Why Most LPs Are Playing it Safe Right Now
No one ever got fired for investing in Tier 1 VC
Trace Cohen’s Tech/Startups/VC Newsletter / Please subscribe here to receive a few more emails
It’s an age old problem that founders complain when VCs wont invest in them and GPs complain when LPs wont invest in them. But beyond not being a “fit for them at this time” and “cheering from the sidelines,” it also has to do with changes all the time in the stock market, competition, world events and even vibes/trends
This is kind of how the tech world feels right now…
Basically it comes down to risk tolerance and what LPs can stomach — your gut feeling. A few years ago (feels like a lifetime ago…) in 2021 we were in the ZIRP Era; no fundamentals, vibes and Covid induced drunken exuberance where everything was awesome! But now we’re dealing with the consequences and are now getting back to basics; which in the short term there are debts to be paid, to make up for our lack of stringency and DO (not due) diligence, while in the long run, we will be better off. What doesn’t kill you, makes you stronger right?
When large LPs with substantial capital, like those who can invest $100 million in VC funds, decide how to allocate their assets, they face a strategic decision; should they put all their eggs in one basket by investing in a single fund, or should they spread their investments across multiple funds? While diversification is a cornerstone of good investment strategy, managing multiple investments can introduce additional complexity and overhead. So let’s delve (iykyk) into the financial implications and management considerations of these fund managers and their strategies.
Single Fund Investment
Imagine a LP chooses to invest $100 million into a single fund that has a 75% chance of delivering a 2–3x return. Mathematically, the expected value of this investment can be calculated as follows:
- Expected Return = 75% x (Average of 2x and 3x returns) + 25% x (Original Investment)
- Expected Return = 75% x ($250M) + 25% x ($100M) = $212.5M
- 2X+ over 7–10yrs is fine and relatively safe
Multiple Fund Investments
Alternatively, the LP could choose to distribute the $100 million across 10 different funds, each receiving $10 million, with varying probabilities of success and return multiples. For example:
Scenario 1
- Probability of Success: 50% to 3x each $10 million fund investment
- Expected Return per Fund = 50% x ($30M) + 50% x ($10M) = $20M
- Total Expected Return = 10 x $20M = $200M
- So 2X but a lot more work to manage
Scenario 2
- Probability of Success: 33% to 5x each $10 million fund investment
- Expected Return per Fund = 33% x ($50M) + 67% x ($10M) = $23.3M
- Total Expected Return = 10 x $23.3M = $233M
- So 2.3x but a lot more work to manage
Basically the outcomes are very close whether you invest in 1 fund or 10. We can debate the % of return/risk factor but we can agree that generally a larger established fund has a higher chance of success returning capital VS a first or second time fund manager. There are a lot of other intangibles like fees, follow-on SPVs etc but ultimately even if the multiple funds returned a few extra million, that wont move the need for the fund and worth the risk of their job.
Simple table of multiples to show what it takes to make $$$
I created this simple chart just to show you how much it takes to make “just” 20–130x your money over an expected 10yrs on just one investment. With one fund, imagine they have 20–30 investments, where as 10 funds would be making 200–300 investments, but smaller checks. More shots on goal, smaller checks and more to keep track of but also you will see and learn so much more.
Management Complexity and Risk Considerations
Managing multiple funds not only requires more administrative effort but also involves greater oversight and due diligence. Each fund must be evaluated for its strategy, management team, market focus, and performance metrics. This increased managerial demand can be significant:
- Due Diligence: Assessing 10 different funds requires extensive research and analysis, increasing the time and resources spent.
- Monitoring: Keeping track of the performance and compliance of multiple funds adds to the operational complexity.
- Relationship Management: Maintaining relationships with multiple fund managers can be logistically challenging and time-consuming.
These factors contribute to why larger LPs might opt for fewer, potentially larger, fund commitments. The administrative burden of managing numerous smaller investments can outweigh the diversification benefits, especially when the financial upside is not significantly higher. Basically why put in the extra work for basically the same outcome…
Playing It Safe: A Rational Choice?
I’m in a lot of Family Office/VC/LP groups and one thing we all agree on is that “Nobody ever got fired for investing in a16z.” This reflects a broader sentiment that choosing safe, reputable options often protects one’s career and reputation. For large LPs, investing significant sums into established, larger funds with moderately high success probabilities may present a lower risk of substantial failure. The trade-off between potentially higher returns from more speculative ventures and the steady, reliable growth from established entities often tilts in favor of the latter, especially when job security and reputational risks are considered.
VC firms are forecast to raise less than $200 billion in 2024, a 48% decline from 2021 levels. Fundraising is only expected to grow 2.9% annually through 2028, less than half the rate of other private capital strategies including private equity, private debt and real assets funds.
https://pitchbook.com/news/articles/venture-fundraising-forecast-quant
Expected AUM is to be flat for the next few years
Historically and anecdotally we have always said that Emerging Managers outperform larger funds but there is a lot of survivorship bias etc that we’ve never really been able to pin down. And I’m surprised no one has actually done this work/research yet…
But the latest research by Pitchbook shows that with that potential higher upside, also comes lower downside.
And because of this and countless others reasons, mostly that way too many people raised way too much money in 2021 and will never return any to investors, it’s now the hardest time for Emerging Managers to raise funds. Countless new LPs like angels, Family Offices and established LPs (endowments etc) over extended themselves and got burned — it’s only been 3yrs so no real liquidity is expected yet anyways but unfortunately many valuations of marked up startups haven’t fully come down yet.
So what’s next?
Deciding whether to invest in one fund or multiple funds involves balancing expected returns with the complexity and risk of management. While diversifying across multiple funds can offer higher returns under certain conditions, the increased managerial burden and risk may lead large LPs to prefer the relative safety and simplicity of fewer, larger investments. This strategic conservatism is particularly pronounced in environments where the stakes are high and the margin for error is small.
That’s the PC version…
The real answer is that we need LPs to take bigger risks — big and small, which isn’t going to be easy. But on the large LP institution/endowment side, it’s mostly a job, so taking additional risk really isn’t worth it / not much upside. Sadly this will continue to play out through 2025 until we can get some more liquidity into the market via mostly M&A if it doesn’t get blocked and some IPOs once the window opens a little more. But it’s also an election year…
So please meet with, invest in and support Emerging Managers — they are the foundation and scouts of our tech/VC world! I know a lot of them, so if you have any interest, please reply back and I’d be happy to introduce you!
