Why LPs think SVB's failure has an upsideMarch 24, 2023
After a mad scramble two weeks ago to get cash to companies with deposits trapped in Silicon Valley Bank, the VC ecosystem is back to business as usual. The bridge bank that controls SVB's former assets and liabilities has not only guaranteed all deposits, but it is also honoring all lines of credit and offering new loans.
But for most people investing in venture capital throughout the last boom cycle, things don't feel quite the same.
Venture was in a precarious position even before SVB failed, but having its main bank disintegrate made the entire asset class even more vulnerable, an LP at a university endowment told me. "I think it will force a correction more quickly than it might have otherwise," the person said. As grim as that may sound, LPs see benefits in a speedier rationalization of the asset class.
Gloomy statistics and anecdotes abound.
Stripe, a company whose business model VCs often cited as the most scalable ever invented, recently slashed its valuation by nearly half. Tiger Global and SoftBank's Vision Fund 2 wrote down their venture investments by about a third in 2022, declines that will likely fall further this year as private company marks catch up to tech stock declines.
Recognizable brand businesses such as exercise equipment maker Tonal, grocery deliverer Good Eggs and crime tracker Citizen are reportedly raising capital at significant discounts in deals where non-participating investors lose their preferred shares. And Founders Fund reduced the size of its $1.9 billion fund to $900 million in large part because its leader Peter Thiel believes the opportunities in VC are not as ample as when the vehicle was raised about a year ago, Axios reported.
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Challenges facing startups are numerous. Hundreds, if not thousands, of startups are grossly overvalued, which means they would need years of runway to grow into their previous valuations. Scores of newer VC firms will likely not be able to raise another fund, translating into less capital available to support their portfolio companies. And with SVB up for sale, the future of the industry's most generous venture debt provider has become one giant question mark.
"It feels like winter is here, and it's going to be a long, cold winter for many companies," said Maëlle Gavet, CEO of Techstars, one of the world's largest pre-seed investors.
With access to venture debt becoming more limited and expensive, startups will have an even greater need for venture equity at a time when most VCs are becoming more discerning about the companies they fund. As a result, many companies will fail.
An increase in startup mortality rate, which has been extremely low for years, is not necessarily bad for the ecosystem, according to the university endowment LP. If SVB's collapse accelerates the weeding out process, it only benefits the tech industry. "The sooner entrepreneurs and employees realize that they are working hard to build something that isn't viable, the sooner they can put their skills to use in better companies," the university endowment LP said.
While a jump in loss rates means that venture is likely to underperform other asset classes over the next few years, many LPs are finding themselves overallocated to venture capital and may welcome a natural slimming of their venture portfolios.
VCs' excesses have been throwing off LPs' capital allocation models for years. Limited partners told me they expected about 50% of startups to die at the seed stage, but the survival rate was significantly higher over the last several years of the boom cycle. That meant venture funds didn't have enough capital reserves to participate in the later rounds. Many firms, ranging from Susa Ventures to much larger Khosla Ventures, responded by raising sizable opportunity funds, leading to further imbalances in LPs' portfolios.
The current winter will put an end to this vicious fundraising cycle. Companies will fail and fund performance will suffer, but the end result will be a more sustainable and streamlined asset class.
When the industry shreds its worst excesses, the snow will melt, and LPs, who have been cutting back on new managers and writing smaller checks, will again be excited about investing in venture capital.
Featured image by Jenna O'Malley/PitchBook News
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