Nearly a year ago, venture capital firms were cautioning founders of the coming lean times in the private markets, as high-flying valuations and a long run of a zero-interest-rate environment came crashing down. Now, top VC firm Lux Capital is warning their investors, or limited partners (LPs), of a new phase in the markets: What they're calling "crushing consolidation" in the VC space.
Despite the current gloom, the Lux Capital team sees “a very promising future being formed out of the strife in the markets,” as the firm, known for its bets on science and tech-heavy sectors like biochemistry and A.I., wrote in their recent Q4 2022 LP letter. And Peter Hébert, cofounder and managing partner at Lux Capital, is upbeat: "Despite the pain that's out there, and the turmoil, these are the conditions that ultimately lead to excellent companies,” he told Fortune. He believes "this is absolutely the time you want to be an investor."
But first, there will be that strife.
While some market watchers may be hoping for a so-called “soft landing” for the economy, Lux anticipates “market conditions to be very volatile with wild chaotic swings” including large layoffs, which they believe will spread from white collar to blue collar workers; “significant LP pullback from being overcalled and overallocated”; and “GPs being under-reserved and under duress.” That's all likely to trigger that "crushing consolidation in the venture industry," and "startup founders and fund managers will realize that the estimated $300 billion of ‘dry powder’ will in fact prove quite ‘wet’ due to not-yet-realized and largely spoken-for capital," the Lux team writes.
That could bring about a "flood of recapitalizations and drastic down-rounds, with managers forced to play their hands protectively against punishing pay-to-plays and other highly structured terms.” Smaller funds, meanwhile, may “face existential struggles and either call it quits, merge together or be absorbed into larger platforms,” they predict.
On the flip side, large mega funds might “struggle with the reality of having deployed record amounts of capital at record high prices.” They argue that for VC firms that went all in on sectors like e-commerce, enterprise SaaS, and fintech, “rearview returns won’t be forward ones, and what worked in the recent past (and for whom it worked) won’t work in the future.” Lux Capital's Hébert, meanwhile, anticipates this current tricky market environment will "absolutely" last through 2023.
But the upside? Lux Capital sees “future returns from funds deployed in 2023 and 2024 vintage years, with declining entry prices and more orthogonal investment strategies, may prove to be the very best in nearly a generation.”
Read the full LP letter below, or here.
