By Jim Marshall, Silicon Valley Bank
Across the venture capital industry, surprising trends in early-stage investing are developing. With record numbers of funds raising capital, a saturated investor base and increasing pressure for liquidity, smart VC firms are differentiating themselves and tapping into new capital sources.
Emerging managers, also known as micro or seed VCs, now have over $20 billion in assets under management.
At SVB, we define emerging managers as VCs with under $150 million in capital, fewer than three institutionally backed funds and likely no in-house CFO. We closely track 970 emerging managers worldwide, of which 577 are in the U.S.
Of U.S.-based funds, 205 (36%) are collectively raising more than $10 billion, with 127 of these firms (62%) raising their first fund.
But the number of successfully closed funds is declining: 48 in 2017 versus 74 in 2016. Overall, early-stage-deal activity has declined over the past three years (see TechCrunch).
Many of the most active institutional limited partners have already made their bets and are focused on re-ups from their existing managers.
For example, Cendana Capital, an institutional LP focused solely on the seed sector, has seen the average fund size in its core portfolio grow to $70 million in 2017 from $40 million in 2012.
Era of specialization
Emerging managers will need to find new ways to raise funds and attract promising startups, especially as 57% of new fund managers have no track record.
Deep sector expertise is one method. Currently, 11% of funds are vertically specialized, a trend likely to continue, particularly with funds focused on frontier technologies. The recent growth in hardware and cryptocurrency funds underscores this trend.
Funds can also use a more diverse investor base, perhaps strategic corporates or seasoned entrepreneurs with knowledge of different sectors to attract potential portfolio startups.
Finding new funding sources and building relationships early in the fundraising cycle will be crucial. These sources include family offices and traditional venture funds.
Individual VC partners have long invested in seed managers, but now funds are getting into the act, too. This is one way for funds to dip their toes into new technology areas before fully committing.
Newcomers may fare well in 2018
We expect diversity among fund managers to flourish in 2018, and this bodes well for newcomers, including women-managed funds and funds located outside traditional venture hubs.
More than half the funds closed in 2017 (54%) are located in either the Bay Area or New York. Fourteen percent of closed funds in 2017 have female general partners, compared with 8% at the top 100 VCs (according to Crunchbase). At firms currently raising Fund I, 18% of GPs are female.
Diversity of backgrounds and professional experience makes for a stronger ecosystem.
We are seeing more GPs with operational and entrepreneurial experience. While institutional LPs historically preferred to back VCs with track records, 50% of emerging managers are either former serial entrepreneurs or operating executives, compared with 43% hailing from established VC firms.
Overcoming liquidity challenges
Lack of liquidity in the market looms large and is a tough hurdle for emerging managers. Existing LPs will want to see performance and liquidity options before aggressively investing in new managers. Smaller funds will need to generate returns earlier to remain viable.
Emerging managers will need to find creative ways to generate liquidity, perhaps selling a portion of their positions through private rounds and private equity-led exits.
How crowded is this market – really?
As emerging managers grow more professional and diverse, we’re seeing the rise of what we call “conviction-based investors,” similar to what Homebrew’s Satya Patel describes as “investors of record.”
These managers are anchors in the ecosystem: they typically lead investment rounds, reserve capital for follow-on investments, target a minimum 8% ownership and build more concentrated portfolios.
While the seed ecosystem may appear overcrowded with firms and capital, only 35% of the emerging managers that we track in the U.S. fit our criteria for this category.
These funds serve as an example to new fund managers, demonstrating what it takes to cross the chasm to secure institutional LPs.
In 2018, trends to watch include new fundraising and investment strategies, creativity in generating liquidity and increased diversity in fund locations and founder backgrounds.
Emerging managers are the new face of early-stage venture investing but they will need to find ways to differentiate themselves to be sought out by great founders.
Jim Marshall, head of the Emerging Manager Practice at Silicon Valley Bank, provides targeted financial services and expertise through its offices in innovation centers worldwide. Jim’s team provides GPs with services and strategic guidance, from fundraising to fund operations to portfolio company support and creative liquidity solutions. He can be reached at [email protected] or +1 650-926-0192.