Trusteeship Podcast Episode 54: What Boards Need to Know about Venture Capital

Introduction:
Welcome to the Trusteeship Podcast from AGB, the Association of Governing Boards of Universities and Colleges. We cover everything higher education leaders need to know about the challenges facing our nation’s colleges and universities. More important, we provide the facts and insight you need to solve those challenges and to be the storytellers and advocates higher education needs.

Venture capital can be a powerful portfolio driver for institutional investors when approached strategically. In this podcast, Cerity Partners Senior Principal Nat Fraser talks with AGB Senior Consultant John Griswold about how venture capital is a critical asset class that offers significant return potential, but requires careful understanding of its unique risks and dynamics. Thank you for starting us off, John.

John Griswold:
Well welcome everyone. Thank you for joining us today. I’m joined by Nat Fraser from Cerity Partners and we’re glad to have him today as our expert on venture capital. I think we’ll start with a little stage setting. Can you just give us an idea of the different sequences in private equity, venture capital?

Nat Fraser:
Certainly John. So private capital is a broad asset category and includes everything from private equity buyouts to seed stage investing in VC backed companies. While private equity managers are typically going after profitable businesses and can value those businesses based on their profits, venture capital is much more elusive in terms of the valuations of companies which generally don’t have any profits, sometimes might not even have any revenue. So we are talking about startups, we are talking about the innovation economy, we are talking about very, again, early stage businesses where a lot can go right or a lot can go wrong. And we’ll talk a little bit more about some of those factors through the conversation today.

John Griswold:
So seed and pre-seed and seed or before VC, and then of course private equity M&A follows it if you look at the whole arena of equity capital.

Nat Fraser:
Venture capital can apply to pre-IPO, later-stage investing or seed-stage investing. So it’s really the notion of buying equity into companies that are growing quickly but aren’t necessarily cash flow positive and encompasses everything from business plans, or maybe not even business plans, backing a founder who has a great track record and mentality of running through walls and investors want to bet on that person and just their work ethic or their ability to inspire others, all the way through companies that might have over a hundred million dollars in revenue and are preparing for a public listing.

John Griswold:
Why is VC an important part of an institutional portfolio in your opinion? And what should boards and investment committees be aware of when they invest in it?

Nat Fraser:
Venture capital can be a high-returning asset class and has over the last 10 or so years. The last two years have been more difficult with high valuations in 2020 and 2021 creating unattractive points and frankly creating some headwinds for those companies as they’ve scaled since then. But over the long term, VC, again has created some nice investment opportunities and for a mature portfolio for an institution can be a valuable part of the return driver and the upside potential within those portfolios.

John Griswold:
So if I’m a trustee on an investment committee but I’m not an investment professional, what should I be aware of in terms of venture capital investing? You mentioned the higher return, but what’s the risk?

Nat Fraser:
I think it’s always worth remembering that in venture capital you are fundamentally giving money to companies that are losing money every single month. They’re burning money, they might have revenue, but it rarely offsets the costs of hiring engineers, of building out a sales team, of refining a go-to-market strategy. And so this idea of pouring money into companies that are losing money every month, I think is fundamental to the risks in venture capital, and understanding that for these companies to achieve some of their potential, they will most likely need to go on to raise additional financing. And if the company has grown so strongly and it’s obvious to the market at that point that this is a good bet to make, that additional capital will likely be there. But it’s not always within the company’s own ability to control the financing rounds down the road, it’s oftentimes very subject to market environments at those points in time.

And so you have to understand that this is a risky game where you can see 10 X funds, you can see 100 X portfolio company outcomes, but there are many, many, many write-downs and many write-offs as well. So when the companies can execute and can grow and can scale and can eventually return dollars back to limited partners and back to their institutional backers, it can be a great portion of the portfolio, but not one where you’d expect there to be no losses either. So it’s a more volatile asset class, higher dispersion of returns and something that needs to be thought through when you’re exploring a commitment to venture.

John Griswold:
We know institutions like Yale and Harvard who have been doing this for several decades, have had good success in it, if they’re able to access some of the top managers, and of course there’s quite a dispersion between top quartile and bottom quartile managers in this sector, how do smaller institutions access this asset class?

Nat Fraser:
That’s a great question. Of course, there are fund-to-funds who are out there raising capital and really selling the access they have to some of these elite exclusive VC names. The best venture capital managers can oftentimes choose which partners to take on as LPs. And so having that access is very important and that’s what fund-to-funds look to solve is a turnkey solution to getting access to those underlying elite managers. However, you don’t necessarily need to go that fund-to-funds route if you have a team internally or if you were to partner with a new CIO with the relationships and the network across that same elite field of venture capitalists and gaining access to the best VCs is part of what our team does and has worked on really since our get-go.

I’ve been covering venture capital for 16 years now and pretty well networked with scores of other limited partners and have met with thousands of venture capital firms directly and oftentimes getting access to those groups is really about building your own reputation as a limited partner in the space, as a consistent provider of capital, as a group that just knows the lay of the land and can run an efficient due diligence process, but maintain transparency and really do it through the mindset of a partnership throughout.

And so whether that means gracefully passing on a fund, but leaving a venture capitalist with a good impression where they might go on and share nice things about you to another VC, or in instances where you do come on as a limited partner, you make the investment, you might even be invited onto the limited partner advisory committee. And it’s proving your mettle in those settings as well, being a good sounding board, helping the venture capitalists understand the LP’s perspective when it comes to potential risks within the portfolio or the perception of conflict within the portfolio. And so it’s really about finding folks with the reputation in the networks in those elite circles of VCs that you really need to bring onto your team.

John Griswold:
These are long-term investors, of course, endowments, particularly, many foundations as well, consider themselves virtually perpetual funds. Going into venture capital you have to re-up in each case by general partnership and by fund, but what’s the importance of staying with that once you’ve started to invest?

Nat Fraser:
I think there’s maybe two elements to the question that I think bear mentioning. The first are relationship considerations. So if there are groups that can pick their partners and you’ve come into one fund, they might expect you to come back for the next fund. And opting to pass could mean the end of a good relationship with a hard group to gain access to. So I think that’s certainly part of it. But in terms of consistently deploying into the space, I think it goes beyond just the relationships with VCs and it’s really about vintage year diversification.

Certain markets will be very expensive, and maybe that means that new deals are priced too high, but if a fund is trying to exit investments during that time period, that’d be a great time to sell. Whereas after a big market sell-off you might not see much in the way of new liquidity, but it could be a great buying opportunity. And so not knowing what the future has in store, maintaining ample diversification is really paramount for allocators to the space and something that institutions needs to be mindful of as they’re building out this portion of the portfolio.

John Griswold:
You’ve mentioned earlier some of the challenges that come out of the last couple of years starting with COVID, of course, increased inflation and interest rates, there’s still a lot of dry powder out there in the VC world, though, a lot of it, frankly, collecting fees but not being put to work. Is that a problem going forward? What’s your outlook and what’s your outlook for 2025?

Nat Fraser:
So there were record amounts of capital raised, certainly going into the bubble years of 2020 and 2021. I think we’re seeing a correction, not withstanding the still large amounts of dry powder or commitments that have been raised but not yet deployed by VCs. That’s what we mean when we say dry powder. However, we’re seeing that correct and normalized. The number of new funds raised last year tallied just over 1400 as compared to over 4,000 in 2021. And the amount of capital has come down in a similar fashion, I think about $160 billion raised last year, that’s as low as it’s been since 2015.

So I think we are through the froth, we are through the bubble years, and that correction has created some pain in existing portfolios and certainly for many managers who would’ve liked to go out and raise new funds in 2023, 2024. But I think it bodes well for the health of the industry and the investing environment that VCs are deploying into today, not just in terms of valuations, which have improved, certainly outside of the white-hot AI space, but also in terms of the diligence timeframes and the terms that investors can seek when negotiating investments in these startup companies. Things are just a lot more sane, and again, I think that bodes well for new investments.

John Griswold:
On the other end of the spectrum, if you will, what’s going on with the IPO market? Why is there so little liquidity and exits?

Nat Fraser:
Yes, much been written about the IPO market. I think since 2022, there have been something like five or six months where we’ve seen over 20 IPOs in the US in a month, and now five of those have come in the last six months. So maybe we’re seeing some green shoots, but it has been difficult. The IPO window has been effectively closed for the last three years, and it does make it difficult to return capital to LPs who can then recycle it into new VC commitments.

In terms of 2025, there are reasons to be optimistic. There have been some IPOs so far this year, not withstanding more near term volatility in public markets. I think there’s a renewed sense of optimism, frankly, not just for IPOs, but also for M&A. The prior administration’s FTC was famous for using a broad interpretation of regulatory rules to block different mergers. And so while the future is yet to be written, reasons to think that there could be more pathways for returning capital to investors, both through IPOs hopefully, but also M&A, never mind the continued sophistication of other avenues for liquidity, namely in the secondary market or through a general partner’s use of continuation vehicles.

So folks are finding creative ways to return dollars to LPs, but it’d be great if some of those traditional routes, M&A and IPOs come back into the fore.

John Griswold:
Yeah, no, it would be tough, we’ve signed up for a ten-year fund and it turns out to be a 15 or 20-year fund. In fact, the value is still there, probably, and you’d have to guess that that’s the case, but it’s just going to be slow for a while. Why don’t we just dig a little deeper you mentioned AI, the bubble here, people call it a bubble but it certainly has had some legs recently. What stages and sectors of VC are you thinking do you favor now?

Nat Fraser:
So across sectors, now, we focus on all sectors and we are speaking with and investing with VCs who really are investing across the whole spectrum of sectors, one area where I’m probably more excited today than a few years ago is biotech and life science. Valuations here have been absolutely crushed, the public markets have been absolutely brutal for biotech and life science investors. However, the innovation in the science hasn’t slowed down. What we’re seeing in terms of AI meets drug discovery is very exciting. What researchers can do with new genetic editing tools and CRISPR-Cas9 applications is really neat. And then AI meets medical records and healthcare data has some really cool opportunities bubbling up as well. So I think life science and biotech is interesting today.

And then just talking about AI more broadly, obviously we’re seeing it in all kinds of forms, both in public markets but in privates as well. I’ll just comment there, I think if there’s one big takeaway for AI in VC, it’s that previously slept on industries, stagnant industries, industries that didn’t necessarily inspire VC dollars because they frankly weren’t growing fast enough or weren’t thought to be large enough, are now actionable for VCs where AI tools can help scale revenue so quickly that the massive outcome at the end of the day isn’t necessarily required to create a really nice return for a fund.

So we’re all familiar with the term unicorn. This was first meant to describe a billion dollar valuation company with strong growth and all the glitz and glamour, the term that I’ve heard more recently is donkacorn, where a business doesn’t necessarily need to hit that magical unicorn status, it might end up in the multi-hundred million dollar range and still produce a outcome for VC investors because of the growth to get to that point made possible by AI tools. So lots of exciting stuff going on in AI. I think entry valuation will always matter, and so investors need to be cognizant of just what the prices you’re paying and what that means for the multiple on investment through that portfolio company’s life. But lots to be excited about with AI and VC today for sure.

John Griswold:
Yeah, AI certainly has become the shiny new object for Wall Street and elsewhere. And for investors too, I’m sure there’s some that would be considered AI washing just like greenwashing was, but in fact, I think there really is the promise of revolutionizing productivity and cost efficiency in this economy. What are the effects so far as you can tell, of the new administration and their attempt to reduce regulation, reduce the size of the government funding in many cases? What’s the impact on the VC landscape in your view?

Nat Fraser:
I think investors are mostly optimistic about the new administration, and their tack towards balancing safety with innovation. I think the new administration, populated by technologists and several VC investors, is keenly aware not just of AI safety risks, but also the risks of falling behind in AI innovation. And so we’re seeing what I think are strengthening tailwinds in terms of how regulation is looked at, both in AI and across the tech ecosystem.

I was with an investor who happens to work at OpenAI just before the holidays, and this individual had previously worked at Facebook on the Libra project, this was the blockchain initiative that Facebook used that they were going to implement digital currencies across their huge platform. It was very exciting at the time, a lot of people were very enthusiastic about the potential benefits of this technology, and it was completely squashed by regulators. So what this individual told me is that the new administration represents the boot coming off the neck of the blockchain industry and now blockchain is just one of many sectors that VCs are focused on today. But that was certainly promising to hear in terms of more tailwinds from regulators, hopefully in the years to come.

John Griswold:
I was listening to a gentleman who was in the trucking industry and they were talking about the effects of not only blockchain but AI on their business. And so far that’s been astonishing, talking about figuring out the most efficient routes for trucks to take for deliveries, and of course all the efficiencies that can be applied to trucking because they’re one of the biggest users of fossil fuels particularly. In fact, do you see anything else in the landscape going forward that would affect VC? What would unlock the IPO market for instance in your eyes?

Nat Fraser:
I think the IPO market is one where investors are always waiting to see somebody else jump in and let them know how the water is. So I think if a couple of the big names that are ready to go out successfully do so this year and trade favorably, I think that’ll really encourage others to list as well. There are some very successful at-scale companies in older VC funds that are coming up on the ends of their lives, and I think investors’ eagerness to see some liquidity will hopefully light the fire underneath some of these. But it’ll be a wait-and-see game, and hopefully those companies brave enough to list in this environment trade well and encourage others to do so.

John Griswold:
You foresee a loosening, if rates do start coming down at some point, will that loosen a bit of the stress that’s in there now?

Nat Fraser:
Certainly. Rates coming down do a lot for really just greasing the skids in the investment world and lowers the cost of capital across the board. I think it could lead some of the big corporates and strategics to be more acquisitive if borrowing costs come down. And so rates, they’ll impact private capital markets more broadly, probably most directly for buyout funds, which are financing their acquisitions with a lot of debt, frankly and if that costs less, then we’ll see deal activity and valuations increase. But it hits VC as well, just the whole risk on risk off mentality and the cheaper money is the more easy it is for investors to go risk-on which in terms of private capital allocations might mean more interest in VC.

John Griswold:
So what keeps you up at night other than everything we’ve been talking about?

Nat Fraser:
Well, there’s a lot to be worried about right now. Liquidity we’ve talked a lot about already today, but I think that’ll be the real panacea in the VC market once we start to see distributions come back. I know in 2024 distributions for VC funds as percent of net asset value were as low as in 2009, and so we’re just not seeing dollars back. So it would be amazing to see that reverse course, whether it’s M&A or IPO, just to see liquidity back would be fantastic.

Frankly, valuations increasing like they have in AI is a little worrisome. We’ve seen some amazing progress with the most cutting-edge models from the likes of Perplexity or OpenAI but I’m curious how much incremental benefit comes from the frontier models being developed now for release later this year or next year. And I think one way to think about it is if yesteryear’s models, which have been mostly commoditized or fantastic for creating a personal assistance with, call it 120 IQ equivalent, it’s probably a pretty massive market for that sort of AI tool.

What’s the market size for an AI tool that costs much more money, but is producing a 200 IQ equivalent or 250 IQ equivalent? Obviously very valuable but if the number of buyers or customers for a tool like that are more limited, you could make the case that dollars going into LLM development right now may not be very well spent. So those are a couple of market-related concerns. And then I always have the extra challenge of maintaining a strong pipeline of potential new VC commitments, and some of those will end up having to pass on and it’s never easy to come to the realization that a group that you believe in might not necessarily consummate in a new LP relationship or a new commitment to their fund.

John Griswold:
Fantastic. Any recommended reading or podcast that you suggest that our listeners would find interesting and educational in this area?

Nat Fraser:
Sure. I mean, there are so many fantastic podcasts these days. I’ve got several in my regular rotation. There’s a fantastic podcast called Acquired, which will do deep dives into different companies and their stories, and really ranging from Standard Oil 160 years ago through the latest and greatest technology startups today. That one’s fantastic. And Sarah Guo of Conviction Capital has teamed up with Elad Gil, he’s a very well-known angel investor, to launch a podcast called No Priors, which I think is also wonderful, and they’ll get into some nice deep dives and new technology trends just to name a couple. But yeah, there’s no shortage of good options out there.

John Griswold:
Well, they sounded like good ones. If anybody has a question, they can get hold of AGB and we’ll try to answer questions. I want to thank you, Nat, and thank the audience for listening. Hopefully this is useful as you venture into venture or have continuing investments in it, but it certainly, as the old saying goes, interesting times to say the least.

Nat Fraser:
Indeed.

John Griswold:
So thank you very much, Nat.

Nat Fraser:
John, thank you so much for having me. I enjoyed it.

Conclusion:
Thank you, Nat and John. For more information on Cerity Partners Services, please visit ceritypartners.com. Thank you.