#26 Episode - The Three-Body Problem in VC

Key Takeaways: The incentives of the three key players in venture capital are diverging, $500B in unrealized gains are at risk of being marked down in the coming years, venture deal terms are starting to look less founder friendly, and three practical tips for venture capital managers to stabilize their operations.

The Three-Body Problem has vexed scientists for over 300 years after it was first discovered by Isaac Newton. The problem describes the odd result of what happens when two orbital objects in space, such as the Earth and the Moon, interact with the gravitational pull of a third celestial body, such as the Sun.

While the motion of two objects is predictable and follows a linear path, the introduction of a third body results in random, unpredictable and unstable motion. No math equation can solve for it. Not even Einstein’s General Relativity.¹

Author Liu Cixin popularized the Three-Body Problem in his science fiction novel published under the same name:

In the novel, the problem is described as follows:

“The three-body system is a chaotic system, one in which tiny perturbations can be endlessly amplified. Its patterns of movement essentially cannot be mathematically predicted.”²

The Three-Body Problem in Venture Capital³

As applied to venture capital, the Three-Body Problem refers to the industry’s three key players and the cost of capital as the driving force influencing market behavior:

1—Founders are seeking funding before capital dries up

2—VCs are sitting on a $300B powder keg, hesitant to draw down capital

3—LPs want to preserve their cash to invest in high-yield assets with less risk

In 2023, with interest rates going up, incentives are diverging:

Venture Fund Metrics

Over the last decade, a record amount of venture capital has been raised and deployed:

• In 2021, there was a record-breaking 18,521 US venture deals, which was 39% higher compared to 2020.⁴ The total deal value reached an unparalleled amount of $344.7 billion, showing a year-over-year increase of 101%. Moreover, VC-backed exit values surged to an extraordinary $753 billion, an increase of 131% YoY. Times were good for venture capitalists during rock-bottom interest rates.

But by the end of 2022, as markets faltered and interest rates crept up, deal volume slowed down and exits all but dried up.

• In 2023, the amount of dry powder—or venture capital raised but not deployed—has accumulated to about $300 billion in the U.S. This abundance of capital comes at a time when M&A exits and public listings have been heavily slashed.

Venture portfolio valuations have not adjusted. VCs are still riding the wave of mostly unrealized gains (TVPI)—while realized returns (DPI) have been left wanting.

This graph shows another angle of the hidden risks in the top 25% of VC portfolios:

There are three main takeaways from this graph:

• The orange horizonal line is the average return of the top 25% of VCs taken from 1997 through 2017.⁵ (In other words, ~2x DPI is the average of top quartile funds.⁶)
• The gray vertical bar (TVPI) indicates the markups of the top quartile’s portfolios. The blue bar (DPI) represents actual returns. In simple terms, gray bars are mostly paper markups in the early years and blue bars are actual returns of the top quartile of VCs from ‘97-’17.
• Over time, as TVPI and DPI converge, the gray bars and blue bars sync up and the gray bars and blue bars eventually become one. For example, despite the 5x TVPI in 2012, LPs have only received 2x their investment (DPI), while the ~3.5x in 1997 is the actual return of capital distributed to LPs in that vintage.

Here's a look at more recent data from Silicon Valley Bank which shows corrections of the average VC portfolio (all funds) may already be happening:

Will we see massive markdowns and TVPI corrections, or will the next few years significantly outperform the last 10+ years?

If we believe the next few years will outperform as the last 10+ years, then the vintages between the years 2012-2016 represent the largest set of returns in the last 40+ years of venture capital. However, if the markets do not outperform the next few years, the orange line represents a regression to the mean.⁷

The key takeaway is as follows:

• $500B in unrealized gains are at risk of being marked down in the coming years

Historical Lessons from the Dot Com Crash

For founders, a similar situation occurred between 2001 and 2004. After the Dot Com crash, capital was tight, which forced founders to accept more investor-friendly terms such as liquidation preferences greater than 1x, liquidation participation rights, and full ratchets that gave investors full anti-dilutive ownership percentages.

Some investors have described today’s funding environment as an “existential crisis,” urging founders “to buckle up” and prepare for a potential “mass extinction event”:

Some recent data are bearing this out—here’s a graph of liquidation preferences >1x:

In addition, valuations across all stages are being slashed across the board (Seed stage has fared the best, but it is still down from 2021 valuations):¹⁰

This comes at a time when cash is tight for startups as runway is dwindling for many and the clock is ticking until the next round—an average of 24+ months:

While “dry powder” is legally available capital, at the same time, LPs want to preserve cash as interest rates creep up. LPs have an incentive to slow down their capital calls knowing that (a) near risk-free investment returns are increasing, and (b) their investment portfolios are at risk of markdowns.

For VCs, calling capital now is a little like playing a game of Jenga. Making too many capital calls could destabilize the venture capital system, similar to how removing one too many blocks from a Jenga tower can destabilize or lead to its collapse.

Three Practical Tips*

Based on conversations with my fund clients and their limited partners in the past month or so, I have three suggestions* that could potentially stabilize the situation:

1. Offer LPs co-investment opportunities with carry and fee discounts/waivers.
2. Adjust management fee schedules by pausing or slowing down fees in 2023. Your LP Advisory Committee (LPAC) should vote to avoid any conflicts of interest.
3. Consider subscription lines of credit for short-term cash needs,⁸ but exercise extreme caution when using this strategy—there's no such thing as a free lunch.⁹

*Not legal advice, speak to your counsel to evaluate your specific situation for risks and other legal considerations.

While the state of the venture capital markets for 2023 is faced with challenges—such as cash preservation and the risk of markdowns—the future looks bright for VC firms. VCs are still sitting on $300B+ in capital commitments and have the opportunity to stabilize the system by offering co-investment opportunities, adjusting fee schedules, and exercising caution with the use of subscription lines of credit. By taking these practical steps, VCs can navigate the current landscape and continue to drive innovation and growth in the years to come.

Credit to Kyle Harrison and his article "Dreaming Of Dry Powder" for my source of inspiration and whose original ideas I poached from above. Also major hat tips to Juniper Square for their Q1 2023 - State of Venture Capital report in which several graphs from Pitchbook were kindly repurposed, as well as Silicon Valley Bank (SVB), State of the Markets H1 2023.

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Thanks,

Chris Harvey