I listened to a fund of funds investor give her perspective on how her team and other large institutions have changed how they evaluate venture fund managers. Their focus has shifted from increasing portfolio valuation (i.e., markups on start-ups) to distributions (i.e., cash returned by exiting start-ups). Part of the reasoning was around private market valuations’ lag in correcting and its impact on portfolio allocation.
Venture capital investments are private investments, so finding their correct market price usually happens when new funding rounds happen. If a company last raised in 2021, the company’s valuation is usually marked at the 2021 fundraising-round price. Public companies’ valuations are adjusted in the public markets every day, and many have been on a downtrend in 2022. Because venture investments are slower to be marked down, some institutions are over-allocated to venture capital relative to their entire investment portfolio.
For example, venture capital might have accounted for 8% of an investment portfolio in fall 2021 when valuations were high. The max allocation for venture capital in the investment portfolio is 10%, so that 8% allocation was below the limit. As the public equities in the portfolio decreased in value in 2022, venture capital values remained flat (they continued to be marked to their 2021 level because companies are avoiding raising in this environment). That means venture capital might now account for 12% of the overall investment portfolio, which is above the max allocation.
Given this dynamic, the fund-of-funds investor said her team is now more focused on distributions: how much capital have fund managers returned to their limited partners (LPs). For those overallocated in venture capital, distributions are an ideal way to increase cash allocation and reduce their venture capital allocation. Managers who have returned or are returning cash are viewed in a positive light.
She mentioned that part of a venture fund manager’s job is to know when to sell. Given the rich valuations in 2020 and 2021, her team is looking closely at 2017 or older fund vintages that didn’t use the rich valuations as an opportunity to distribute capital back to LPs.
Very interesting how the LP focus has changed from valuations/markups to cash returns. I suspect this focus will be top of mind for more venture fund managers and trickle down to CEOs of their portfolio companies. This, combined with a tough IPO market and other variables, could make 2023 an active year for acquisitions.