Limited Partner Unlocked shorts: What we're Hearing from LPs with Meghan Reynolds of Altimeter

0:00Welcome back to another episode of Venture Unlocked, the podcast that takes you behind the scenes of the business of venture capital. I'm your host, Samir Kaji, and today we have another version of Venture Unlocked Shorts, and this time it'll be a recurring conversation series on what we are seeing and hearing in the LP world. Joining me in co-hosting this recurring series is Megan Reynolds, who leads capital formation at Altimeter Capital. Megan recently attended iConnections in Miami, one of the biggest global cap intro summits in the world, which served as the inspiration for this episode, where we discuss what she observed during the summit, including how LPs are thinking about early and late stage VC and the place overall in private portfolios.

0:39We really hope you enjoy the episode and don't forget to leave us any comments on other things you'd like to hear about the LP world. So let's get right into the episode now. Samir Kaji is the CEO and co-founder of Allocate. Allocate and Venture Unlocked are independent of each other. Any statements or references made by Samir or his guests regarding third parties, investments, or securities are solely their views and opinions and are not intended as investment advice or an endorsement of such parties or securities by Samir, his guests, or Allocate. Allocate or its clients may maintain relationships with or investment positions in guests, third parties, or securities mentioned in this podcast.

1:16This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Megan, it's so great to see you. I'm so excited about doing this recurring, What are we hearing from the LP world? It's an area that you and I spent a ton of time in. Recently, you were actually at one of the biggest cap intro global summits in iConnections in Miami. I think a good place for us to start for this week's episode is really going through maybe some of the takeaways. It does feel like 2022 and 2023, to a certain degree, LPs had their pencils down, particularly the institutional LPs that had the denominator effect.

1:55We weren't seeing the liquidity that we had seen before. And coming into 2024, a lot of people are really curious. They're like, what are LPs now thinking? So maybe you can provide us a little bit of background on how was that summit and what were the things that you kind of took away? Man, this was our first time at iConnections, which for those that don't know, I would say it's the closest thing that our industry has to a trade show. It is this massive event in Miami. I actually think next year they're going to be doing it at the Miami Convention Center. That's how big it is. And, you know, kudos to the iConnections team.

2:32Ron and Caitlin, they did an excellent job. But really bringing together thousands of managers and LPs for a day of deep content and then a day of kind of speed dating across managers. And, you know, my conclusion coming out of that is, well, one, how fascinating this industry has evolved, but we actually had sometimes something that looks like a trade show. Two, it is still really hard to raise capital. I mean, you have managers there, and it's really an alt-wide conference. You have hedge fund, credit, real estate, private equity, a lot of venture from the smallest managers to the very large.

3:09And I would say the word on the street from GPs is that it is still incredibly hard to get capital out of the hands of LPs if they're not already in your existing investor lineup. I think the exception to that might be credit, where we've seen a huge amount of LP allocations move into private credit over the last year. I think if any dollars have been pried out of the hands of LPs, it's gone into credit for obvious reasons, given how rates have moved. But that being said, I'm seeing a real warmth coming out of the LP community and a warming from this fundraising winter that people are there to meet managers again.

3:53Like they were excited to, in two days, get a wide swath of new potential relationships to build over maybe not this year, but over the next several years. And I think denominator effect has eased. They've taken some time away from new managers, they know instinctually that you've got to keep deploying across multiple vintages. And I would predict that maybe not 24, but 25, you see real capital start to go into new relationships for LPs as they parse through the performance of the past cycle, particularly in privates. And I'm speaking really from the venture perspective, kind of who has done well through the cycle, whose performance has been sustainable, whose process is strong and repeatable, and trying to bring new managers into the book.

4:48It's similar to what we're hearing too. And I'm feeling just in terms of the different LPs that we talked to, which are a range, right? Everything from fund to funds to endowments to family offices. A lot of people did invest in this run-up during 2019, 20, and 21. Problem was a lot of those folks that allocated a lot, the capital was called really, really quickly for folks. And then post-2021, so just in 2021, total exit volume was massive,$800 billion worth of exits. And 2023 was about $61 billion. So you had a lot of capital calls and now the liquidity window has shut down. So it's also created this liquidity issue for a lot of families, individuals who no longer can allocate to what effectively is the longest of the alternative classes to be illiquid.

5:40But at the same time, you see the sobriety come back to the market. So a lot of LPs that we talked to recognize the importance of not just investing in the peak times, but investing in these early parts of a cycle where you have a reset. And in this case, of course, it's coupled with a new technology paradigm in artificial intelligence. And that I think we're also hearing in the different conferences and the discussions we're having. One thing I wanted to come back to you about it during that conference overall. So you have venture and within venture, there's a wide swath of types of managers.

6:16There's the emerging managers, small, sometimes 50 to 100. Then you have the more established brands, was there more of a presence of any type of VC fund from just talking to LPs? Was it more of a flight to perceive quality of let me go to the brand names? Were people open to some of the more emerging managers too, just from what you heard around the water cooler? Well, look, I would say there was definitely a wide range of GPs kind of size experience from$10 million emerging funds to some of the largest, most well-known funds out there present at the conference. Folks, meeting calendars were full.

6:58And I do think there's an openness to meeting emerging managers. That being said, I think it's really hard. And I think that there's ultimately a flight to quality. And I think if you're, you know, for emerging managers that are coming out of pre-existing firms, maybe spin-outs, there's some underwritable track record. I think that's where there is traction. You know, people realize that there's interesting things, interesting returns are generated and funds ones and twos, but it's difficult. And the world of everyone and their mother has an adventure fund, which was 2020 and 2021, is over. I mean, it's going to be really tough.

7:44And you and I can talk about in future episodes, kind of this concept of zombie funds and funds starting to recognize that it's going to be difficult to raise going forward. Yeah, I think that's right. And remember, during most of the 2010s and going into, of course, 2021, there was effectively an elimination of that J-Carivore in the early years. You typically have negative returns. No one had negative returns because as a seed stage manager, in many cases, during that peak time, you had companies going from seed to Series A within six to 12 months. And during that time, there was a huge markup for those companies, typically three to five X markups at least.

8:28And that was coupled with, of course, a period of rapid development, so more companies, more companies getting markups. So you got these really insane numbers that were found in the first two years of a fund. Oftentimes, I would see 30%, 40%, 50%, 60%, 70 % IRRs, where historically, you would have negative for about three years. And I do think that really helped people raise capital. And of course, things have now changed to a large degree, where the J curve is back, it is probably a little bit longer, because deployment has slowed down, the time between rounds has slowed down, and also the macro has changed.

9:06And one of the things I wanted to perhaps distill down to is just the LP view on venture versus other asset classes. And in today's market, for example, you can get the three-month treasury and it's north of 5%. We talked a little bit about private credit, which is white hot, and of course that went white hot in 2022 when rates went up. and even in private equity buyout, that with some of the best firms, you can get north of a 1.8x. And so looking at venture is a very different calculus than most of the 2010s. So just curious, what did you hear from LPs in looking at venture versus some of these other asset categories?

9:49LPs that are allocating are looking for their venture portfolio to provide real ballast. And I think that there's a reckoning going on around what are realistic return expectations for my venture portfolio. And does it provide the ballast that's needed to justify an allocation to venture relative to a private equity, which is viewed as a pretty steady 1.8 times net, or a private credit, which has really interesting yield right now. LPs are looking to seed in series A, where they, like a couple of years ago, they're allocating across, you'd hear this kind of consistent interest in seed in series A and later stage and growth and a diversified venture portfolio within that kind of sub-asset class.

10:38And now very consistently, you hear seed in series A, seed in series A, seed in series A, because I think that there's this perception that that will provide me the balance that is needed for this piece of my portfolio that's going to give me the juice. And I don't know, I'm interested to hear you opine because you spend a lot of time with allocators and LPs thinking about what's the right allocation amongst venture managers. And I always get very skeptical when I hear investors saying one thing consistently, it makes me want to flex to the other side, just given, you know, momentum is not really, is not always where you want to be spending time in the investment landscape.

11:21But curious to hear what, you know, how you advise people, one, if you're hearing the same thing, and then two, how you're advising people, how you think about returns between earlier stage and later stage. So I've, I've a lot of thoughts on the subject. And this is an area that we spend a lot of time on in terms of thinking, where are LPs really interested? Why are they interested? Does it actually make sense in today's environment? I'll go into those things, but there's probably three things I want to start off with in outlining why I think we're hearing what we're hearing. Number one, we're all, as investors, grown to recency bias, meaning in the growth markets in 2019, 20, and 21, everyone was overpaying because you had public market multiples at 25 to 50X and growth stage investors that were investing in some cases at 100X forward-looking multiples, which for the next 12 months, that is crazy valuations.

12:22And particularly when you look at the long-term being 6X for enterprise SaaS in the public markets, if you go back even further, maybe it's about 9X. A lot of people got burnt, I think, by investing into both funds and co-invest in 2020 to 21. So that, of course, creates a little bit of scar tissue where, as you mentioned, a lot of LPs say, I don't want to do growth. The second thing is fundamentally within the growth market, we saw a big change in that end of the time period where you saw big crossover funds come in, which got bucketed into venture capital, but at the end of the day, not really venture capital funds.

13:01And there was a stat, and Mark Suster brought this up yesterday on a podcast, where he said of the capital that was raised, I think it was like 732 unicorns that were minted in 2021. Of those, 60 % of those rounds that turned those companies into unicorns were led by four investors. And he said this, Tiger and SoftBank were two of those. If you think about those investors, they're no longer doing this because there's not that arbitrage between the private and public markets. The final thing I'll bring up to outline why I think we're hearing what we're hearing is that early stage has always been viewed as true venture.

13:41And it's far enough divorced from the public markets where people are saying, even if the liquidity market isn't great for 2024, 24, 25, my early stage portfolio, because I'm getting that true power law, these companies will mature in five, six, seven, eight, nine years. Therefore, I don't have to think about what's happening in the macro right now and over the next few years. Therefore, that's where my flight to quality is going to be or flight to safety, which is a little bit ironic because that is the most risky part of the overall venture business when you're investing in companies at inception.

14:15What I'm seeing right now is, first, I do think that people are gravitating towards seed in early stage for sure. And we are seeing LPs really focus on that. And one of the things that comes out to me is when I see bigger firms, for example, raise a growth in early stage, a lot of LPs say, well, I just would love to do the early stage. I don't want to do the growth stage. You know, part of it is all those factors that I just brought up. Okay, now let's step back and maybe analyze this a little bit. Now, everything I just said, there's certainly merits to it. And particularly in the seed stage, when you're investing in companies early and the fund sizes are, generally speaking, anywhere from$25 to$200 million, you do have the opportunity as an LP to get the highest top-end return.

15:02and the data is there. It's hard to debate. And ultimately, it's pure math where one company can return a multiple of a fund, whereas for a billion-dollar fund plus, that's just much more difficult. And the way to get a 3 to 5x is you have to be in one or two of the biggest companies of that year, whether it's a Stripe, a SpaceX, or a company like that that can result in a multiple turn on the fund. Now, from a risk element, the seed funds typically, if you look of the entire population, higher standard deviation of returns. So as many top end returns, there's also many of those funds that severely underperform versus the larger funds, you typically have a much more narrow band of returns.

15:47So we have to look at it from a risk and return element. The other thing that I think is just interesting, I'm going to cite Carta data, is that with so many people gravitating to the seed, what we've seen is even though deal volume has come down from Q1 2021 to Q3 2023, valuations have actually gone up, both for seed and series A. Series B and C valuations have gone down fairly dramatically, 22 and 37 % respectively. Now, some of the seed stage valuation uptick is because the round sizes are bigger. And of course, that creates slightly larger valuations versus B and C rounds have gotten much smaller.

16:31But at the same time, to get a Series B or Series C round today, companies need to have much stronger fundamentals. So we've gone away from raising a hope and a dream and a narrative to having things that are really fundamentally based on what the public markets are looking at and what really late-stage investors are looking at. So we do think that all of these things should be considered when making a decision on early stage versus growth. You cite some super interesting stats. I think I agree with a lot of what you're saying. I clearly am biased because of where our firm is active, so I won't chime in on the various arguments, but the data is what it is.

17:15I think we've spoken very publicly that you're going to see just about what you were saying on the bar getting really high to raise capital. I think we fundamentally at Altimeter don't believe that most of the unicurrents that were minted to the tune of 95 % of them will ever see the valuations that they saw at the peak. So there will be a lot of fallout from a capital raisings perspective for these companies over the next couple of years. And that's going to make it really hard for investors to continue to underwrite later stage managers because you're looking at track records where there's still a lot of questions around performance and fallout.

18:01And you and I both know, I think if you look at it, just looking at Cambridge benchmarks and how even top quartile managers' evaluations have come down, we've seen them come down kind of 15 % to 20 % since the peak. There's still far to go in terms if you're going to just think about things coming more in line with public market multiples. And that's going to make it really hard to parse through data, track records as people evaluate new funds. but on the flip side of that, there's the opportunity in it, which is much more valuation, much more rational valuation environment to be deploying capital.

18:36And those companies that make it through to the other side are going to be those of high quality, durable revenue, and those that can sustain themselves in the public market. Plus on top of that, you have this ethos of getting fit in Silicon Valley, more efficiency and of higher quality companies that make it a hopefully more sustainable investment and asset class going forward. Last thing we should maybe touch on is going back to some of the things you just said, and I don't know the exact number of unicorns, but I think there's roughly 1 ,200 or so global unicorns out there. Over half of those were minted in one year, being 2021.

19:18And much of that was the product, the supply of capital that was there and the investors who were willing to pay those prices, knowing that at that time, it seemed there was a likely buyer in the public markets that would pay more. And in many cases, if you look at what happened is just the multiple compression has created a very tough market. And the 95 % number that you mentioned is sobering in terms of companies that raise at these huge valuations that may never not only grow into those, but won't even have an exit at any time soon, anywhere close to that. And I generally agree with that. I think that there's going to be many of those companies that get stuck.

20:02And some of these companies are actually very good companies. And an example would be a company that does$55 million in next 12-month revenue that today might be valued at$400 or$500 million, whereas a couple years ago, or at least 2021, would have been valued at between$2 and$4 billion. And so it leads me to the question is, what is the exit path for these companies? The IPO market is tepid, as you know. The M &A market is very difficult. and it's difficult not only because the acquisitions have slowed down for many companies, but it's the FTC, for example, being involved with bigger transactions.

20:47Adobe Figma is a great example where Adobe had to pay a billion dollars as a breakup, which could act as a deterrent going forward. Some of these companies may be closer to profitability if they do certain measures, cut, burn, and maybe that opens up things like private equity. But what is the path, do you think, for many of these companies to work through the system? For many of them, it's going to be a long journey. I mean, it's going to, the system, it will work through the system. The pig will move through the Python and it will come out on the other side healthier and where it should be, the market's going to set the price.

21:23But I think it's going to take a long time to work through. This is not a, it all gets worked through the system moment in the next two years, it's going to take a long time. And the paths are where they are. You IPO or you get it wired or you continue to move on and raise additional capital or you move to profitability and you sustain yourself in private markets. I think a lot of this will lead to more volume in the secondary market for venture. We can talk about that on a future episode. There will be more, just like in private equity, where companies are staying private, they're changing hands within funds.

22:04And then secondary private equity continuation funds, LP selling stakes because they're not getting liquidity. There is a market here that will sustain that for a long time so that people can get liquidity when they need it. But I totally agree with everything you're saying. There is a path. We know what the path is. It's going to take a long time to work through. But in the meantime, there's ways to manage your portfolio that you can work with that and meet your needs. But it all leads back to this view of safe haven and seed in series A, because you're not going to see the volatility or the perceived volatility and marks that you'll see in those later stage rounds that were done at very high valuations, because a lot of those investors were in much earlier.

22:54So there's more of a cushion in those returns. So you won't see the same levels of, you know, it won't feel as dramatic. But it will be interesting that, you know, to watch to play out and it will take years. Unlike the public markets, the correction happens essentially overnight. It's a very gradual and short time for things to really run up at a long time for the actual pain to be felt given the nature of the private market. And in this case, it's going to be even longer than most cycles because companies raised so much money in 2021. So you can gradually kind of play this out for a lot of folks.

23:32You had a great segue for our next one, which is a big area of discussion in the LP world, which is secondaries, which is how do you get liquidity early? Given that many of these companies will be in the private markets for longer, are there things that GPs are doing? and what are LPs expecting in the venture market that could maybe align with some things that have happened in private equity. So we'll save that for next time. Megan, this is a lot of fun. Thanks so much, Megan. This is fun. I'm excited that we can have this conversation. Thanks so much for listening to another episode of Venture Unlocked.

24:06We really hope you enjoyed it. To learn more about Venture Unlocked, be sure to go to ventureunlocked.substack.com where you'll find detail notes of the show and a listing of past episodes. You'll also find us on Apple or Spotify, where you can subscribe to get all of the latest shows as soon as they're released.

24:53Thank you.