Raising a VC fund in a bear market
Henlo everyone! For those who noticed my Twitter bio change, I recently started a new VC fund Varrock (iykyk ⚔️). Now that my fundraising is wrapping up, I wanted to share my biggest learnings in my journey fundraising throughout the bear market.
1. Outside of returns, LPs care most about concentration and ownership.
In venture, it can take up to a decade to see someone’s track record and know if they’re a good investor or not. The next best proxy is looking at concentration and ownership.
Concentration: what % of the fund do you underwrite per investment.
Say an institutional LP invests in 20 funds, which gives them exposure to 400-500 underlying portfolio companies. The top 10 companies combined (looking through the VC portfolios) can return multiples of the LP’s entire portfolio.
VC is an extreme power law industry, in which only a handful of companies drive almost all the returns and only a few funds can get exposure to these companies. No other industry has a starker difference between the top decile and the median. The top decile is one of the best asset classes while the median underperforms the S&P 500.
That said, there is nothing more frustrating for an LP than seeing a fund having the rare opportunity of investing in a winning company but not moving the needle on fund returns because the initial check size was too small. This is also why just because a VC has a bunch of good companies in their portfolio doesn’t mean their fund returns are actually good.
In my opinion, the sweet spot is underwriting 3% of the fund per investment. This means a 33x outcome on any portfolio company will return the fund, which is very doable in a bull market. Going lower on concentration – 2% or 50x, 1% or 100x – means you need more extreme outlier outcomes to return the fund, and that is very difficult to do consistently across multiple vintages. Conversely, going higher on concentration – 4% or 25x – starts to reach diminishing returns relative to the portfolio risk you’re taking.1
Fund size is also important. Too big of a fund, there’s thesis creep of having to invest up in Series A in order to deploy the fund if you pitched LPs a seed fund. Or put a significant percentage of the fund in BTC and ETH, which LPs are getting more averse to paying fees for market beta.
Ownership: what % of the company do you own.
The biggest competitive advantage for smaller funds is getting the most ownership in the earliest rounds when valuations are super low. Valuations tend to increase faster than companies are derisked, so the risk/reward at the pre-seed/seed stage is often the best.
Ownership is an indirect measure of a fund’s ability to win deals. If a small fund is co-investing with large funds in big hot L1/L2 infra deals, the first question LPs are going to ask is why shouldn’t they instead invest in the large funds that are lead investors in these deals given they have more ownership and less brand risk.
Funds that struggle to win deals often end up 1) spraying and praying and having a portfolio of 100+ companies, and/or 2) co-investing in later stage rounds where the check size is small enough relative to the round size to not get squeezed out by other investors.
LPs also like to minimize portfolio overlap among funds and tend to avoid cliquey groups that all co-invest together in the same deals. So when asked the question “Who do you like to co-invest with?”, most people would assume a good answer is name dropping other tier 1 brand funds, but actually it may not be good if the LP already has exposure to such funds. LPs ideally want their portfolio of funds to each have high ownership and be independent of each other.
2. There are so few LPs who have dry powder.
This might come as a surprise to people since BTC is at an all-time high, but LPs are generally much more sensitive to macro (aka Fed interest rates) than they are to crypto prices.
Many LPs overallocated to the crypto space in 2021/2022 and are still licking their wounds and waiting for DPI from those vintages before making more commitments. Fund of fund LPs, in particular, also have to fundraise from endowments, foundations, sovereigns, pensions, family offices, etc. and fundraising is more difficult the more degrees separated from the startups. LPs like to give the impression that they’re still actively investing, and likewise often you don’t know they don’t have dry powder until deep in the diligence process.
VCs that raised their current fund in 2021/2022 are now down to their last few checks. This trickles down to startup fundraises too as anecdotally rounds are taking longer to get done. VCs are being extra selective deploying their last few checks. Delaying going back to the market to fundraise from a shrinking pool of LP capital saves VCs from getting punched in the face by reality, and they can hope that the BTC post election bull run will improve the LP fundraising environment in a few quarters. Otherwise most funds will have to downsize.2
So even though crypto prices are higher today, arguably fundraising is more difficult now than it was back in Q4 2022 when crypto prices bottomed during the FTX fallout. Back then, LPs were scared of allocating to crypto but at least they still had dry powder. Now LPs are more lukewarm about crypto (the election certainly helped LP sentiment), but unfortunately many LPs are already fully allocated and sitting on the sideline until they have more cash on hand.
3. Avoid the pressure from LPs to specialize.
Many LPs like specialist funds because it’s easy for them to fit in their overall portfolio. If they want to cover the entire crypto ecosystem, they can invest in a DeFi fund, an NFT fund, a DePIN fund, a Solana fund, etc. It’s also easier to pitch a specialist fund as you can argue why your dealflow and selection may be better than everyone else’s if you’re spending 100% of your time in one specific category.
While specialization works for LPs, it puts your fund at big risk of being a one trick pony. You become very susceptible to the macro environment for that vertical. If, for instance, NFT prices are down across the board, it’s difficult to make money even if you’re world class at picking NFTs. And even if it does work out, you’re also at risk of getting blindsided by the next big trends that come afterwards. 2020 was a good vintage to invest in DeFi, but specializing in DeFi meant missing out on NFTs, new L1s/L2s, AI agents, and everything else that came after DeFi summer.
Long-term successful franchises are generalist funds. Survival as a VC means constantly reinventing your brand and staying on the bleeding edge of the industry. After all, VCs are paid to frontrun the next big narratives. Otherwise VC careers have pretty short shelf lives – as an example, try to find a telecom equipment investor who’s not already retired.
Ending this with an announcement of an announcement. Stay tuned for Varrock’s public fund announcement soon™ (but actually, in the upcoming weeks). In the meantime I’ve already made investments in projects so please reach out if you want to chat!
The exception to this model is accelerators. Even though accelerators can spray and pray up to hundreds of companies per batch, they also need to get very high ownership in the earliest rounds so that any one outlier outcome can meaningfully drive the overall fund return. Y Combinator, for instance, gets 7% of every company per batch. Accelerators are more straightforward for LPs to due diligence since it’s all about ownership.
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