The State of Private Markets

2023 has seen Capital Calls for VC funds fall off a cliff. It might be easy to point to a market downturn with naturally more cautious GPs. Indeed, this may tell part of the story. Yet there are mechanics that go right into the heart of fund economics that may explain why VCs, many of which taking longer to raise their next fund, are spreading out their committed capital.

One suggested reason, explained by Jan Voss, is due to the the investment period is the time in which a fund makes initial investments in new companies. During that time, the GP receives the full management fee, (usually) paid on committed capital. In addition, there may be a certain amount of “recycling”, in which capital from early exits can be partially reinvested.

Once the GP hits a threshold of 50-75% invested capital, their fund reaches the follow-on period, in which investors are usually only allowed to make follow-on investments in existing portfolio companies. Recycling is also no longer allowed, and capital from exits is distributed to LPs. Most importantly, however, is what happens to the management fee: Once we go from investment to follow-on period (the “Switch Date”), management fee is often charged instead on INVESTED capital (with exits/write-offs reducing this amount), and in most cases, the amount charged actually drops (i.e. to a lower fixed percentage or to 90% of the prior year’s fee).

In ‘20/21s when VCs had no issue with raising capital, they were keen to deploy quickly and hit the Switch Date, as only then would they be allowed to make new investments from successor funds (on which they can charge full management fee on top of the lower fee on the prior fund). Today, things look different: VCs have a much harder time raising a new fund - and deploying their fund quickly puts them in danger of hitting the “Switch Date”, resulting in a lower management fee to pay for ongoing operations.

Others have argued that this merely due to the valuation standoff with founders and existing investors wanting to avoid downrounds, particularly at post Series A. There may indeed be a latent reticence to recalibrate to market conditions, outside of the most overvalued late-stage growth companies.