Unique events are transforming venture capital today. As an LP, you can either go on the defense or offense.
Raising a venture capital fund in any climate can be difficult — particularly for new partners. And 2020 seems to be an even bigger challenge. There has been tremendous instability in the public markets, the inability to meet face-to-face due to COVID-19, and, to top it off, it is a presidential election year in the United States.
The world is changing, fast. General Partners (GPs) will need to ensure that their investment thesis fits a world that is increasingly remote and increasingly digital. At the same time, Limited Partners (LPs) will need to adapt their due diligence process to adapt to this “new normal.”
In particular, we are seeing three key trends: 1) the migration of talent, 2) the globalization of venture capital, and 3) the growing use of data to source, diligence, and provide value to founders.
Migration of Talent: The lockdown caused by COVID-19 made companies embrace new technology and work from home overnight. While some struggled with the change, others leaned into the opportunity. Facebook, Shopify, Square, Twitter, Coinbase, Upwork, and others decided to become permanently remote organizations. This trend will accelerate the migration of top talent across the country and, indeed, across the world. Existing VCs have been slow to adopt this trend, which creates an opportunity for those raising first time funds. It will no longer be sufficient to invest only in your backyard.
Globalization of Venture Capital: VC is no longer a regional industry. Startups aspire to be national and global competitors — they seek talent from all places (as mentioned above), and the barriers to getting users or paying customers globally is falling every year. As a result, we are seeing globalization in the VC industry that was simply not the case 8-10 years ago. In fact, Kauffman Fellows Research Center reports that as of 2018, the U.S. now sees less than 50% of global venture capital dollars, down from 80% in 2000.
The Growing Use of Data: Traditionally, VC firms are introduced to startups through their network (e.g., former companies, other founders, business school connections). At best, though, VCs invest in one out of every 20 deals — which means they spend 90%+ of their time on companies that are not a fit. Data can create an advantage that can make all the difference in identifying the right company, before other VCs have the chance. We explore clear uses of data that can help funds with sourcing, diligence, and post-transaction support.
Right Now, LPs Can Decide to go on Defense or Offense
When faced with uncertainty or unknown situations, it is natural for humans to be defensive. This is especially true for LPs, as they are well-versed in risk management.
For LPs, being “defensive” means investing in existing funds, established funds, and large “index-like” funds. If an LP has already invested in a GP and they are doing well, it is very likely they will receive another check in 2020.
Yet, we know there are emerging managers (EMs) today who are building the next Andreessen Horowitz or Lowercase Capital. We know there are opportunities to ignore the conventional wisdom and build a new, more sophisticated venture fund.
We know this because there were standout companies that weathered the 2000/01 dot-com bubble (Qualcomm, eBay, and Amazon immediately come to mind). There is also an entire class of startups, led by Uber and Airbnb, that were built in the midst of the 2008/09 recession.
“There is rationale for being thoughtful and aggressive,” said Conrad Shang, Director of the University of Texas/Texas A&M Investment Company (UTIMCO). “While some LPs are dragging their feet, use this time to invest in notoriously hard-to-access funds and back the new innovative batch of promising general partners.”
“While some LPs are dragging their feet, use this time to invest in notoriously hard-to-access funds and back the new batch of innovative promising general partners.”
Being Thoughtfully Aggressive Can Diversify Risk and Help You Identify Breakout Fund Managers
Venture is an industry that is defined by being aggressive and visionary. In normal times, these characteristics are not enough to differentiate you.
But right now being aggressive and visionary are unique. Think of your capital as an opportunity. The best LPs are asking themselves questions like, “Who can I help that will do the most good?” and “Who is trying to solve the most audacious problem right now?”
If you can be thoughtfully aggressive right now — while others are pulling back — you can pick up clear wins. Moreover, we believe the most adaptable LPs will outperform those that are stuck maintaining the “conventional” way things have been done.
Outside of Silicon Valley, there are tech hubs being built in cities like Los Angeles, San Diego, Austin, Denver, Atlanta, Cincinnati, Portland, and Chicago.
Given the large shift toward remote work, we believe these tech hubs will only grow in importance, leading to two large shifts.
First, LPs should look at which geographies they are underexposed to and make investments. Now that meetings are taking place via Zoom and Google Meet, it does not matter if the fund is 30 minutes or 3 time zones away.
Second, LPs should demand their GPs think globally. “Are your GPs investing where the talent is? Talent is adapting fast, and funds are struggling to keep pace,” said Collin West, founding partner of Kauffman Fellows. He went on to say that funds with a strict geographic focus will miss out on breakout companies that are mostly or fully remote.
For emerging managers looking to launch their first fund, there is pressure to stand out and show that you understand where the market is headed. Put bluntly, the question LPs will ask is: “Why does this fund need to exist?”
A great answer to this question can change the trajectory of 2020 for you.
“Why does this fund need to exist?”
LPs Can Find Opportunity in Funds Solving Structural Problems in VC
Venture capitalists pride themselves on being bold and investing early. However, there are several structural problems in venture that have not been addressed yet.
Solving Funding Gaps
Our prior report shows how the coasts received two-thirds of all VC funding from 2001 to 2017. As mentioned above, we believe this happens because firms have a tendency to over-index on startups in their backyards.
While there has been a rise in the number of seed-stage funds across the nation, there is a clear funding gap in the later stages. “How do you raise $10 to $30 million dollars outside of the Bay Area and New York?” asked Conrand Shang. “Eventually, as firms scale they need to raise money from Silicon Valley VCs and, on exit, those returns are funneled back to the Valley.”
As a result, LPs should look for up-and-coming markets. For example, in 2012, there were only 7 unicorns in 3 countries (CB Insights). Fast forward to 2020 and those numbers have exploded to 400+ unicorns across 29 countries.
Moreover, we have seen giant M&A activity across the country including: Texas (HomeAway sold to Expedia for $3.9 billion), Utah (Qualtrics sold to SAP for $8 billion), and North Carolina (Red Hat sold to IBM for $33 billion).
Software to Scale Up Sourcing
In 2020, we have to look past the traditional model of opening an office in every geography and investing in startups nearby. The world is global. Businesses, small and large, are being revolutionized by software. And it’s time for VC funds to adapt.
The best hedge funds use data and a team of PhD data scientists to churn through public company data. There is an opportunity to do the same for VC funds. For instance, deal sourcing has always been a numbers game in venture. Partners need to meet with numerous firms in hopes of meeting (and correctly identifying) promising startups.
But what if you turned that model on its head and asked for company data upfront. Then you could use that data to filter through companies and find targets faster. In exchange for sharing this data, the founders would be able to get funded much quicker so they can get back to running their company.
Limited partners should look for funds that are leveraging software and data to source and vet the right companies, as it is a compounding advantage. This one shift would allow GPs to spend less time on fund administration and more time helping founders create value.
Why Solving These Problems Matters to LPs
At the end of the day, LPs are supposed to allocate capital to the best funds, and GPs are supposed to back and support the best founders.
We urge all LPs to be thoughtfully aggressive in these uncertain times. Rather than pull back and do what is safe (e.g., backing the same funds you have for the past 5 years), look at the opportunities around you.
In particular, the best returns will come from LPs that back funds investing in remote companies, underserved geographies, and leveraging data to save time. The next era of Uber, Airbnb, and Slack are being made today. And they may not be in Silicon Valley.
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