Portfolio management in the age of unicorns

Market volatility pulled the rug from under late-stage private company valuations in recent months and stalled the market for new offerings.

With the IPO window closed tight, at least for now, VCs have reacted with investment caution. Deal making in the United States slipped in the fourth quarter and could do so again in the first. So how should partners manage this new period of uncertainty?

“The pendulum had swung awfully far toward growth and now it’s swinging back toward profitability and a focus on unit economics, where arguably it should be,” said Peter Denious, head of global venture capital at Aberdeen Asset Management. “The question is, ‘Did the pendulum swing too far over to growth at all costs and how far towards profitability and controlling one’s own destiny is it going to go?’ That’s where time will tell.”

Denious says the adjustment is likely to play out over quarters, not months and the result could be a period of lower valuations.

His message to GPs: Focus anew on portfolio management and maintain discipline around follow-on investing.

With unicorns in particular, it is important get these companies into a position that where they are not completely dependent on capital to grow in an environment where capital becomes more expensive.

VCJ recently explored the details of portfolio management with Denious. What follows is an edited transcript of the conversation.

Q: What do you make of the venture environment so far this year?

A: The signals are pretty clear the environment we are operating in as an industry is very different in the early part of 2016. What that means and how it all shakes out from here is very difficult to say.

Right now, what we are seeing is just a slowdown. It’s a slowdown in every part of the venture ecosystem, whether its fundraising, whether its investment. Were just seeing a general slowdown in the velocity. And that is probably not a bad thing.

Q: Still the fundraising market appears relatively active right now. Would you agree?

A: It’s active right now. It’s mostly a bit of an echo, if you will, from a very big first half of 2014. Many of those managers are back, having invested their funds in two years. They’re back raising in the first half of this year.

Particularly, many fairly large, well-known brand names in venture are raising in this first half. There’s definitely a pretty big echo from the first half of 2014. But I think we are seeing a slowdown in terms of emerging-manager new-fund formation.

Q: Turbulence aside, what were distributions like last year?

A: Phenomenal. Both 2014 and 2015 were phenomenal years for liquidity for the industry. It’s really a reflection of all the IPO activity that occurred, particularly in 2014. It takes managers some time to unwind those positions and to get out of those companies. Its the result of the very healthy IPO market we had in 2014.

Q: You’ve been talking recently about venture portfolio management. What is your message to GPs?

A: If you think about the way venture capital firms are organized, they are partnerships with each individual partner going out and sponsoring and making investments and over time putting together a portfolio of, say, 10 to 15 investments.

What we have found in some cases is that managers tend to get very focused on their 10 to 15 projects. Some are not necessarily stepping back and looking at their entire fund with a kind of portfolio management approach to managing a fund.

That’s what this is all about, making sure the fund mechanics work efficiently.

Q: What should GPs do to be better portfolio managers?

A: It is a real discipline around follow-on investing and supporting the companies that really are going to be game changing and world changing.

In contrast, those that can and should be sold in an M&A transaction are still phenomenal companies, but they are better partnering as part of a broader solution.

The simple fact is that not everyone can be a $20 billion company. Some of these companies deserve to exit and be part of something else when they’re $500 million or $800 million companies.

That still makes for great venture outcomes at least for early-stage investors.

Q: How receptive are GPs to the notion of de-risking a portfolio?

A: I’d like to say everybody gets it. It depends on how much cash you have. It depends on how well financed the companies are.

The more well financed they are and the more the unit economics are clear, the more confident GPs are around the companies, even if they may be losing money. If they are not well financed and the unit economics are not clear, we’re seeing a different attitude.

Q: How active a role should LPs play in encouraging portfolio management?

A: We tend to not weigh in too heavily on these highly subjective and difficult decisions. We are not equipped to render an opinion because there are so many details that we’re not privy to.

The venture funds often have a lot of companies in them and we’re not following the underlying investments to such a degree where we could really have a strong opinion on how a venture manager should handle any one company. It’s much more a question of talking to the GPs about how they might be reserved, how many companies are in a loss making position and how many months of cash do they have. Asking them some of the basic questions at a portfolio level, and getting a sense of where they are and how vulnerable their portfolio might be, if this is a prolonged period of volatility with less capital available at the late stage.

Q: There has been a lot of talk about a unicorn shakeout. How do you see the unicorn environment today?

A: There will be write-downs in venture, generally speaking. The more later stage an LP’s portfolio is focused, the more pronounced those write downs will be.

It is very difficult to predict what the magnitude of those write-downs might be, and it’s very company specific. For one of the first times in venture history, structure is really going to matter. As we went through the course of 2015, more and more structure was put into these term sheets. That could come home to roost as we sort this out as an industry.

Q: Does this make you cautious toward the industry?

A: Generally speaking I’m bullish on a couple fronts. One, I don’t think we’re anything remotely close to 1999. I don’t think we’re going to see the level of attrition among the unicorns we saw in 1999, proportionately. I think most have real businesses, not all, but most.

The question is, ‘What are they worth?’

The second reason I’m bullish about venture is the most important ingredient for venture is what we call the innovation cycle. The one thing we must have as an industry for things to work out well is a lot of innovation and interesting innovation.

We are in a very dynamic period for innovation.