VC 101: the denominator effect

Danny Crichton:
Recently in the Lux Capital office, my colleague Chris Gates, the producer of the Securities podcast, along with biotech investor, Shaq Vayda, we're talking about the global macro environment right now in venture capital and specifically the crisis that we've seen since November 2021 when tech stocks hit their zenith and the bubble sort of popped. And we've seen a massive pullback in the public markets and public equities, and a lot of VCs slowing down their investment track over the last couple of months.

And that's led to something among limited partners and other capital asset managers known as the denominator effect, which is where portfolio managers oftentimes have to move money from one asset class to another as each asset class relatively performs differently. And so we talked about the denominator effect. We talked about a couple other different patterns that we're seeing in the venture world. And I figured that since it's summer and it's July, and we'd already have talked about enough terrible news going on in the Securities podcast the last couple of weeks, I figured we could do something a little bit different, which is sort of a Venture 101, looking at some of the trends that are going on, defining the denominator effect, and talking about basically what we're seeing in the world today.

So here's Shaq. Here's Chris, take a listen.

Chris Gates:
Let's just jump in. The context for this was basically, we were in an all-staff and I had some questions about some fundamental VC stuff around what happens in a downturn? And everybody looked at me and they were like, "The denominator effect, do you know about it?" And I was like, "You know, I don't." And so I was hoping that Shaq, you'd come on and you would help walk me through the denominator effect and maybe how that plays into risk for VC moving forward in the next six months?

Shaq Vayda:
Yeah, no, happy to. And I feel like even stepping back, I think it's even broader than just VCs. I feel like it's a good thing for everyone to understand, and I'll explain why. So at the highest level, what are LPs, right? And LPs are, they are groups of individuals. There are sovereign wealth funds, there are university endowments, there are large insurance firms. All of them have capital, frankly, that they're trying to put to work. And as part of that, they create a strategy. So they say, "What are the different types of strategies?"

Chris Gates:
Like, what do they want to put the money in? What are the different buckets, right?

Shaq Vayda:
Exactly. What are the different buckets that they want to put money into? And some might say, public equities makes total sense. Some might go for something like fixed income like bonds. Others might look to the private markets and say venture capital or buyout funds. So every LP has their own strategy, and they're all trying to figure out exactly what is that right formula for them. So the denominator effect is what happens is, let's actually take an example here. Let's say you have $1 million, you're an LP and you want to allocate $1 million of capital.

Chris Gates:
Round number. Love it. Let's work with round numbers for me please.

Shaq Vayda:
Easy. Easy. So, you might say 90% of that's going to go into the public markets. Public markets tend to provide liquidity. That's just a fancy word for saying you can buy and sell it on a daily basis. It provides visibility into the metrics. You have good sense of how companies are trading. So you want 90% of your million dollars to go into that. So $900,000 going into the public markets. The last 10%, you're going to be a little bit riskier with, you're going to go into a venture, right? So you put 10% of that in a venture, $100,000 is sitting in your venture funds that you're allocating into.

Chris Gates:
So, that's my interpretation is that with all of these funds, VC is the 10%, it's the small, it's the riskier bet that people... It's the smallest bucket of the endowments' collection of buckets, right?

Shaq Vayda:
That's exactly right. Yeah. Historically, and that's always been the case, is that VCs are usually, it's not even... VCs, even a smaller bucket inside of the bucket of private investments. So they're competing for dollars with folks, like the big private equity buyout fund, they're competing with growth equity funds. There're all of these different carve outs of buckets. And based on the LP, they have different strategies. So they might say, "We want to give more to the buyouts, a little bit less of the growth. We want to give a little bit more to the growth, a little bit less of the VCs." So everyone's juggling all of these balls at any given point in time.

Chris Gates:
Got it.

Shaq Vayda:
So you've decided you're going to give 10% to the VCs.

Chris Gates:
Right.

Shaq Vayda:
Now that you've given 10% to the VCs, all of a sudden we have a market correction, like we did today. Or like we've been having over the last couple of months. And as part of that, your public position, your $900,000 that you've already put in the public markets is no longer worth $900,000. It's gone down, let's say 10%. So now all of a sudden that $900,000 is actually worth $810,000. We'll just call it $800. Make it easier, okay? So now you have $800,000 in public exposure. Your private investments, because they're not what's called a mark-to-market, where they're not basically measured every single day, you still think you have $100,000 in venture funding, which is great.
So you started out with this strategy, remember, 90% public, 10% venture. Now let's rerun the math. So you have $100,000 in venture and $800,000 in public equities. So now you have one over nine.

Chris Gates:
Right. Your percentages changed. Everything's changed.

Shaq Vayda:
Your percentages changed. Now all of a sudden you have almost 11%, 12% in venture. You said you only wanted 10%, and now you have more in venture, and now you have less in public. So what do you do? You have to rebalance.

Chris Gates:
Right. Just like I do with my private investments, you got to rebalance it. Right.

Shaq Vayda:
Exactly. So you're going to now start to sell some of the other amount, and now you have to go feed the other bucket. You have to get the water balance back to what it was before. Well, what are the downstream implications of that?

Chris Gates:
The VC firms don't get money, right? It's basically like they're divesting in that riskier asset.

Shaq Vayda:
That's exactly right. I think there's three scenarios that play out historically. One is, new fund manager, so folks who are just getting started for the first time. If you're an LP and you're thinking about allocating, and you've already seen this rebalancing happening, you're way less likely to go and give a net new manager funding. You're still dealing with what's called capital calls. So capital calls are just a fancy way of saying when you've decided to invest that $100,000 into the VC, you don't give them all the money upfront.

Chris Gates:
This was new to me. Now I'm like, oh, they don't give you all of it at one time?

Shaq Vayda:
Yeah. They only give you a specific amount upfront, and then you, over time draw down against that. And every time the VC firm says, "Hey, we need a little bit more of that $100,000 that you promised us," it's called a capital call. So each of those capital calls are continuing to happen. So you're already over committed on your VC asset class. You're going to continue to have to pay those capital calls. So, you know over time, you're going to get further and further away from that 10% mark that you wanted to. All right?
So there's three scenarios. One, we already said you're not going to necessarily look to new managers. Two, you're really going to try your best to make those capital calls happen, right?

Chris Gates:
Yeah, totally.

Shaq Vayda:
And then three, you might even look to sell out of a position. You might even look to sell out of your existing relationship with that VC firm to a secondaries firm.

Chris Gates:
Okay. Yeah, because my question was, do your capital calls, do people ever not fulfill them? Or just like, "Oh, well, if we don't have the money or now."

Shaq Vayda:
Yeah.

Chris Gates:
Do they?

Shaq Vayda:
Has it happened? Absolutely. It's relatively taboo. I mean, there's a whole set of legal constraints around it, and folks frankly want to do their best to not do it. However, liquidity at the end of the day is the thing that LPs want, especially in the downturn. They want the flexibility. They want the ability to move things into interesting areas where they see growth coming up. And venture is not a liquid asset. Venture tends to be an eight to 10-year holding period. So you won't see that money back again. So in the event they have to make a very tough decision between incremental investment into a venture firm because of a capital call, and seeing a high conviction event in the public markets, they might not fulfill that call.

Chris Gates:
Okay. So that's the extreme end, right?

Shaq Vayda:
That is.

Chris Gates:
Will you go over the other options?

Shaq Vayda:
Yeah, yeah, absolutely. So again, going back to this whole, you started with a strategy and your strategy said that you thought 10% was the right number. And your goal is to try to get as close back to that number as you can. As you continue to make more investments and your public positions haven't recovered, what you've done is, the fraction just is broken. So you really are going to be skittish on any new manager investments unless you're convinced that this is the one, like this is absolutely the one. That's the only scenario in which you would continue to do those investments.

One of the other things that you might see is an LP who might not have that much confidence in their manager and really believe that their exposure is just so high that they need to get out of that position entirely. There are firms that exist to purely buy the collection of assets. So the entire portfolio that VC has accumulated, they're able to buy that off of them.

Chris Gates:
So basically an LP could be like, "Look, I have a bunch invested in this one VC firm. I don't want to be there anymore." Somebody will buy it.

Shaq Vayda:
That's exactly right. There are firms who are out there who will buy it, which going back to the math equation here, that fraction, now all of a sudden that denominator, we're moving back in the right direction. We sold some of it out. So the denominator got smaller. So we're getting back to our ratios of that 10% mark.

Chris Gates:
Do we not like those types of LPs, the ones that have bought, why? I would imagine for some reason that they're less quality?

Shaq Vayda:
Yeah. So this is where it gets interesting. A lot of the times it's considered incredibly taboo to do such. And most GPs are incredibly upset with an LP who sold out of them. It almost shows that they no longer have faith in them as investors. So this is considered the last resort. I will say in the last couple of years, just as the financialization of everything has happened, these things have moved in a, they've moved in a way where it might be a little bit more normalized today than it was before.

With that being said, though, the best funds want to make a very curated list of LPs. So they want only the best of the best, and they're trimming everyone else out. Now, if one of those LPs were to do an action like that, the GP might say, "We're done. We're never allowing you back into our business again." So it's this weird dynamic where it is the trump card, and once you've played it, you really can't play it again. So you have to be really, really... And in a market like this, is the only time we'll ever see anything like that.

Chris Gates:
Okay. My next question is how do VC funds die? Been just watching Bill Gurley's Twitter and Bill the Gurley's, like, "Look, we're going to see a lot of funds close." I've not been watching this space in a time where funds close. I really have only seen them open and open at a very dramatic rate. So how does a fund die?

Shaq Vayda:
Yeah, that's a great question. So venture historically has had different timelines in terms of deployment cycles. In other words, when you raise a venture fund, you have an idea of how many high quality opportunities are out there such that you can actually deploy the cash in a sufficient manner. Historically, that was probably closer to about five years.

Chris Gates:
So getting the money and then trying to invest in a bunch of companies in five years and get rid of all of it?

Shaq Vayda:
That's exactly right. And saving a little bit of that for follow-on capital. But point being, for the most part, you want to deploy the majority of that, let's just say a hundred million dollar fund in about five years. That was always the goal. During the most recent vintage of years, the 2020, 2021 cycle, we actually saw most firms raising at about two-year cycles. So deploying at a significantly faster clip than anything we had done before.

Chris Gates:
I saw that at TechCrunch and just our inboxes flooded with funding rounds.

Shaq Vayda:
That's exactly right.

Chris Gates:
Deluge was the word that everyone was using.

Shaq Vayda:
And I think I just saw a tweet today that we've only had two announcements today. So very, very different time. Now, if these funds raise with the expectation that they were going to be raising every two years, and going back to the point of how do funds die? Well, funds die when they frankly can't raise from LPs. And if you allocated capital at a clip that was that quick, and you go back to those same LPs, and now these LPs are dealing with the denominator effect where they don't actually want to allocate anymore into that venture asset class, you probably can't go back to those same LPs.

And now, as there're a larger tightening of the belt across the board, there might not be the ability to raise future funds. So now you're really banking on those two years worth of investments to play out exactly the way you expected and then be able to raise a fund based on those returns. But as we talked about, ventures' a long-term duration, eight to 10 years. So you're going to be sitting around on the sidelines for a long time waiting to see.

Chris Gates:
Waiting, just waiting. And I feel like that is, there's a little bit of a shift in narrative around what a smart fund is. I feel like in the past three years, it's been about how many deals you could get done and how fast you could deploy capital. I feel like right now everyone's like, we're not going to be able to raise more. And so the smart ones were the ones that still have dry powder or whatever.

Shaq Vayda:
Yeah. I think the firms that will come out of this world in a better spot are the firms that looked around and said, "Even though the music's playing, I'm not participating." And the firms that did choose to participate, we'll have to see how many of those stick around. But the firms that are sitting on dry powder today, those are quite interesting. I mean, you think about 2008, 2009 timeframe, right? Those were some of the best returning firms we've seen ever. There are quite a few companies.

Now, one other interesting data point, going back to capital calls. So remember, as you don't get all the money upfront, you still need to go back to those same LPs, even if you're sitting on dry powder to go get that capital back. Now, in a world in which that same LP is struggling because their public positions are down significantly, for you to come in and say, "Hey, by the way, I have a massive capital call I need you to pay for." That's a little scary. That LP really, even though they're contractually obligated to give it to you, you want your incentives to be aligned. And your incentives aren't aligned if they're not feeling well, and now you're asking them to give you even additional cash. So you need to have incredibly high conviction that that is a bet that you want to make. Because at that point in time, they're going to give you that cash and that cannot be something that...

Chris Gates:
So any deals that are happening are going to be extremely high conviction?

Shaq Vayda:
That's exactly right. I think the bar, well, the bar is always high, I think the bar is considerably high. And that is why I don't think we're seeing the hundreds of TechCrunch press releases today that we may have seen a year ago. And it's because every firm is doing extra due diligence. If they're going to make a capital call in this environment, they need to be incredibly confident that...

Chris Gates:
I've also been thinking a lot about the shift in power dynamics. It feels like it's been a long time where the power has really resided in the founder's field. The founder gets to set the terms. There's so many different funds trying to give companies money. There's more money than there are companies to give to. And it feels like in this downturn that potentially the power dynamics shift back to the VCs almost going back to a different era of VC. What are your thoughts on that?

Shaq Vayda:
Yeah, we've always believed that capital constraints breed creativity, right? In other words, when capital's abundant, it's easy to experiment in many, many different things simultaneously. You might say, "Oh, this is an interesting product market fit, but what if I go and try these three different adjacencies and find additional product market fit here or here or here?" It allows this ability to experiment, get optionality. What it doesn't do is it doesn't build this internal machine or internal process to really go and find one pain point and solve it incredibly deeply.

In a capital-constrained environment however, we're going to see startups that focus on one problem, one thing, and absolutely either succeed or die, but solve that one thing. And that to me is ultimately what we're going to be looking for in this environment. So the power shift, I don't believe has necessarily gone away from the founders, but I believe it's going to bias towards founders who are able to build in a closed, narrow scope and build something that really solves a problem. Versus founders who may have thrived in a environment in which they can do many things simultaneously and not really prove out that they actually have a fundamental...

Chris Gates:
Okay. Awesome. Thanks so much, Shaq.

Shaq Vayda:
Of course.

Chris Gates:
Yeah. I appreciate it.

Shaq Vayda:
Thank you.