In most industries, a crisis that threatens to eliminate many of its weaker companies would create an opportunity for the stronger players to grow their revenues by acquiring middling ones at very attractive prices.
But that’s not the case for VC.
Few in the VC industry would deny the industry had become bloated to unsustainable levels during the later years of the boom cycle. A decade ago, there were about 850 active VC firms, according to PitchBook data. By 2023, that number swelled to over 2,500.
Josh Wolfe, the co-founder of Lux Capital, told me last year that the number of VC funds would be cut in half during the downturn as many firms struggle to hit fund size targets or raise capital altogether.
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Part of Wolfe’s predictions have already come true, as mega-funds such as Tiger Global and Insight Partners have scaled back fundraising ambitions. But it will take years to find out just how deeply the industry is going to thin its ranks and pare down the number of funds out there.
In contrast to private equity, which has been busy acquiring complementary businesses that saw their profit margins dampen amid macro volatility, venture firms are unlikely to join forces with other VCs.
“Unlike traditional [registered investment advisers] such as independent wealth advisers and private banks, it’s rare for VC firms to acquire other firms or teams to grow AUM or expand product sets,” said Samir Kaji, co-founder and CEO of Allocate, a platform for investing in venture funds. “It is unlikely going to change in the near term, despite the number of small firms that may have a hard time raising capital on their own.”
Furthermore, stronger firms have no incentive to buy out their weaker peers.
Existential angst
However, in cases where an underperforming firm has one strong GP, it’s much less expensive—and less risky—for a stronger firm to hire that partner, especially if it’s somebody with expertise in an area in which the larger fund is trying to grow, said Kelly DePonte, managing director and head of research at Probitas Partners, a fund placement advisory firm.
“A small fund that’s not performing well—it shouldn’t exist,” DePonte said.
Multi-product firms like General Catalyst or Andreessen Horowitz have always launched new strategies by hiring specific individuals or appointing someone from within their existing ranks. Not once did they buy an entire team.
But there also isn’t much benefit to merging an outperforming firm with a mediocre one.
Unlike large buyout funds with few partners and an increasingly larger staff of principals, associates and analysts, VC firms tend to be upside-down pyramids with GPs at the top and a smaller cadre of support functions.
For that reason, combining VC funds won’t result in significant cost savings if non-GP positions are eliminated. On the contrary, more partners would have to divvy up management fees earned by the fund. Merely increasing AUM is unlikely to help the firms hit more home runs.
VC firms will look for ways to pinch pennies within their existing organizations. Even Sequoia, one of the industry’s most powerful players, isn’t immune from cost cuts and just acted to lower its headcount.
Artisanal touch
Moreover, LPs would likely see a potential combination of two distinct venture funds as a negative signal. Pensions and endowments invest in VC funds because they subscribe to the firm’s bespoke strategy and thesis.
Combining two partnerships into one entity also would require establishing a workable chemistry and trust, something that’s easier said than done in venture capital. In 2015, the partners of Kleiner Perkins and Social Capital explored a merger of their firms but the two sides failed to agree on a direction for a combined firm. The industry hasn’t seen any other major mergers, before or since then.
While mergers aren’t the answer to the industry’s problem, it is possible that the industry’s bloat will be helped by secondary markets. Chris Douvos, a managing director at Ahoy Capital, said he expects an explosion of new secondary funds to pop up and buy stakes in VC funds (and their portfolio companies) on the cheap. Many failing firms will simply sell their assets and move on.
Still other firms will turn into so-called zombie funds. They’ll continue to collect management fees even though their funds will run out of capital to deploy.
Allocate’s Kaji said he hopes the industry will find creative solutions beyond the simple secondary market to provide liquidity to these firms’ LPs.
As for survivors, they’ll continue to raise funds. Several firms continue to close on large funds, such as Goodwater Capital‘s $1 billion fundraising that was announced this past week.
But venture capital probably won’t resist consolidation forever. As the industry continues to evolve and mature, VC firms may eventually find ways to realize synergies from combining with other firms.
Featured image by Chloe Ladwig/PitchBook News
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