Why Venture Firms Are Scaling Back the Size of Megafunds

As markets have wavered, IPOs became less attractive as monetization events, many early stage companies appear overvalued and venture focus on startups has shifted from experimentation to investment in sure things, big endowments and pension funds are allocating less money to venture funds. 

The result is that the size and number of big funds has shrunk. JL
Berber Jin reports in the Wall Street Journal:

For the past decade, Silicon Valley investors raised larger and larger funds in the hopes of capturing more of the technology market. As startups swelled in size, venture capitalists wrote massive checks to companies that looked little like young businesses. The strategy backfired when the tech market crashed last year, leaving megafunds with overvalued stakes in startups (with) little prospect of going public. University endowments and pension funds cut back money allocated to venture firms. Venture firms raised 7 funds of at least $1 billion for the first 6 months of 2023 (compared to) 33 such funds for the full year 2022 and 23 in 2021.

Venture firms are scaling down the megafunds they raised during the technology bull market, showing how startup investors are pruning their ambitions despite a sharp rebound in the value of publicly traded tech stocks.

For much of the past decade, Silicon Valley investors raised larger and larger funds in the hopes of capturing more of the fast-expanding technology market. As startups swelled in size, venture capitalists wrote massive checks to companies that looked little like the scrappy young businesses that the venture industry was designed to support.

 

The strategy backfired when the technology market crashed early last year, leaving megafunds with overvalued stakes in startups that had little prospects of going public. SoftBank’s first Vision Fund, a $100 billion vehicle launched in 2017 that popularized a brasher approach to investing, has shed billions of dollars in value this year as it writes down the value of its startup stakes. 

Some venture leaders say they are abandoning the once-popular strategy in favor of a more modest investment approach. 

In March, venture firm Y Combinator eliminated a growth investment arm called Continuity that had plowed more than $3 billion into late-stage startups, citing the need to refocus its efforts running its startup accelerator. 

Y Combinator built a name running the accelerator program, which provides funding and training to founders building new companies. The firm launched Continuity in 2015 and invested more than half of the unit’s latest fund of $1.4 billion when startup valuations peaked in 2021 and 2022. 

Social Capital, the venture firm run by the serial SPAC promoter Chamath Palihapitiya, earlier this year abandoned its plans to raise a $1 billion fund. In his “All-In” podcast, Palihapitiya said he made the decision after the market crash made it difficult to assess the value of his existing startup portfolio. 

Chamath Palihapitiya PHOTO: BRENDAN MCDERMID/REUTERS

“I could barely stand the idea of me putting money to work right now—of my own capital—without any answers,” Palihapitiya said in the podcast. “But then the idea of having a bunch of sovereign-wealth funds and folks that were ready to work with us, I don’t know, just not the right time.”

Last fall, Palihapitiya also shut down two SPACs after failing to find companies to take public after the market crashed. 

The cuts are coming even as the tech-heavy Nasdaq has risen over 30% this year, thanks in part to recent optimism over artificial intelligence. Venture investors say that many of the opportunities from that sector are concentrated in small startups and that there still aren’t many attractive investments among later-stage companies. Shaky receptions to a trio of initial public offerings this month show that the new-issue market is still in recovery mode.

“When money got a little easier, did the marginal investments sneak in? Yes. And that’s why we’re all sort of taking pause and getting back to basics,” said Alfred Lin, a partner at Sequoia Capital. Last month, Sequoia downsized its own business by separating its U.S. and European unit from its China and India units. The split came in response to U.S. government scrutiny of Sequoia’s China ventures. 

Alfred Lin. PHOTO: BRENDAN MCDERMID/REUTERS

Venture firms raised seven funds totaling at least $1 billion for the first six months of the year, a slower pace than in prior years. Venture firms raised 33 such funds for the full year in 2022 and 23 in 2021, according to data from PitchBook. The declines have mirrored a drop in the size and frequency of later-stage funding rounds, where megafunds once invested the bulk of their cash, the data show. 

The smaller funds are also the result of a much tougher fundraising environment, as large investors including university endowments and pension funds cut back the amount of money allocated to venture firms. The IPO market for technology startups has remained largely shut for over a year, delaying the payouts these investors need to reinvest large amounts of cash in new funds. 

Tiger Global Management, after investing much of its latest $12.7 billion fund when startup valuations peaked in 2021 and 2022, downsized its ambitions for its latest fund, raising around $2 billion so far, according to a securities filing. The firm told investors that some of its existing backers cut back their commitments to the new funds, people familiar with the matter said. 

Tiger’s partners also told investors that the firm was raising its investment bar given the cooled market, the people said. Earlier this year, Tiger also explored selling a portfolio of its startup stakes to help return some cash to its investors and asked some startup founders to return its initial investment, people familiar with the matter said. 

Venture giant Andreessen Horowitz also discussed breaking apart its future venture funds into smaller funds dedicated to specific sectors like fintech and enterprise investing, people familiar with the matter said. Its latest venture fund of $2.5 billion is among the largest in the industry.

“We’re in a bit of a rationalizing state of the market,” said Beezer Clarkson, a partner at Sapphire Partners, which backs venture firms. “In these tougher markets, this is a behavior you’ve seen historically.”

The retrenchment has sometimes hurt these firms’ reputation with founders, who are increasingly relying on their existing backers for financial support at a time of dwindling cash across the industry.  

After Y Combinator shut Continuity, its growth investment arm, 10 startups backed by the firm sent a joint letter to its leadership expressing their disappointment with the decision, according to a copy viewed by The Wall Street Journal. The letter was reported earlier by the Information.

In an emailed response to the startups, Paul Graham, Y Combinator’s co-founder, said that the board had unanimously concluded that it had been a mistake for the firm to start the growth fund and that it had become impossible to run it well alongside its startup accelerator.