Can Venture Capital Weather the Current Financial Drought?

By Matthew Johnson 2024-09-10

The venture capital industry is facing significant challenges as returns from investments dwindle, market stability is low, making it difficult for investors to reinvest in the ecosystem. Traditionally, money flows through the venture capital system via IPOs or the sale of startups. However, these returns have been so minimal lately that limited partners (LPs), the outside investors who fund venture capital, are increasingly more hesitant to pour more money into new venture funds. This hesitation is creating a cash crunch, making it harder for venture capital firms to raise new funds.

Marc Cadieux, president of Silicon Valley Bank, highlights the issue, stating, “The money is not making the round trip.” This means that the capital LPs are providing to venture funds is not being returned through successful investments, which in turn affects their willingness to invest more.[1]

At the end of 2023, North American venture firms saw a significant imbalance, with LPs being asked for approx 5X more capital than they were receiving in returns, a sharp increase from the previous year. This liquidity issue is even more severe than what was seen after the 2000 dot-com crash. LPs, including family offices, foundations, and pension funds, rely on these returns to fulfill their capital commitments, but with the current downturn, they are struggling to meet these obligations.

Raising New Funds Is Getting Harder

One of the primary ways investors see returns on their venture investments via IPOs has nearly ground to a halt. Additionally, the number of meaningful startup acquisitions has decreased, partly due to increased regulatory scrutiny and antitrust concerns. These factors are making it harder for venture capital managers to raise new funds.

In the first half of 2024, only 255 venture funds closed in the U.S., putting this year on track to be the lowest in a decade for fund closings. Venture firms are finding it more challenging to raise funds, with many reducing their target sizes or exiting the market entirely. Some venture capitalists who considered starting their own funds have decided against it due to the tough market conditions.

The current lack of returns is causing LPs to focus on a small number of established venture managers, exacerbating the divide between successful firms and those struggling to raise capital. While major firms like Andreessen Horowitz and Thrive Capital continue to raise large funds, most of the market is finding it difficult to keep up.

A Growing Secondary Market

As returns dwindle, the secondary market, where stakes in startups and venture portfolios are bought and sold, is becoming more active. This market has grown significantly since the last downturn and is now a critical source of capital.

Impact on Startups

The lack of returns is also hitting startups hard. Venture managers are cautious about raising new funds and are reluctant to burden their already strained LPs. This caution is slowing down the rate at which startups can raise capital.

Funds that started investing in 2022 have been particularly slow to deploy their capital, with only ~43% of their funds invested in the first two years, compared to over 50% in previous years.

While there are some signs of improvement, such as a slight uptick in distributions from IPOs and acquisitions, the overall outlook remains uncertain. Factors like potential interest rate cuts and changes in the political landscape might help, but the path forward for venture capital remains challenging.

In summary, the venture capital industry is grappling with a severe cash crunch, making it harder for firms to raise new funds and for startups to secure the capital they need. As returns remain low and the secondary market grows, the industry is looking for ways to get back on track.

References

[1] - WSJ -By Yuliya Chernova https://www.wsj.com/articles/can-venture-capital-keep-itself-afloat-41ec1a04