How VCs are adapting their strategies to new market realities

To put it mildly, 2022 was a rough year for venture capital. Overall deal count was down 14%. Deal value dropped 30%. U.S. VC exit activity was valued at just $71.4B, down an astonishing 90% YoY. Since venture distributions are a function of exit activity, LPs have far less capital to commit to new funds this year. As Axios reported in Axios Pro: Deals Report, “The global deal making environment was experiencing a downturn before Silicon Valley Bank failed in March.”

All this uncertainty and volatility—driven by rising interest rates, inflation, geopolitical turmoil, and more coupled with the denominator effect—have thrown many portfolios akimbo, putting private capital and venture holdings at a much larger proportion than they were this time last year. That means ​​investors are taking their time to sort out portfolio valuations, monitor market changes, and re-forecast their financial goals before allocating large amounts of capital to new VC funds. This slowdown had made fundraising that much harder for firms.

However, as recent Pitchbook data shows, while the $11.7B raised in Q1 2023 might be significantly down from the $73.8B raised in Q1 2022, it matches the $11.7B raised in Q4 2022. Looking at the data optimistically, the argument can be made that we are potentially at, or at least close to, the bottom of the dip.

With VCs being much more selective and doing further diligence before making investments, many are spending more time helping current portfolio companies shore up their balance sheets, cut and burn, or find a graceful exit.

Perhaps the market will normalize over the next year or so, but in the meantime, what should firms do now?

First and foremost, VCs need to acknowledge reality. Exits and valuations are down, and hiding the ball won’t get you far. General Partners (GPs) are on the front lines; most Limited Partners (LPs) depend on them to understand what’s happening. The collapse of SVB shined a bright light on the venture community, grabbing the attention of even those who would normally never pay attention to the VC space. Everyone could read the headlines, but no one knew what they might mean. In the days following the collapse of SVB, hundreds of companies scrambled to let investors know how little—or how much—it affected them.

When things are up in the air, proactively sharing context on large fund positions helps LPs understand their exposure and the impact of the headlines on the underlying companies in a fund. For instance, in a letter to investors, Sequoia Capital marked down the total value of its holdings in FTX, the world’s third-largest cryptocurrency exchange, to $0. The note is an excellent example of how firms can protect their relationships with LPs by being as transparent about their losses as they are about their wins.

Increasing the frequency and intention behind virtual or in-person LP meetings and focusing on high-value touch points that build trust is another way VCs can double down on the partnership. Technology can help streamline those efforts and foster true, bidirectional communication and coordination.

With a modern, interactive environment, a dynamic investor portal provides a shared, secure view of key partnership details, including important documents, investment reports, and investor profile information. Relationship intelligence provides insights around every relationship in a firm's collective network—allowing VCs to efficiently manage valuable relationships and prevent communication lines from going quiet.

It’s not enough to come to the table with last quarter’s reporting—VCs need up-to-date data and a narrative that helps LPs understand what is happening and what it means for them and their investments. Investors often lack the detail and transparency they’d like because a GP might only send a few high-level reports throughout the year. That’s not enough when things fluctuate daily. LPs want consistent updates on what is working, what is not, and, perhaps most importantly, why. if you don’t have your fund and investor data at your fingertips to share out with LPs, you risk undercutting your LP experience.

While this period of “wait and see” can be seen as a challenge for VC firms that thrive on doing deals, this lull creates an opportunity for operational spring cleaning, providing the time and space for firms to ensure they have the right internal infrastructure and third-party partners in place to take advantage of the eventual rebound.

VCs can easily afford to add platforms and tools during boom times, playing Frankenstein with various investor relations solutions and software components. The issue is that these data sets often don’t talk to each other, let alone exist as a centralized source of truth for deal and relationship information. “Hacking” your way to success often undermines the usefulness of the tools and creates unintended pain points that hinder a firm’s ability to act with confidence.

Now is the time to take an honest inventory of your current infrastructure—what processes could be refined? Which systems could be upgraded, replaced, or sunset? Which of your partners are delivering meaningful impact? Make the changes you need to get the right data, systems, and operations in place today so you can move quickly—and accurately–when it’s time to get aggressive.

At its core, venture investing is a sales process, but most GPs have never worked in sales, officially.

Here are a few questions to ask yourself:

• Are you asking your LPs for referrals? How often and when? How easy do you make it for current LPs to refer you to their networks?

• Is your reporting set up to support you in delivering a clear and detailed story about your team’s skills and successes to prospective investors? Could an LP answer why you, among all the VCs who invest in your sector or stage?

• Is your fundraising team in sync at every step? This means the GP, the finance team who will respond to deep investor diligence, your IR team, your lawyers, and your fund administrator. Every stage of the process can make or break the relationship with an LP.

• How can you foster internal discussions to make you all smarter? Unlock the institutional-knowledge locked in the heads of your team and ensure every individual can leverage the experience and expertise of the group.

• Do you have full access and information on your firm’s entire collective network to identify potential LPs?

You will miss the moment if you’re still figuring out answers to these questions when others start to capture LPs’ returned allocations to venture.

No one has a crystal ball, and the will-we-won’t-we threat of recession still looms. However, managers who held off on fundraising late last year still have low dry powder and cannot wait to go to market. Those in the industry through past cycles know what the returns of funds birthed in challenging vintages can be. There are more high-quality companies now than in any past pull-back, and these companies will increasingly be available to invest in at much more reasonable valuations. For the venture manager committed to delivering trustworthy communications with LPs, professionalizing operations, and marketing a clear story to new potential investors, 2023 has the potential to be a career-making year.

This article was originally published in Affinity's latest blog.