existing funds. The wisdom of this type of collaboration is plain: doing the right thing for your investors nearly always makes sense in the long run, and we imagine that such managers will be well served by this collaboration when they do return to market.
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