20VC: Will LPs Pull Out of Existing Managers, How Will Fund Sizes Change Moving Forward, Is Now The Time to be Aggressive on Secondaries, What is the Discount on Secondaries Today, Who Will Win and Lose in the Next Five Years with Hunter Somerville, Partn

Hunter Somerville is a Partner @ Stepstone, one of the largest secondary buyers, fund investors and players in our ecosystem with over $600BN in capital responsibility and over $100BN AUM. Additionally, Hunter serves on the LP Advisory Boards for Felix Capital, Foundry Group, Imaginary Ventures, Scale Venture Partners, Boldstart Ventures, Ludlow Ventures, and more. Prior to StepStone, Hunter was a general partner with Greenspring Associates, a venture capital and growth equity investment firm that merged with StepStone in 2021. Before that, he worked as an associate for Camden Private Capital. In Todays Episode with Hunter Somerville We Discuss: 1. Three Types of Secondaries: What are the three different types of secondaries? What is the current situation with company secondary opportunities today? What is the current landscape for fund secondary opportunities today? What are GP-led restructuring or strip sales? How do they work? 2. LPs Today and Moving Forward Investing in Funds: Will we see a wave of LPs not commit to their existing managers? What is the denominator effect and how does that impact LP deployment into funds? What are the top 3 reasons why LPs will not re-commit to existing managers? Do LPs feel VCs have fairly marked down their venture books in the last 6 months? Does Hunter agree that if you have not returned cash to your LPs when you could have done ijn the last 5 years, then you are most in trouble? Why does Hunter believe we will see more international LPs entering venture than ever before? 3. Liquidity: When Does the Cash Hit: Why was liquidity so bad in 2022? How did that compare to 2021? How does Hunter forecast liquidity environments in 2023? What could drive them? How active were Stepstone in secondary buying over the last few years? Is now the time to be greedy when others are fearful in secondaries? What discount was Hunter seeing both on fund and company side secondaries in 20-22? What is the current level of discount being applied to both company and fund secondaries? 4. AMA with One of the Largest Secondary Buyers: Which LP class will be hurt the most from the last fund cycle? What would Hunter most like to change about the world of venture? What was Hunter's biggest mistake on a company investment? What are the biggest mistakes LPs make when they do direct investing? Why are big-name people entering firms as GPs not always a good sign?

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  I think everyone should be more cognizant of what fund sizes make sense in the go-forward environment. I think what you'll see is smaller investment sizes in the managers that they like, in the ones they really like, they'll just stay the same instead of growing. I don't think it's like a time to just start pushing money out the door aggressively.

• 0:17Harry Stebbings?

  Secondaries, they are on the minds of LPs, they're on the minds of Jeep, they're even on the minds of employees. Never before has secondary has been such a prominent thought and topic. And today, we debunk secondaries in detail with one of the most renowned players in the secondary's market. And so I'm thrilled to welcome Hunter Somerville, partner at StepStone, a player in our ecosystem with over $600 billion in capital responsibility and over $100 billion in AUM. Additionally, Hunter serves on the LP advisory boards for Felix, Foundry, Scale Venture Partners, Bold Start and more. And prior to StepStone, Hunter was a general partner with Greenspring, a venture and growth equity firm that merged with StepStone in 2021. But before we dive into the show today, I cannot stand it when I have to ping multiple people on my team to find

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• 3:40Speaker 02

  You have now arrived at your destination.

• 3:44Harry Stebbings?

  Hunter, I am so excited for this. We're just going to hit the ground running today. We're going to go in hard because it's a very important topic for us to discuss. When we chatted before, you said there were three types of secondaries. And I want to lay the foundations, Hunter. What are the three types of secondaries?

• 4:00Speaker 00

  Really, at a high level, there's company secondaries and there's fund secondaries. And then within the fund secondary category, there's things called GP-led restructurings, strip sales, tender offers, that are variations on the LP interest piece, except done in more of a scaled way with many LPs instead of one-off transactions between a buyer and one LP seller, categorically how we think about the secondary world.

• 4:25Harry Stebbings?

  Okay, so if we take those three categories and we break them up, if we start with the company secondary positions, what's the current situation with company secondaries today? Why are they interesting?

• 4:35Speaker 00

  Yeah, so on the company secondary side, the typical sellers that we'll talk with or that we'll see are folks that have been invested in a company for a long time. So that could be friends and family that provided the initial capital at the very beginning. That could be angel investors, that could be micro VCs or seed investors. And then the other part of it is around the employee side. So you'll have employees that have scaled with the company, have been there for a while, that would like partial liquidity in year seven and eight. Or you could have people that have been let go of a company, which we've obviously seen a lot of in the past two years, that still hold stock and would like to get liquidity and really have no ongoing information rights or knowledge on what the company is doing. All of these constituents will want partial or full liquidity at some point,

• 5:19Speaker 00

  and particularly in an environment like the one we have now, where other liquidity options are more limited. You're not seeing companies go public, you're not seeing strategic M&A at as a robust of a clip. And so they need to think more creatively about getting liquidity.

• 5:32Harry Stebbings?

  We're going to talk about how they think creatively about getting liquidity and dive in deeper there. But on the second, on the LP interest side, what are we seeing today there? And you said before about the denominator effect. For people who don't know what it is, what is the denominator effect?

• 5:46Speaker 00

  Yeah, the denominator effect is effectively when you have both a public and a private book. The public side has gone down more significantly. The private side has come down, but not at the degree or the speed that you've seen the public side go down. And what you're left with is over-allocation on the private side, in your venture book, in your buyout book, whatever that may be. And in order to rebalance and get back to the target allocation you've set out to your board, you need to find a way to do. And if it's not going to happen as a result of markdowns, you're going to have to think about secondaries as another option.

• 6:18Harry Stebbings?

  Hunter, I have to ask you while I have this. Do you think venture investors have marked down their books adequately enough, given the repricing in the situation that we're currently in?

• 6:28Speaker 00

  It's a hard question because if you look historically, people have generally carried things at last round pricing or have taken a discount to last round pricing. Many of our managers actually took discounts to last round pricing even before correction, just to be conservative and because they didn't have an issue around interest level of other LPs wanting to get into their funds. But many carried at last round pricing and have done so for decades at this point. You're going to have a much different methodology on how to approach things in this year and the coming years. I think we looked on average, funds have come down around 19% on the venture side. Somewhere between 15 and 20, I would say, is what we've typically seen. Whether or not you think that is enough, I think people have very different opinions around it.

• 7:10Speaker 00

  Probably there could be incrementally more markdown than what we've seen. But I have been surprised and happily so that people have taken discretionary markdowns more proactively for the first time in my history of doing this.

• 7:23Harry Stebbings?

  Can I ask, Hunter, what would you advise me as a manager when you have, and this isn't the case necessarily for me, but say managers out there, you have often fund of funds who quite want you to keep your books well priced. They have to go and raise money from other institutions and individuals and actually your marks being high is in their interest. And then you have endowment funds and other LPs who actually want a much more realistic and reflective pricing analysis. How do you cater when you have different LP classes that want different things?

• 7:49Speaker 00

  I wouldn't base my decision on what either constituency wants because I think you're exactly accurate. The endowments would prefer to take the pain upfront within the first year and other groups would probably prefer to have it continue to be marked up. But I would make an independent decision on what you think is truly reflective of fair value. And in my opinion, I would look at the companies that are shorter on runway that are going to need to raise within the next 18 to 24 months. And if those companies have hit a growth phase and a price that's too high, then I would take a discretionary markdown on it. If instead it's businesses that have three to five years of runway and are going to have no need to raise and are continuing to compound and grow, I'm not as aggressive about thinking through markdowns on those businesses

• 8:32Speaker 00

  because they raised in a way that should give them the flexibility to grow and eventually exceed those. Valuations when they need to come back to market. So I segment the world differently.

• 8:42Harry Stebbings?

  We mentioned endowments there and again, sorry for going off piece. We mentioned down there, but I speak to many. And what many remind me of is that they have continuous and guaranteed net outflows in the form of scholarships, maintenance to the universities and these outflows of cash going out that are needed independent of like markets or cycles. But then they have constrained liquidity now more than ever. And so I'm seeing this real pullback from the endowment class more than ever. Are you seeing the same? Is that normal and typical? And how do you think about that?

• 9:13Speaker 00

  We've seen that in prior cycles as well. Endowments are always more aggressive on their investing in private equity and in venture. And they've done very well as a result to that over the past 20 years. But you do find yourself in scenarios like this due to denominator effect where you become over allocated as a result of being aggressive in these spaces and for the reasons that you described. And that does situationally give rise to secondary opportunities from them specifically. But I wouldn't say they're the only sellers. We're seeing family offices that were overly adventurous in this category need to sell. And we're seeing corporate pensions similarly looking to sell. So it's not just specific to them.

• 9:52Harry Stebbings?

  So if we think about this constrained liquidity and we think about this denominator effect, obviously with the inequity that creates in terms of where the public and private books lie. Do you think we'll see a ton of LPs not reallocate their existing managers to re-equalize their books?

• 10:07Speaker 00

  I think what you'll see is smaller investment sizes in the managers that they like. In the ones they really like, they'll just stay the same instead of growing. And in the ones that are on the fringe or in their respective penalty boxes, as you may say, those are the ones that they'll give less latitude to in this environment and probably lop off of their book. But I don't think they'll start abandoning groups that have done well by them. They just may need to come in at a slightly smaller size and then try to build that back in the future if things change at a macro level.

• 10:36Harry Stebbings?

  Are you able to do that in terms of the top names? When you downsize, they don't take it so well. For LPs listening, how should they think about being wary of losing allocation or losing relationship or trust with top tier managers when they do need to downsize?

• 10:51Speaker 00

  It's not an easy answer. We've always preferred to be consistent in our sizing and not size up and size down. But if your options are the way they are in the current environment and you only have so much that you can allocate, you then have to cut off all of the middle performers or the upper middle performers and just maintain it in the best groups. And that has its own challenges and creates portfolio concentration. But obviously, you'd want to maintain the same investment sizes in high-quality performing groups. If you do find yourself in a scenario where you have to build that back over time, you have to think of ways to stand out as an LP partner and be more than capital and find ways to be helpful with directs, with secondaries, with the ability to help in business development. Being an LP should not mean that you're just passive capital, at least for the good ones.

• 11:36Harry Stebbings?

  You mentioned the kind of how people are resizing positions. This, an LP told me yesterday, if you're a manager in the last five years that has not returned cash when you had the chance to do, then you're first on the chopping block in terms of reallocations. Do you think that's fair? And what do you think are other core reasons why you're first on the chopping block?

• 11:54Speaker 00

  I think LPs will pay more attention to how folks dealt with public position and whether you got out of those when you could, whether you decided to hold them much longer. People increasingly got more comfortable holding publics longer than the typical six to 12 months you saw historically. And so I think that will be viewed as a negative point to some degree. But showing DPI is going to become more and more important, mostly because LPs will struggle to evaluate what true TVPI is. And unless you really have a deep understanding of the value-driving companies and the underlying assets, you really just can't do that benchmark exercise and look at how TVPI compares to what the respective benchmark is. Because people will carry stuff so dramatically differently in valuation, you're going to end up making really bad decisions.

• 12:39Speaker 00

  And the ones that are the most aggressive in TVPI carrying value are the ones that need the capital the most versus the ones that have been more conservative. So you really need to have some sophistication and knowledge of the value-driving companies. And DPI is like, undebatable. Either you've generated that, you have realized results, and it's not going to swing in the future like TVPI is. So current carrying value becomes less important than a nuanced point of view of projected value within these funds.

• 13:06Harry Stebbings?

  I've spoken to many GPs at kind of multi-billion dollar funds and they say, ah, don't worry, we've got four billion raised last year that we haven't touched yet. We've got six billion raised last year that we haven't touched yet. Do you think there's any risk on those actually in terms of their ability to call, given the size of those funds?

• 13:21Speaker 00

  There are plenty of people in those advantaged positions, but most of what I've seen from growth funds and late-stage funds, or even if they have the capital, they're not actually deploying it. And good for them, because it would be even worse if we find ourselves in a scenario like now and people are pushing money out the door aggressively just for the sake of doing so to come back to market faster. But it does become a question of like, how long should they be able to just sit on the money and not invest it? And it also goes back to whether or not the fee structure is on invested capital versus committed capital. And if it truly is on invested capital for some of these growth funds, then I think LPs are fine being patient and respecting the discipline of the manager. If it's uncommitted, that becomes a more problematic scenario. And I think everyone should be more cognizant

• 14:04Speaker 00

  of what fund sizes make sense in the go-forward environment, because round sizes are smaller across the board and growth financings just aren't happening at the same clip.

• 14:13Harry Stebbings?

  We saw such large funds in the last few years being raised. Do you think managers should return capital, make them smaller, readjust?

• 14:21Speaker 00

  On the growth fund side, a lot of funds became way too large and there's just not going to be as much opportunity in the near term. I think that will change in the medium term, although a lot of what you'll continue to see are extensions to last rounds or slight upticks. I don't think you're going to see massive upticks like we saw before where companies were 2X last round after six to nine months. We're not close to that environment, nor will be in the near to medium term. But you'll see some interesting extensions, companies that grew into the pricing and you can come in at what someone paid a year and a half to two years ago. I'm not completely bearish on growth investing. I just don't know that it makes sense immediately. You can be patient, you can wait for more companies to need to come back to market, to show more operational metrics, to show efficient growth and not rush it.

• 15:06Speaker 00

  But yes, I think some of these funds are probably too large overall for the opportunities that we now find ourselves in.

• 15:12Harry Stebbings?

  I'm just looking at several of the multi-billion dollar crypto funds and it's no shade, but it's just a genuine question of why are you going to spend the money? Genuine question. Do you have an, or should they say, you know what, actually, given the market conditions changing, we're actually going to return 35% of the capital and have a $1.3 billion fund, not a $2 billion fund?

• 15:30Speaker 00

  It's a good question, and I think people will make their own individual decisions. I mean, to the crypto side, the only potentially interesting thing, there is no mainstream generalist money at the growth stage investing in that category. So the people that will be coming in and supporting those companies are the crypto native folks. Whether or not they should be is another question.

• 15:48Harry Stebbings?

  Now, I'm going to move to the third tier before I get too deep in the weeds when I didn't plan to so early. But GP-led kind of structurings, you defined them a little bit earlier. How do these work in reality? Imagine, I don't know what they are, just for explanation, how do they work in reality? What's the process?

• 16:06Speaker 00

  And most people on the venture side don't know what they are. It's been happening, as I'm told, in private equity and buyout now for the past seven years. But venture is always slower to adopt some of these structures. And I think we'll see a lot more of it in the second half of this year and the following two years. We have done a handful of these transactions historically and have been more at the forefront from our side. I think they can be very interesting, but they have to be thoughtfully put together. And there's really types of how you can do it. There's a strip sale where you could go and buy out 20% of a manager's entire portfolio. You don't pick and choose the assets, you just provide liquidity on 20%, whatever the percentage is, of an entire portfolio. That gets turned from TVPI into DPI.

• 16:50Speaker 00

  Generally, it's approved by the advisory board. And so it's a way to get liquidity across an entire portfolio where there's a lot of TVPI and there's no DPI. You could do a tender offer where a secondary buyer comes and says, we will buy from anyone at this discount level. The LP then can sell and that discount level is shared across an entire LP base. And then the most complicated version is a continuation fund where you'd buy from a bunch of LPs at once. And you would create a new entity in order to allow the manager to play for higher upside in their assets for longer. That is generally used at an end of life point of time within a fund. And as in venture, most venture funds exist past year's 15, so it takes a while. And the best assets take the longest.

• 17:35Speaker 00

  So you can end up in scenarios where a fund is in year 12, 13. And it's really just two companies that make up eighty to ninety percent of the NAV. And the company isn't ready to go public. So you're effectively playing that forward and providing liquidity to LPs. That feel like they've been in the fund for long enough and would rather deploy in the manager's next fund or deploy in more aggressively in a new vintage. All of those are things GPs can proactively use as a way to change TVPI into DPI. And stand out against each other, particularly for some of the newer emerging managers that have no DPI. I think if you wait around and have four or five funds and have returned no capital, you're actually introducing organizational risk from an LP standpoint.

• 18:19Harry Stebbings?

  Is there not a misalignment here between GP and LP? If you would have proactively engaged in selling through one of these different mechanisms, one of the three mechanisms. When actually you know that there's more juice to be gained from the asset laced down line, but you need the DPI to raise your next fund. It is suboptimal actually in the long term for the LP for you to do that secondary sale, whatever structure you choose. But for me, the GP is better because I get the DPI to then go and raise my next fund. Is that not a core misalignment?

• 18:48Speaker 00

  It's all situational. On a tender offer, you're just giving people a choice. They don't have to do anything. So some people may want it, some may not. You can proceed accordingly. With a strip sale, you're bringing it to the advisory board. They're making a determination. And so they should be representing the interests of the entire LP base when they're making that call. You could argue in some scenarios, if you're buying off of current TVPI, it's already overinflated. And in order to actually get to that TVP at the end of the day, it might not make sense from a duration standpoint to even consider that. The GP-led side can become tougher to navigate and make sure that all interests are aligned. But generally giving people an opt-out, giving people a choice is best practice and the way to do that in the correct way.

• 19:31Harry Stebbings?

  Which of these structures do you think is most interesting right now when you look at strip, continuation and tender offer?

• 19:37Speaker 00

  I think it really depends on the LP base. It's important to be able to do all three and think of what makes the most sense, both for the LP base and for the GP. I think strip sales and tender offers are much more. Logistically easy to put together.

• 19:52Harry Stebbings?

  Yeah. Can I ask, when we think about liquidity and ways to gain liquidity, when we look back to, say, Q4 2022, how was liquidity then?

• 20:00Speaker 00

  2022 was a bad year for liquidity across all of venture. I think if you look at most of 2022, 2021 had quarters that exceeded all of 2022 from a liquidity standpoint. And so 2022 was a rough time for venture, but it followed off of 2021, which was one of the best years, if not the best year in liquidity ever for the asset class. And so it's a big change and 2023 I think will be incrementally better, but 2022 was a tough time in terms of driving capital back.

• 20:29Harry Stebbings?

  How is 2023 going to be better? IPO windows have never been more firmly shut. Acquisitions seem few and far between. The only liquidity that seems to be coming is Figma, which delayed liquidity from the transaction last year. Where is the liquidity coming from?

• 20:42Speaker 00

  I said incrementally better off of 2022, which is historically low. So I'm not saying we're going to see a step change in 2023 by any means. What you are seeing more aggressively is buyout and private equity come in and take out both public venture-backed businesses as well as doing majority recaps in private businesses. And I very much think the secondary side will become more robust as a liquidity mechanism. The other thing we didn't describe is the GPs themselves could start selling partial positions in their companies and do one-off asset transactions too. There's a lot of different ways that liquidity could be pursued. But yeah, don't get me wrong, I'm not saying 2023 is going to usher back what we saw in 2020 and 2021,

• 21:25Speaker 00

  but I think 2022 was quite low, 2023 will remain quite low as well. And hopefully we start seeing some more significant improvement in 24 and 25.

• 21:35Harry Stebbings?

  Dear God, please let it rain.

• 21:36Speaker 00

  In the interim, people need to think more broadly about what liquidity solutions can be.

• 21:41Harry Stebbings?

  Absolutely. And we said what we saw in 2020, 2021, and what we saw was crazy pricing in most markets. How active were you over the last few years in secondary buying markets, given the levels of pricing?

• 21:53Speaker 00

  What we did more of in prior markets was on the company secondary side. So we would come in, we'd buy out those. Early shareholders and most of what we were doing was buying common early preferred and then shifting it to the recent round or converting it into more recent preferred, which obviously provides better downside protection than buying straight common outright, where you're buried under a waterfall and where you have uncertainty on what future capital raises could look like, and that can be pretty scary. We also targeted businesses generally where the runway was like three to five years. My friend E. Tai calls those businesses canned camels, where they have no reason to come back and raise capital quickly and have pretty extended runway. That's the type of profile of business that

• 22:36Speaker 00

  we'd really look for on the secondary side. In this environment, it's been much more balanced because the LP interest side has become so much more significant and we're seeing one-off LP interest opportunities to pursue in conjunction with the company secondaries.

• 22:51Harry Stebbings?

  What makes an LP interest opportunity really enticing and interesting versus not one?

• 22:56Speaker 00

  Same as a company, it's really driven by the underlying value-driving assets and that they represent a very high percentage of the NAV. We actually want two or three companies to represent 70 to 90% of what we're buying. When it becomes overly dispersed, it becomes overly diversified and aggregates more to mean level returns. And we're pursuing companies that we think are interesting at discount levels that help us bridge the gap. Like we just talked about in primary growth, there's just not that much to do right now because you wouldn't want to pay last round price yet. On the secondary side, you can actually create effectively a down round without the drama and disruption of doing that by buying at a 30 to 40% discount off of last round and creating an arbitrage that you're comfortable with. It really is very different than how to think about

• 23:41Speaker 00

  primary growth.

• 23:42Harry Stebbings?

  Speaking about kind of the secondary pricing there, maybe I'm wrong here, but I've broken into many secondary providers and even in the good times, 2021, there was always a level of discount because they knew you needed to sell for some reason, nature of the beast. What level of discount did you buy in 2020 and 21?

• 23:59Speaker 00

  Yeah, I was looking at data from Jeffries earlier, just to remind myself on industry level returns. And I believe that the average discount to venture ticked up as high as just 12% in 2021. So quite low overall, but if you were to fast forward that to 2022, it's back down at an industry level to 34%, which is deeper than you've seen for a while. So things definitely got frothier on the pricing side in 2021, but are back down to levels and even below levels that we've seen over the past decade in overall pricing. Anecdotally, it's still a little bit deeper on the discount side in LP interest than on company secondaries.

• 24:40Speaker 00

  On LP interest, a lot of what we're seeing is in the 30 to 45% range. A lot of what we're seeing on the company secondaries is in like the 20 to 35% range.

• 24:51Harry Stebbings?

  I'm really shocked on the company side. It's that low actually still. I spoke to a very prominent secondaries buyer the other day and they said, honestly, we're not picking up phone calls unless you're selling at 60%.

• 25:01Speaker 00

  Yeah, and there are those opportunities to consider too. It's just what level of quality you would want to consider, when last round occurred. It really depends on a lot of different parameters.

• 25:11Harry Stebbings?

  Given the change in the levels of discounting, despite my surprise, it's a significant change in terms of the discounts. Do you feel now is the time to be greedy when others are fearful, Hunter?

• 25:20Speaker 00

  Selectively. I don't think it's like a time to just start pushing money out the door aggressively. But I think there are very interesting opportunities in LP interest right now, where people just need to sell for the reasons that we described. On the company side, you have to be very careful. You need to understand cap tables, you need to really understand runway. You need to understand what structure or capital could come in on top of you before an eventual exit. And so it is not a scenario where you want to be trivial around that. And a lot of people that look at company secondaries don't have a relationship with the management of these companies and don't get full information. So they're actually buying in a very imperfect way with not a lot of granularity

• 26:01Speaker 00

  on what actually the company is doing in the next few years financially. And I think they're going to really get burnt by that. The people that do the company secondaries the right way are the ones that actually have a direct relationship, information, the investments that they're doing.

• 26:17Harry Stebbings?

  It's so funny, I'm actually not being rude. If you can see, I'm writing notes on my hand to remind myself of, you said about really understanding the cap table. What do you want to see in understanding the cap table?

• 26:28Speaker 00

  Deep-pocketed investors that actually know how to do reserve management, that will be there to support the companies in the future. If you don't have that, you're going to be more susceptible to down rounds or complete wipeouts. You need to understand which funds of those managers are in it, how long in the tooth they are, whether you have trust and alignment with them, structural elements around LIC preps that could come in now or in the future. There's a lot to consider, both that you could see at time of investment and that you could expect in the next few years.

• 27:00Harry Stebbings?

  You mentioned information there also. Despite my youth, I've seen certain situations and the truth is, Hunter, I've found, the higher the quality of asset generally, the less information you get, and that's a gross generalization. But it tends to often be that way because they also know that they can in a lot of cases, or it's more sensitive for whatever reason. How do you make decisions when information is not freely available? Is it just brand buying? And this may not be for you, but just what does the LP ecosystem do?

• 27:27Speaker 00

  For a lot of people, that's the case. The nice thing for us, whenever we do any company investment, is we have one or multiple fund managers from an early stage that are already invested in the company and sit around the board. And so when we're considering a secondary or a primary investment into a company, it's always through a warm introduction from the GP directly to the senior management. What many other direct secondary funds are doing are cold calling departed employees or reaching out to people that they know need to sell and are really relying on their own point of view of the company instead of ongoing information and monitoring. And that's just the complete opposite of our ethos. We always put our GP relationships first and then the GPs set us up for success at

• 28:10Speaker 00

  the company level with the direct and secondary investing we do. We always want to have an informational and we always want to have a relationship advantage. And so we won't pursue something that's Completely opaque or where we're not connecting directly with the senior management of a company at time of investment.

• 28:25Harry Stebbings?

  How does one get scale when you're buying from early employees? If you think about early employees, early angels, friends and family, you name it. Often it's in the kind of drips and drabs of a million, two million, two million, one million. How does one get scale? How does one collectivize these atomistic sales into a collective that is purchasable by a larger institution?

• 28:46Speaker 00

  The same reason that I described our approach. It's when you actually consult with senior management because they do not want to do 10 of these over the course of a year. They want to clean up their cap table in one fell swoop. They want to do it thoughtfully and they know which people may want to sell or would want partial liquidity. And so if you are doing it on a one-off basis, agreeing with one counterparty, you're going to get drips and drabs. And you're going to get imperfect, ongoing information. If you do it in consultation with the actual leadership of a company, they'll view you as both a current and a future solutions provider. And they'll want to do it in a more thoughtful, lumpy way.

• 29:23Harry Stebbings?

  You mentioned there about kind of the opportunities coming from existing managers within your portfolio. How much weight do you place on the manager recommendation versus independent underwriting that you do on your side?

• 29:33Speaker 00

  We put weight on both, but we will never do anything where we don't have someone that's been involved with the company for multiple years. And since most of what we do on the fund side is very biased towards early stage. These are people that have actually worked with the company for a long period of time before we'd get involved. There's just no replacement for that in terms of pattern recognition and the qualitative elements of partnership. We really feel like it gives us an informational advantage. And then like others, we layer on the typical assessment you would do with customer calls, objective review of both current and future performance. And planning around that. But I think our secret sauce continues to be the relationships that we have with our GP partners.

• 30:13Harry Stebbings?

  What do you think are the biggest mistakes that LPs make on the direct investing side? Many obviously have a fund investing platform and then a direct investing platform. What do you think are the biggest mistakes LPs make when it comes to direct investing?

• 30:25Speaker 00

  That they get rampant adverse selection and oftentimes put Pushed into fee-bearing SPVs that even further dilute their end-of-day return. Generally, what we've tried to do with most of our direct investing is actually to lead the primary rounds or to be a big secondary provider. I think with some of these SPVs, particularly the larger ones, you get pushed into scenarios where there's actually a higher level of risk for the expected return. Generally, people think that's like a safe 2X, but it's oftentimes in businesses that burn a lot more money and where the pricing is higher due to the round size that's coming into the business. And so I think you get a perceived sense of safety on some of those. And if you're already underwriting to a 2X and it doesn't execute to perfection,

• 31:09Speaker 00

  then you're getting an even lower end-of-day return.

• 31:11Harry Stebbings?

  I think the big question that a lot of people have is the spread between what people are willing to buy and what people are willing to sell is still super high. Are you seeing that converge now? Is there a realization happening now within the sell side that actually they need steeper discounts?

• 31:26Speaker 00

  Yeah, it's very different from 08 to 2010 because then when you were buying at a 30% to 50% discount, you were causing someone to maybe get a 1X or to lose money because the funds weren't written up to the level that they are currently. Now, if a fund is at a 3 to a 4X and you're asking them to take a 50% discount, they're still going back to their board with a 2X return and the ability from an opportunity cost standpoint to then deploy it into what we all expect to be very good vintage years. And so I think it's an easier argument to be made to consider even a deeper discount in an environment like we find ourselves in.

• 32:01Harry Stebbings?

  What about the company side? Is there a realization and the spread coming down there as well?

• 32:05Speaker 00

  Company side, people I think of a little bit differently philosophically, but at the same time, they know that there's not going to be an IPO in the next two years. And a lot of those constituents are smaller. They're high net worths, they're individual departed employees, and they're going to be less patient than an endowment would be to wait out getting full liquidity. So I think it's a different dynamic.

• 32:27Harry Stebbings?

  What would you advise managers if you were to advise managers today? Say you advise me on how I'm thinking about approaching the next year through secondary provision, through finding liquidity. What would you advise me?

• 32:38Speaker 00

  I think it really It comes down to like your LP base and consultation with them and what they're looking for. All LP bases are created differently. Some have very high net worth percentages, some are all institutions. Some have patient institutions, some have institutions that would prefer more medium to liquidity type options. So it's different. For me, I would look at the portfolio. If there are assets that you really like, but you feel are higher priced and offer maybe one and a half to two X kind of arbitrage off of whatever last round prices. I would think about pruning some level of that exposure and riding the rest forward. If it's companies that are still very fully priced, but you think there's three to five X potential from here.

• 33:20Speaker 00

  I'd probably be less interested in doing anything around seeking secondary on that.

• 33:24Harry Stebbings?

  Final one. We're seeing managers basically go to the UAE from Silicon Valley like they're on a bus trip. It's back and forth so common now with kind of LPs pulling back in a lot of ways in domestic markets in the US. Do you think we're going to see a wave of funds now funded largely by the UAE in a rise of alternative LP classes? That maybe weren't so prominent in this next vintage of funds?

• 33:49Speaker 00

  I do, I think there will be a lot higher level of international participation and particularly in the growth funds. Just because on the growth side, if you want to write a 50 to 100 million dollar check, even in the early stage funds, if people are doing less, it's going to be harder to find the ability to put that kind of capital to work. And a lot of the newer investors into venture also are going to be more cognizant of duration. So they'd prefer the growth funds or the later stage funds just because they're not going to be naturally comfortable with waiting 12 to 15 years to have a fund wrapped up. And so it becomes a better way for them to start a program and then they'll layer on the earlier stage stuff at the end. So I do think you will see a higher proportion of international capital coming in in this environment.

• 34:32Harry Stebbings?

  You know what worries me is, sorry, I'm going off piece, but we had a lot of European family offices in particular who entered venture for the first time over the last five years, say. And they entered with advisors, be it your Goldman's, your UBS's, your Pictet's, you name it. Bluntly, they're not on the ground as much as we are in the venture ecosystem. And so they deploy to the large managers of your COTUS, of your Tigers, who are obviously getting absolutely hammered today. There's not an indication on them, I'm not throwing shade on them, but just given the stage of market. Getting hammered today, and I speak to these families and they're like, I knew venture was a bad market. I knew venture was bad. And I'm concerned that we are actually tarring a generation of previously new LPs who could be great with this entrance. Do you think that's fair and do you think I'm right to be worried?

• 35:14Speaker 00

  Yeah, no, I think there will be some LPs that were new to the asset class and come away with sour taste in their mouth with recent vintage years. But I think when you put together a program, it should always be done with thoughtfulness around stage and diversification by stage. We've always biased ourselves towards early stage. I think at the same time, as you've seen a lot of larger late-stage groups, you've seen a lot of very interesting, right-sized, smaller managers that have either been spin-outs from established brands or have started new franchises that do things the right way, that deploy semi-deliberately and that do it in a fund size that makes sense. And so if you can couple great early-stage managers with reasonable fund sizes,

• 35:56Speaker 00

  mix in some of the more thoughtful brands and then find something to shorten duration, whether that be secondary or the more thoughtful late-stage players, you can create a more balanced portfolio. And while it's contrarian to invest in vintage years like this, it's always proven out to be some of the best performers when all is said and done. So the people that decided to come in at the height and then leave right now will get the worst of any outcome versus if they just think about how they can do venture a little more tactically and take advantage of a less competitive environment right now.

• 36:28Harry Stebbings?

  Do you think we'll see an increase in LP class, especially in the early stage, buying GP states or insisting on having GP states as part of it? And what I mean by often you'll have it, no, like buying part of the management company. I have many GPs ask me now, hey, the fundraising environment's harder. Should I sell part of the management company because it comes with a 20 million cheque? And the leverage they have now is greater. Do you think we'll see an increase in that demand for those management company positions? And do you think they should take them?

• 36:56Speaker 00

  We probably will see an increase because I have not seen a ton of that. Historically, we never really pursue that from our side. I don't think they should take it unless that's the only option. And if it's that hard to fundraise and they don't have a natural group of family offices or high net worths to support them, maybe they should wait and find a different way to generate a track record before going out and doing it.

• 37:18Harry Stebbings?

  I totally agree with you. I mean, sometimes they're actually, sometimes a bad deal's worse than no deal at all.

• 37:23Speaker 00

  I mean, I've seen some of those where you're beholden to that deal or the carry percentages for three or four funds. And the management company ownership is something a lot of institutional LPs will become wary of or feel like there's preferential treatment around. While it may seem great to get going, it's not always worth it in the future.

• 37:40Harry Stebbings?

  Do you think we'll see a lot more increased price sensitivity on fees and carry from the LP class, again, knowing they have more leverage?

• 37:47Speaker 00

  Yeah, definitely on the emerging groups and the folks in lower Roman numerals for more branded, more established groups. I think there'll be more of a focus, particularly in the growth funds, around invested capital instead of committed, just because of the uncertainty of loyment. And when that capital goes out the door, I think that will probably be more of the LP focus right now.

• 38:07Harry Stebbings?

  Do you think it should be fees on invested, not like AUM?

• 38:10Speaker 00

  I think it depends on the group. But in an environment like this, where it's just going to be slower deployment or very little deployment, I think it's harder when the fee clock is ticking. It's not going to be good from an end of day performance standpoint on the growth funds. In the early stage funds, I feel like there you're continuing to see good levels of activity and it's a great innovation cycle. So I don't think it matters as much on the core funds of the early stage funds.

• 38:35Harry Stebbings?

  I'm just picking your brain unfairly now, but I see so many managers do kickers on performance. I always bluntly feel that if you do as well as a four X or a five X or a six X or whatever those performance levels are, you're going to make a lot of money. Don't be greedy. How do you feel about kickers? And what would you advise maybe earlier stage managers on kickers? Whether to have them, whether or not?

• 38:54Speaker 00

  I don't have an issue with kickers. I don't like it when people get cute and have three or four levels and it just becomes overly complicated. But if someone puts out like a step up, I also don't like when it's less than three X and people start doing like kickers at two X or two and a half. That's just not high. Enough for a venture fund. I think it really needs at a minimum to be a kicker of three X net net or above. And then I oftentimes do like when someone does five or a 10 X kicker, just because they really believe in their ability to generate that. And I appreciate that, but I'm okay with it. I just don't think you need to go too low on the initial kicker. And I don't think you need too many levels to it.

• 39:30Harry Stebbings?

  Yeah. GP commit wise, when you think about that, I actually have a real problem with GP commits because often you see, A, I don't think they're thought of as proportional to wealth. They're just like stamped as, oh, it should be X and it's, they should be proportional to wealth. But B, it actually removes, because often I speak to obviously many friends who are managers, they use the fees to pay the GP commit, which means they don't have that money to invest in team, the fund, building a firm. And so as investors, LPs shooting themselves in the foot by insisting on a high GP commit where they just use their own money to recycle back. Do you agree with me? And how do you think about those GP commits?

• 40:04Speaker 00

  Yeah, no, I think you're right. I like to see a decent level of GP commit, but there's no reason to push it to an extreme kind of percentage level. And I do think the net worth percentage is much more important than whatever the absolute dollar value is. And most people don't think about it that way. So I think both of those are good points.

• 40:21Harry Stebbings?

  No, I totally agree. Listen, I want to do a quick fire round, Hunter. So I say a short statement and you give me your immediate thoughts. Does that sound okay?

• 40:27Speaker 00

  Sure.

• 40:28Harry Stebbings?

  So what did you believe last year that you no longer believe?

• 40:31Speaker 00

  I think we touched on this a little bit, but just on valuation policy. I was so used to venture funds always carrying things at last round and maybe some of the best groups taking arbitrary discounts. But I never thought valuation policy would change as much as it did have public comp reliance, option pricing modeling inserted, broad scale discretionary markdowns. I just think how people will value these assets has probably been forever changed on a go forward basis.

• 40:59Harry Stebbings?

  What would you most like to change about the world of venture, Hunter?

• 41:02Speaker 00

  I think the fund size question that we talked about, just people really being thoughtful about the amount of capital that's needed, both in the growth funds, but even in the main funds and whether or not you should have a separate growth fund from a main fund. Some people should, some shouldn't, but I'd like people to actually raise what's Reflective of the environment for the next two to three years when they'll be deploying it. What's the trend most investors are not seeing, Rick? I think it's the secondary side, which we spent most of the episode today talking about. I just don't think people think about this segment within venture. And venture isn't this tiny cottage industry anymore that it used to be. And as a result of that, and as a result of the limited liquidity options, the secondary part of venture is going to be very significant for a long period of time.

• 41:46Speaker 00

  And I think pretty interesting and also a compliment from a duration standpoint. If you're doing a lot of early stage venture, it's going to be one of the only ways you can make sure you're getting your capital back and complementing what you're doing on the seed and Series A side. What's the hardest element of your role today? For most LPs, it will be understanding whether TVPI is real or not. And that's going to be increasingly difficult with the way valuations are and the benchmarking exercises we talked about earlier. For me, it's understanding the organizational dynamics at a lot of these firms. I think what you're going to end up having happen is increased infighting in a lot of groups because you have older GPs that have done very well, that are staying on longer than they ever expected

• 42:30Speaker 00

  just because they're going to be needed to get funds raised in the future and they have the deepest track records. And then you're going to have younger, hungrier GPs that are up and coming, that want to deploy a larger amount of the capital and want to take advantage of these good vintages. And I think that's just naturally going to create conflict in certain partnerships. So understanding where that's a problem or understanding where it's a healthy dynamic and well planned is going to be important from the LP side. And it's not the easiest thing to get a true sense for. We saw a wave of GPs retire post-fundraise. How do LPs feel when that happens? Weird that's happened for us. It's generally been something that has been telegraphed or we've expected. I don't think it's great form if you're not having some level of conversation

• 43:13Speaker 00

  with your investors around how people's roles have changed over time and what they're doing. And if you know someone isn't doing a lot of new deals and they're helping more and mentoring, et cetera, the expectation is they're probably going to go to venture partner or senior advisor or move in that direction. You can expect that if suddenly someone's doing 20 deals and then says they're leaving. That's not great messaging.

• 43:35Harry Stebbings?

  What do you think is the most crazy thing we saw happen in 2020 to 2022 as a period?

• 43:39Speaker 00

  Time back to market. I'm amazed by how quickly some funds came back to market. And you and I have talked about this separately a lot. I think vintage or diversification is important, being deliberate about making new investments over at least like a two year period. I think is really important. And frankly, we saw groups that came back in six to nine months, which is just crazy. You're not going to provide any vintage or diversification. And those funds will probably end up being challenged if they were concentrated in parts of 2021. And you didn't smooth it out enough. And if you manage to do two or three funds within a difficult time period, you're going to actually have problems on multiple vintages.

• 44:18Harry Stebbings?

  But the interesting, sorry, the interesting thing I have to say, when you look at vintage diversification, this period that we're in now is actually the only time in the last decade where I think the true benefits of vintage diversification will be seen in terms of pricing levels amongst portfolio. And so actually like whether you deploy it in 2020 versus 2019 or 2018, prices were all completely fucking nuts.

• 44:38Speaker 00

  Yeah, but if you've had three funds that were playing in that time period and LPs are going to be looking at funds one, two, and three, and they're all bad and it hasn't been spread out. That's a much broader bad track record than just one fund.

• 44:52Harry Stebbings?

  This is true and you are in deep shit. Tell me, on reflection, what was your biggest investment mistake of the last 18 months?

• 44:59Speaker 00

  So I invest in funds, I invest in companies and I invest in secondary. So it's a little bit different for each. I think on the fun side, just underestimating the human element with people that join on a lateral basis that have great pedigrees that you think will be additive. It's not always that way. You can have someone join and it completely messes up the chemistry of a firm and creates really significant organizational risk. So that's what I'd say on the fun side. On the company side, you can pick a winner in a bad category and you can still really not do well if you're entering in at a growth phase. I think we've picked some companies that have proven to be the category leader. But if it's in an area like insuretech or areas of prop tech. Parts of the blockchain space doesn't matter.

• 45:42Speaker 00

  And particularly so if there's not a way to exit at reasonable enough comps or multiple sets. So it doesn't always matter if you pick just the category winner. On the secondary side, I think it's going back towards what type of securities you're buying and underestimating what can come in on top of you or getting seduced by structure. You increasingly see a lot of these structured equity funds out there. Structure doesn't necessarily stay when a company exits. It gets negotiated out by management or the rest of the board. And so you can think that you've protected yourself with structure and it ends up absolutely evaporating.

• 46:15Harry Stebbings?

  Penultimate one, do you think we see a true drought and a really hard time for emerging markets? In boom times, we saw Latam, Africa, India booming bigger than ever. Now we see the complete retrenchment. Do you think we see a really hard years ahead for them?

• 46:29Speaker 00

  Think it depends on the region, but yes, I think there will be more of a reemphasis on the but certain areas like people are much more excited about India and there continues to be interest in investing there. Southeast Asia was a big area of focus, although I think that's come down in the past year. But that was definitely like an area that we got lots of questions around the past two years leading up to this. Latin America, I think you just have to navigate currency issues. China, people have very diverse opinions on both sides of that. But yes, I think there will be more of a concentration and focus on the US.

• 47:00Harry Stebbings?

  Final one, as I said, I like to finish on an air of optimism. What are you most hopeful for when you look out to the next 24 months?

• 47:08Speaker 00

  I'm known as a pretty sarcastic pessimistic person, which I guess is a little bit counterintuitive for someone who invests in venture. But I have to say at the core, and we talk about this at all of our annual meetings, I'm super proud to be a part of this asset class. I think there has been bad behaviors in the past few years and certainly frothiness and mispricing. But venture at its core is all about outsourced innovation and it's the job growth engine for our country. And it represents a very high majority percentage of public market cap, a very high percentage of R and D. And I think it's critical for the next few years in our country from an efficiency gain standpoint, from the utilization of technology.

• 47:49Speaker 00

  To make what we do as a country more efficient on the growth side. And so we need it. It's going to be important at a macro level. It's an important thing, I think, just in terms of workforce standpoint. And so I'll always be long on venture, even if I'm disappointed by some of the behaviours that we've seen in recent years.

• 48:08Harry Stebbings?

  Hunter, I've so enjoyed this. I always love our chats. I so appreciate all you've done for me. Many don't know the support you've shown me over the years. I so appreciate it and thank you so much for joining me today.

• 48:17Speaker 00

  Oh, totally my pleasure, Harry. Anytime.

• 48:22Harry Stebbings?

  Absolutely love that with Hunter. Always the best breakdown of second you. So a huge thank you to him for being so brilliant. If you'd like to see more from us, of course, you can find us on YouTube by searching for 20 VC. But before we leave you today, I cannot stand it when I have to ping multiple people on my team to find information because it's spread across a variety of different tools, documents, spreadsheets. It slows me down and it prevents effective collaboration with our research team for the shows. And that's why I love and use Coda. Coda is the doc that brings it all together, meaning instant collaboration among all of your team with no more blockages. We use it for 20 VC for every show we do, 10 references with 10 founders of the VC coming on the show. And then all the data, information, track records are stored in one searchable place.

• 49:05Harry Stebbings?

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• 49:45Harry Stebbings?

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• 51:12Harry Stebbings?

  But that's enough from me and I can't wait to bring you an incredible episode with Metas CMO Alex Schulz on Monday.