10 Predictions About The Future of VC

👋 Hi, I’m Andre and welcome to my weekly newsletter, Data-driven VC. Every Thursday I cover hands-on insights into data-driven innovation in venture capital and connect the dots between the latest research, reviews of novel tools and datasets, deep dives into various VC tech stacks, interviews with experts, and the implications for all stakeholders. Follow along to understand how data-driven approaches change the game, why it matters, and what it means for you.

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VC has long been a cottage industry that has seen little innovation. This is particularly surprising as VCs themselves are the ones backing the most disruptive businesses. They have a front-row seat when it comes to the adoption of new technologies and business model innovation, yet in the first 60 years following the industry’s inception in the 1950s, the only change was the shift from pen & paper to computer & MS Office.

The reason for this lack of innovation is most likely the absence of competition and pressure to change. Access to capital for startups with less traditional business models and a lack of collaterals has historically been heavily constrained. This is why the VC industry evolved in the first place and, unfortunately, this reality is still true for the majority of new startups today.

As a result of a supply-side constrained market, VCs could long afford to be picky and weren’t forced to innovate. Until the early 2010s. Maturing ecosystems and cheap money policy increased new firm formation but also the assets under management per firm. Access to capital became gradually more available for startups and the shift from a supply-side constrained market to a more balanced, partially in 2020 and 2021 even demand-side constrained market, suddenly forced investors to get their act together.

Ever since I joined the VC industry in 2017, I’ve been observing, pushing, and writing about growing innovation in this rusty industry. In today’s episode, I’d like to zoom out again and look at the major trends and predictions for 2024 and beyond. Let’s dive in!

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The VC industry faces a range of challenges. Overpriced portfolio companies, lack of exit channels, DPI and performance issues, fundraising struggles, generational transition, diversity, you name it.

In the past decade, the VC market has seen only one direction: up and to the right. Following 2022, however, this has suddenly changed and I expect a natural selection in the next year or two.

Looking at the drivers of this prediction, I’d like to double-click on the most dominant market-related components.

Venture returns are power-law distributed. Few outsized winners deliver the majority of returns. For this logic to work, VCs need exit channels like IPOs and M&A with significant liquidity.

Deflating public markets end of 2022 and the resulting liquidity crunch were anything but helpful. Since then, many VCs have sat on piles of paper money but cannot divest and deliver DPI.

This translates directly to LPs which in turn have limited resources for new engagements and re-ups. Consequently, their deployment strategy for 2023 and at least until the re-opening of IPO windows towards the end of 2024 or even early 2025 is extremely selective.

Based on feedback from various institutional LPs, most of them cut back on new engagements with emerging managers and become hyper-focused on performance KPIs for 3rd generation+ GPs.

Second fund generations are a bit of a different breed as they tend to follow the inaugural fund about 3 to 4 years later and are unlikely to deliver tangible performance that soon. Thus, whenever LPs invest in first fund generations, they typically subscribe (at least in their mind) to the second generation too.

I expect several GPs with insufficient exit track records and/or other challenges to disappear in the next year or two.

This will most likely hit firms that were founded in the rising market of 2010-2018ish, as they’re old enough for LPs to require KPIs (raising 3rd generation+) but too young to have distributed tangible money to their LPs. Hereof, they either cut headcount to extend runway into hopefully more friendly market environments, close shop, or join forces with other firms.

Though VC as an industry has historically seen very little M&A, recent activities (driven by different motivations, some even from a mutual position of strength, examples above) might provoke a broader appetite for established VC firms to acquire strategic assets like a brand, portfolio, or an investment team from struggling GPs to enter new markets.

Our partnership at Earlybird has seen three major downturns since our firm’s inception in 1997: Dotcom, GFC, and COVID. Based on first-hand experience and internal analyses, we find that the private venture capital cycle can be split into 4 major phases.

The full cycle historically took around 5-12 years. Downturn and recovery make up about 3 years of this. Generally, we see that transitions between phases tend to follow a more compressed timeline compared to past cycles.

Below is a chart that we first presented to our LPs in 2022 and so far, the predictions for 2023 have come mostly true. Public markets started recovering, e.g. S&P500 up 26% and NASDAQ up 54% in 2023. At the same time, private venture funding clocks in at the lowest levels in 5 years.

Following this cycle, we expect growing private market investments, and more importantly, exits and distributions again in 2024. The first companies will test the IPO waters likely towards the summer of 2024.

Companies that managed to raise funding throughout 2022-2024 certainly did so because they had clear paths to sustainable growth. The more mature ones among them are waiting to see the IPO window open up again. And they seem to be well-prepared.

Assuming that neither the US elections nor any of the ongoing wars escalate, this momentum might then translate into a strong cohort of VC exits in 2025.

I predict that three VC models will dominate and the “in-betweens” will disappear.

Boutiques: Exploding capital availability and competition ahead of the boom in 2021 forced VCs to innovate. Solo GPs and micro VCs (<100m) as subforms of boutique firms were a new breed back then but have established themselves quickly.

Recent studies show that smaller funds outperform larger funds and struggle to keep this performance as they grow. Staying small can be a winning model and given the limited size of these funds, it’s easier to raise them compared to larger funds; thus also a feasible model in the current market environment.

In the long term, the option for outstanding performance comes at a cost of limited allocation. Well-performing boutique funds will eventually attract more LP interest, but struggle to stick to their strategy while meeting target allocations. Therefore, boutique firms mostly stick with non-institutional LPs.

Mega Funds: In line with prediction #1 above, established funds that have returned money to their LPs in the past are still able to raise new vintages. Though sometimes (intentionally) smaller or the same size as before, they have historically grown their funds into multi-billion $$.

While larger funds tend to underperform their x-percentile boutique peers, they offer LPs consistent capital allocation with superior returns compared to other asset classes.

Barbell Approach = The Best of Both Worlds: Talking to different GPs about their long-term strategies, the holy grail seems to be a “Barbell” playbook that unifies the best of both worlds:

The VOID: Having highlighted boutiques, mega funds, and barbell approaches as winning strategies for the years to come, I’m also convinced that the funds in-between will disappear. The funds that started small and grew but neither became an established mega fund nor created a barbell platform will die as they’re too big to deliver outsized performance (compared to boutiques) and too small to attract large institutional investments (compared to mega funds).