Why Venture Limited Partners Increasingly Challenge VCs' Valuations

With net returns to US venture funds down 10.34% and pessimism about the new year still rampant, limited partners are more aggressively challenging VC general partners about valuations of both current and future investments. 

The dearth of market activity generally and of IPOs has made it much harder - and more subjective - to agree on valuations. With no expectation of a return to tech's and VCs glory days anytime soon, investors are being more prudent with their money and VCs are having to adjust to that mindset. JL 

Yuliya Chernova reports in the Wall Street Journal:

2023 is expected to be the worst year for venture fundraising globally since 2015. One-year net returns for U.S. venture funds stood at negative 10.34% as of June 30, 2023. As limited partners consider new investments they are increasingly questioning how fund managers account for the valuations of companies they back. Limited partners scrutinize cash position, burn and valuation of portfolio companies in new funds to a much greater extent than previously.  "[Limited partners] are pushing GPs hard on the numbers,” (which) extends fundraising timelines. Prolonged illiquidity and a dearth of follow-on financing into startups has created greater differences of opinion because there is no market event to indicate a new valuation. 71% of venture managers expect private co insolvencies to rise

What are venture fund portfolios worth now? There is little agreement on that question today, an issue that is slowing down an already sedate venture fundraising market. 

Once all the data is tallied, 2023 is expected to be the worst year for venture fundraising globally since 2015, according to both research firms Preqin and PitchBook Data.

As limited partners consider new fund investments they are increasingly questioning how fund managers account for the valuations of the companies they have already backed, especially when those marks appear high. 

“How much can we trust, how reasonable are the valuations? It’s a very relevant question in the market today,” said Theresa Hajer, head of U.S. venture capital research at investment firm Cambridge Associates, which advises endowments, pensions and other institutional investors.

LPs are trying to come to their own view on the valuations, said Larry Naughton, member of law firm Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, where he works with private companies and venture funds. “I see [limited partners] push the GPs hard on the numbers,” he said, adding that extends fundraising timelines.

It took Los Angeles-based venture firm Act One Ventures some three years to raise its $73 million third fund, which the firm finally closed on Dec. 1, according to co-founder and General Partner Alejandro Guerrero. The firm held the first close on the fund in 2021. “The environment we saw radically changed from when we started to when we ended,” he said. 

Limited partners scrutinized the cash position, burn and valuation of the firm’s portfolio companies in the new fund to a much greater extent than previously, he said. What helped Act One ultimately exceed its original fundraising target was that its companies had a long cash runway, he said. Another major factor was that Act One provided liquidity via secondary sales to the LPs in its first fund, Guerrero said. 

Close to a quarter of venture funds globally spent less than six months raising capital in 2021, according to Preqin. Only 12% zoomed to a fund close in such a short time in the first three quarters of 2023.

 

Valuing private companies isn’t an exact science at any time, and there are a variety of ways to do that accounting. A prolonged period of illiquidity and a dearth of follow-on financing into startups has created greater differences of opinion on appropriate marks because there is no market event to indicate a new valuation. Ultimately the true value of the shares of a company is only known at the time they are sold. 

For venture fund managers, valuation is a balancing act. On the one hand, elevated paper returns may make venture funds look more attractive to LPs. On the other, not being realistic about the value of one’s portfolio can backfire. 

“When you are raising, you are less incented to do a massive markdown,” said Samir Kaji, chief executive and co-founder of Allocate, a platform that connects limited partners with venture funds. Allocate has seen some younger venture managers appear to overvalue their portfolios, he said, potentially in hopes of attracting less sophisticated LPs, Kaji said. 

For Allocate, a fund that is marked too high is problematic. “It’s a hard pass for us, it makes the [general partner] less trustworthy in our eyes,” Kaji said.

Venture fund returns have already declined, yet many in the market expect to see continued pain. One-year net returns for U.S. venture funds stood at negative 10.34% as of June 30, 2023, according to the venture capital benchmark index by Cambridge Associates. 

Luke Carroll, chief investment officer of Reference Capital, said that LPs are concerned by the gap between public and private company valuations. His Geneva-based firm advises LPs, including European family offices and institutional firms, on their investments in venture-capital funds and startups. 

“This valuation discrepancy could lead to considerable shifts in portfolio valuations and exit strategies,” he added. 

The share of down rounds, or financings where valuations were reduced from the prior round, hit 15.6% in the second quarter of 2023 globally, a record proportion of all quarterly financings since 2017, per Preqin.

More than 71% of global venture fund managers surveyed by Preqin in November said they expect private company insolvencies to rise over the next 12 months. That is raising anxiety among limited partners that are evaluating venture funds.

“It’s very hard to hear that all these companies are going to go out of business. Well, are they mine?” said Beezer Clarkson, partner at Sapphire Partners, where she leads investments in venture funds. The onus is on the LPs to assess the health of the companies the venture funds backed, she said.