The California Public Employees’ Retirement System (CalPERS) recently announced a $1 billion commitment to back emerging private equity managers. The goal is to foster more innovation and entrepreneurship in the investment industry by backing the next generation of managers. CalPERS, with around $440 billion of assets as of June 2022, is a juggernaut in the investment industry and can drive change.

The announcement references private equity, but this is a big deal for the venture capital industry. Venture capital is a subset of private equity and should receive some of these dollars.

Many studies have shown that emerging managers generate alpha, and the CIO of CalPERS recognizes this. This quote from her stood out to me:

It’s not about a diversity play. . . . It’s about generating alpha in a more thoughtful way, and leveraging partners we will work hand in glove with.

Can’t wait to see the impact that CalPERS’s commitment has on early-stage venture capital.

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Last week, Fred Wilson shared his predictions for 2023. Fred’s a well-known VC and general partner at Union Square Ventures. His thoughts on start-ups in 2023 were of interest to me. A few points that founders should take note of:

• 2023 will be a tough year for start-ups. As money-losing companies, many avoided raising in last year’s difficult environment. They’ll be forced to raise this year as their cash dwindles.  
• VCs have ample capital to invest but will be more selective. Companies with product–market fit, strong teams, and good unit economics will be able to raise. Start-ups that don’t have these things will struggle to raise, regardless of valuation, and many will fail.
• Valuations will return to the levels of 2015 or so. Seed rounds will be around $10m, Series A rounds around $15–$25m, Series B rounds around $25–$50m, and growth rounds capped at 10x revenue.
• Lower valuations will lead to flat rounds, down rounds, inside rounds, and lots of structure in the rounds. CEOs and boards should accept the pain of lower valuations over a lot of structure.

Fred’s predictions come from someone who’s seen a few VC cycles. Things won’t necessarily play out just as he’s said, but his predictions are something for founders to be aware of.

I’ve had chats with a few founders in the last week about their next funding round. Many have accepted the current valuation environment but haven’t processed what impact a down round or one with lots of structure will have on the cap table and start-ups overall.

I’m of the opinion that Q1 will set the tone for 2023. If the rate of decline in public markets we saw in 2022 persists, Fred’s predictions are more likely to be accurate. If public markets are flat to slightly up, I think conditions for start-ups could be slightly better than Fred predicts.

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Today it was announced that Vista Equity Partners will take Duck Creek Technologies private. The transaction values Duck at about $2.6 billion. Duck is a publicly traded company that IPO’d in August 2022. Its market capitalization (i.e., valuation) peaked around $7 billion in 2021. The company’s valuation was below $2 billion last week before this deal with Vista was announced.

This made me think about Vista buying Salesloft for $2.3 billion in December 2021. Salesloft was a private company doing somewhere in the neighborhood of $100 million in annual recurring revenue.

We can’t do an apples-to-apples comparison of the two companies. For example, Duck reported $80 million in revenue last quarter, of which $27 million was professional services revenue and likely not recurring. Salesloft is private, so we don’t know the details of its $100 million in annual recurring revenue. But the Duck transaction shows that Vista is buying a public company for around the same valuation they paid for a private company a year ago.

Last year, I thought that low valuations of great public companies would make them attractive acquisition targets. I didn’t see this play out last year, but I suspect we’ll see it this year if valuations stay depressed. Vista’s deal for Duck could get things going. If this happens, great public tech companies trading below a $2 billion market cap could see increased interest.

I love hearing company origin stories. It’s always interesting to hear what led someone to start a company. I’ve started asking for the origin stories of younger VC funds too. Emerging managers are founders too, and going from zero to one with a fund can be difficult. I love hearing why they made the leap. I recently heard a VC fund origin story that was different than any I’d heard before.

Venture capital and its outsize financial rewards have been known in areas like San Francisco for decades. A founder from another country was able to take his start-up public and reap a massive windfall for himself and his investors. This hometown story caught the attention of founders and investors in his native country, who wanted to know how they could support the next local founder who’d have breakout success.

A multifamily office in that country was repeatedly getting asked by the families it managed wealth for if it could find some early-stage investment opportunities. Its leaders realized there was no venture capital in the country and decided to start the first venture fund there. They settled on a hybrid strategy of investing in other venture capital funds and making direct investments in start-ups.

Fast forward a few years, and they’ve raised a few funds and had one of their seed-stage start-up investments go public. The fund managers are happy, as are the founders they backed and the limited partners who invested in their fund.

What an interesting origin story.

I watched an interview Robert Smith gave recently. He’s a billionaire and founder of Vista Equity Partners, a private equity firm focused on software companies. Robert was very open, sharing details of his childhood, his journey from engineer to investor, and his perspective on a variety of topics. He did a great job of explaining private equity, venture capital, and capitalization at different growth stages in a company’s life cycle in a way that many people can understand.

I’ve spent time thinking about the impact of knowledge gaps on a founder’s velocity. Robert shared his thinking about knowledge gaps and how filling them is core to his strategy at Vista. Here are a couple of things he said that stuck with me:

“You’re accelerating the corporate maturity of that business. It might take you 10 years to figure out what we’ve done 45 times already. Now I bring that intellectual property into the company.”

“You may not have figured out or may not figure out because you may not be in an environment or circle of people who have dealt with that before. That’s why the expertise we bring is often more valuable than the capital.”

Even though he’s a private equity investor, Robert is also a founder. He founded Vista over twenty years ago and built it to almost six hundred employees and almost $100 billion in assets under management. He was speaking from the unique perspective of both a founder and investor who’s had outsize success. I think it says a lot that he’s built an organization whose success is largely based on creating value by filling the knowledge and capital gaps of people running later-stage companies.

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I chatted with someone who used to work at a family office with a real estate background that manages a large investment portfolio across different asset classes. This person shared a few things that stuck with me:

• Opportunities to create value and wealth in real estate won’t look like the past. The return profile will look different. Individuals and families who own real estate will likely keep it and pass it on for a variety of reasons (taxes is a big one). The acquisition prices seen in the last few decades likely won’t be repeated, making it harder for new entrants to create returns like those of people who started thirty or forty years ago.
• Other asset classes, such as public equities, aren’t great for multiplying wealth.
• Venture is the best asset class for value and wealth creation. It’s a great asset class for those looking to multiply wealth, not just preserve it. But it’s one of the hardest asset classes to penetrate if you don’t have a background in it or existing relationships. It’s also hard for family offices to be successful if they don’t have the appropriate risk appetite and portfolio construction strategy (i.e., in relation to check size and stage). Family offices like venture as an asset class but can struggle to have success.

Interesting thoughts. Some of them I’ve heard from people in other family offices I’ve talked with. We’ll see more capital flow toward owning private companies (i.e., private equity), with many family offices and other institutions specifically wanting access to early-stage private companies (i.e., venture capital). Overall, I think this is good for entrepreneurship and founders. I do think we’ll need to see improvements in how that capital (and other resources) are matched to founders. At the early stage (seed and pre-seed), the process is massively inefficient.

One of the things I like to learn about a founder is their origin story. How were they raised, and what were they doing in life that illuminated the problem their start-up is solving? Sounds simple, but the origin story can be a leading indicator. Today I listened to a few fund-of-fund investors critique an emerging venture capital fund’s pitch deck and give guidance about how emerging managers can best pitch limited partners (LPs).

A consistent piece of advice for all the funds of funds was that emerging managers should lead with their story. The pitch deck shouldn’t jump right into thesis, investment track record, or how much the manager is raising. It should start with background on the manager—what their journey has been and how led them to raise their own venture fund and come up with their investment thesis.

LPs are buying a portfolio of to-be-determined portfolios of investments. Ideally, they’d look at previous fund investments to gauge what a manager’s future portfolio of investments might look like. However, many emerging managers won’t have an investment track record. When that’s the case, LPs are investing in the managers. They want to get to know who the managers are, how they think, and why they are the way they are. Understanding what makes them tick will give LPs more comfort around the person they’re backing and the nonexistent portfolio they’re buying.

This feedback makes a lot of sense, and it was a reminder that emerging VC fund managers are basically founders. Telling an authentic, compelling story—as a manager or founder—can be the key to getting early believers on board.

I listened to a fund of funds investor give her perspective on how her team and other large institutions have changed how they evaluate venture fund managers. Their focus has shifted from increasing portfolio valuation (i.e., markups on start-ups) to distributions (i.e., cash returned by exiting start-ups). Part of the reasoning was around private market valuations’ lag in correcting and its impact on portfolio allocation.

Venture capital investments are private investments, so finding their correct market price usually happens when new funding rounds happen. If a company last raised in 2021, the company’s valuation is usually marked at the 2021 fundraising-round price. Public companies’ valuations are adjusted in the public markets every day, and many have been on a downtrend in 2022. Because venture investments are slower to be marked down, some institutions are over-allocated to venture capital relative to their entire investment portfolio.

For example, venture capital might have accounted for 8% of an investment portfolio in fall 2021 when valuations were high. The max allocation for venture capital in the investment portfolio is 10%, so that 8% allocation was below the limit. As the public equities in the portfolio decreased in value in 2022, venture capital values remained flat (they continued to be marked to their 2021 level because companies are avoiding raising in this environment). That means venture capital might now account for 12% of the overall investment portfolio, which is above the max allocation.

Given this dynamic, the fund-of-funds investor said her team is now more focused on distributions: how much capital have fund managers returned to their limited partners (LPs). For those overallocated in venture capital, distributions are an ideal way to increase cash allocation and reduce their venture capital allocation. Managers who have returned or are returning cash are viewed in a positive light.  

She mentioned that part of a venture fund manager’s job is to know when to sell. Given the rich valuations in 2020 and 2021, her team is looking closely at 2017 or older fund vintages that didn’t use the rich valuations as an opportunity to distribute capital back to LPs.

Very interesting how the LP focus has changed from valuations/markups to cash returns. I suspect this focus will be top of mind for more venture fund managers and trickle down to CEOs of their portfolio companies. This, combined with a tough IPO market and other variables, could make 2023 an active year for acquisitions.

One of the patterns I see in venture capital is fund managers, especially emerging managers, drifting downstream to invest at a later stage as they have success. Managers naturally invest at a later stage as they raise larger funds. More on that here and here.  I understand venture fund managers' desire to raise larger funds, but I see things differently.

Meeting companies at the earliest stages of their formation is a massive opportunity for outsize impact and financial returns. It helps accelerate the success of founders, whose solutions can have a positive impact on society and address overlooked problems. When investments at the time of company formation are successful, they generate outsize returns for founders, employees, and fund managers and their limited partners. Those returns are, hopefully, recycled into other early-stage investments.

Raising larger funds and benefiting from the additional resources generated from increased management fees makes sense, but I think that doing so must be balanced with the risk of not being at the fountainhead of company formation.

Today I caught up with an aspiring founder. He’s been working as an engineer for a growth-stage start-up for the last four years. He’s fully vested and thinking about starting his own company. I always like to understand people’s journey, so I asked about his—specifically, about choosing to get his master’s in computer engineering from Carnegie Mellon.

He told me he didn’t even know what Carnegie Mellon was and ended up at the school by chance. He joined the National Society of Black Engineers (NSBE) as an undergrad and attended their conference. During the conference, he got what he thought was a spam email about Carnegie Mellon and its master’s program. Having never heard of the school, he asked an advisor about it. He learned it was one of the top engineering schools in the country. He decided to stop by the Carnegie Mellon booth to learn more. Talking with the admissions staff, he learned that he perfectly matched the profile they were looking for and that the master’s program was a perfect match for what he was looking for. He was basically admitted on the spot. He accepted and excelled in that program . . . and the rest is history.

Matching is critical at the earliest stages of entrepreneurship and your career. The right conversation can literally change your life trajectory. You must be in the right networks for matching with the right people and resources to occur. This engineer was under-networked and didn’t know what he didn’t know. He didn’t even know that Carnegie Mellon existed, let alone that he should apply. Carnegie Mellon didn’t know he existed, so it couldn’t recruit him. The NSBE was the conduit that allowed him to be matched to Carnegie Mellon. The NSBE played the critical role of finding this engineer by meeting him in his existing network/community. It then connected him with people, companies, and schools in other networks he wasn’t aware of.

This engineer is smart and scrappy, and he has a chip on his shoulder. He’s what I call a high-potential, nonobvious founder (or he will be, when he starts his company). These are the kind of founders I like to bet on. Nothing was handed to them. They earned everything they have by climbing mountains. They’re a little different, so people can’t relate to them, but they’re going to win because they want to prove everyone wrong.

These nonobvious, talented people will drive the next wave of entrepreneurship. Sadly, the current seed-stage venture capital model isn’t set up to find and support these types of founders. I think there’s a massive opportunity to support more nonobvious founders outside the traditional venture capital network, and it’s an area I’d like to focus on.