🦄 Cash is king — turning unicorns into realized gains
By Edouard Lingjaerde, Manager at Reference Capital | Originally published on 🔥 Reference Newsflash.
Guest post by Edouard Lingjaerde, Manager at Reference Capital | Originally published on 🔥 Reference Newsflash.
💸 Unicorns are Good, Cash is Better
Imagine you’ve just backed the next big tech unicorn. The company is growing, valuations are soaring, but the question remains: when will you actually see your money back? This is where Distributions to Paid-In Capital (DPI) comes into play, being a crucial metric for both venture capitalists and investors.
As we know, venture capital is a long-term game, where investments remain illiquid for multiple years before companies are able to exit. While the question “when will my investment exit?” remains similar to five years ago, the expectations around “how will it exit?” have changed significantly.
But here’s a key question: would you rather see modest returns quickly, or wait longer for potentially much larger returns? This dilemma is currently at the heart of evolving dynamics in venture capital.
🏋️♂️ Why Such Pressure for Liquidity?
Venture Capital, like Private Equity, saw a significant inflow of capital between 2018–2023. This was driven by significant unrealised gains during the low interest environment.
While there were many new limited partners entering the asset class during this period, most of this capital came from existing investors. Existing investors ended up increasing their deployment in these years, due to the increased pace of investment from underlying managers.
This all came to a head in 2022, as many mature funds did not take advantage of the 2020 and 2021 liquidity window to crystalize paper gains for LPs and are now struggling to find exit solutions.
This boating in VC has forced LPs to pull back on deployment until additional liquidity can be created to enable reinvestment. This is reflected in the dramatic decrease of ~50% funding from the peak in 2021.
Now with the IPO window closed and M&A remaining mostly muted, LPs are putting more pressure on VC Funds to figure out ways to generate liquidity in order to provide capital to reinvest in their next vintage.
👀 How Are Changing Liquidity Preferences Shaping Fund Strategy?
With scarce capital allocation in the venture space, there is a shift in preference by LPs towards funds that demonstrated both performance and liquidity. Investing in funds that navigate tough market conditions and deliver returns. As a result, capital is concentrating towards top-tier managers known for faster distributions to LPs. For example, top decile venture funds from 2017 have achieved returns exceeding 1x DPI, significantly surpassing the median of 0.2x and the average of 0.6x. This highlights the performance disparity between top managers and the broader market.
This LP preference is having a knock-on effect on deployment pace. While many GPs speak about a current “lack of attractive opportunities” to deploy capital, it’s clear there is also a reluctance to come back to market to raise a new fund without first creating DPI for existing LPs in their mature vintages. This has resulted in a significant build-up of dry powder — unallocated capital.
Mature Funds now face a critical decision: create liquidity by exiting investments or hold positions for higher future returns. While LPs often request distributions, many funds, despite showing promising paper gains (“TVPI”), are cautious about liquidating assets prematurely. Each strategy — quick liquidation versus holding for potential gains — has its merits. Venture funds generally maintain consistent distribution timelines, aiming to return investors’ capital by the seventh year, as fund managers are incentivized to maximize returns within a specific timeframe. This approach benefits both investors and venture firms, as the lack of liquidity affects not only the fund’s ability to meet distribution timelines but also impacts LPs’ strategies for future commitments.
🏪 Creating Liquidity in a Challenging Exit Market
People might have expected that the new normal would be years like 2021, where close to $800bn were distributed (and with a vast majority through IPOs). However, the market has shown that we don’t live in an attraction park anymore. With only $66bn in annual exit value in 2023, we’ve returned to levels similar to 2016, representing more than 90% decrease from the previous highs. And while the industry expected the general exit activity to slow down, we also expected an increase in the number of mergers and acquisitions relative to previous years, following cheaper private valuations — which did not happen.
But why did public listings stop so suddenly? When looking at the recent IPOs, we see that only best-in-class companies were able to sustain their valuations post-IPO. This likely scared many tech unicorns and their investors to go through a public listing. In addition, top companies still trade at a “private premium” to enable larger funds to extract as much value as possible before their IPOs. This incentivizes founders to stay private and take less risk around valuation volatility. Oftentimes, the funds encouraging this behavior are also the “brand names” that can keep raising new vintages no matter the macro environment.
While the market is tough, we are seeing some glimmers of hope with one recent successful IPO example, Reddit (RDDT), which saw a 175% increase in stock price since its listing. But even though Reddit went public at a premium to what the company was initially targeting, the reality is that it went public 35% cheaper than its previous private round, highlighting the points we are making above around incentives to be public.
🔁 Alternatives for Generating Liquidity
So, let’s summarize — we are in a market where companies are still (for the most part) not revalued, where exit activity is frozen, and where investors want to see distributions. So how do we get out of this bottleneck?
Well, fund managers have to become creative and find new ways to generate liquidity. While not reinventing the wheel, three strategies have recently emerged as alternatives to this liquidity drought:
Secondary Markets — Secondaries have seen increased interest from investors, thanks to steep discounts in the private markets throughout 2023. Last year alone, close to $80bn was raised to invest in that strategy, which we expect to become more active in the coming months. Secondaries involve purchasing equity from other investors, often at a discount. The secondary market depends entirely on bid and ask prices, which in turn depend on where investors see the risk-reward for the opportunity, also fluctuating based on macro pressure.
Continuation Funds — Continuation funds are new funds to which assets are transferred, allowing venture capital firms to continue supporting best-in-class portfolio companies, while providing liquidity to investors looking for distributions. To our early question around preferring modest returns quickly or waiting longer for potentially much larger returns, continuation funds provide investors with the ability to make their own judgment on this. On the other hand, this strategy also poses conflicts of interest, as venture managers will try to keep portfolio valuations as high as possible due to the carried interest paid to the previous funds.
Private Equity Buyouts — Private Equity firms are nowadays quite familiar with venture investing, particularly within the SaaS industry. Bain & Company recently shared a research highlighting that $3.9 trillion of capital was available for private equity firms to be invested, with a good amount earmarked for venture opportunities. We have seen those players in more active conversations with our GPs about portfolio companies and have shown interest in emerging sectors outside of SaaS, acting as a potential alternative exit route to public markets or traditional opportunities. Overall, the lower late-stage valuations should act as a catalyst for better risk-return opportunities for PE investors.
🔮 Reference Viewpoint & Expectations
Everything we mentioned might sound quite pessimistic, with more pain still to be felt in the market from bankruptcies, down rounds and layoffs. However, if you were to read between the lines, you might’ve picked up on a few signals that might turn the balance. Indeed, we think that the private market still has the potential to face a Goldilocks scenario, if a few key triggers were to come together.
First, let’s say that interest rates get cut (which we have started seeing in Europe). Second, US presidential elections spur pressure for the White House to soften the macro environment pressures. Those macro tailwinds could provide sufficient ground for the IPO market to reopen, creating optimism and encouraging venture capital firms to resume deployment in private companies at higher rates. In turn, this could lead valuations and graduation rates to increase.
The question remains: are we headed for a soft or hard landing? While we don’t have a crystal ball (sorry!) and there are still many unknowns, we have seen that vintages from the years following 2000 and 2008 have resulted in decade-best performance. The years 2024 and 2025 could be the most interesting vintages in venture capital for the coming decade, which pushes us to optimistic while remaining cautious of the global environment.
Read/ Hear More ⬇️
🎙️ Limited Partner Unlocked: Michael Kim Cendana Capital on the Emerging Manager Landscape, Fundraising, and the Need for Liquidity — Venture Unlocked with Samir Kaji
📄 In Search of Liquidity; Navigating Today’s Illiquid Market as a GP — Industry Ventures
📄 Global Market Snapshot — Pitchbook
📄 VC Tech Survey — Pitchbook
📄 Global Private Market Fundraising Report — Pitchbook
📄 Is a chilly market for IPOs on the brink of heating back up? — Carta
📄 Unicorns — Dealroom
