IRR's Time Comes

One of the most enjoyable parts of this job is meeting different people from different parts of the country and hearing the perspectives on the economy, opportunities, and business. Most of the time, those people are founders and other VCs, but we also spend quite a bit of time meeting with our investors—pension funds, endowments, family offices, etc  Recently, many of these discussions have highlighted for me the increasing salience of time in how they evaluate investments.

Based on these conversations and overall macroeconomic trends, fund managers are going to have to adopt a more traditional private-equity-like approach to portfolio management. There will be a much bigger emphasis on generating liquidity and less patience with moonshot deals after the post-investment honeymoon period (and yes, this will include AI business, because this shift is structural, not strategic).

Essentially, the eternal war between IRR (internal rate of return and the more traditional (at least in VC) MOIC (multiple of invested capital) is about to be settled in favor of IRR. If I were to tell you that I’ll double your money for you, the question you should ask (assuming you believe me) is “how long will this take?” Because if you just toss your money into an index fund, it’ll double in about ten years, and whatever I’m going to do is almost certainly going to be more risky than that (heck, with today’s rates you could get a 2x in fifteen years with an FDIC-insured savings account).

Having spent my early years in private equity, I have always been more partial to IRR, but venture has been more focused on multiples. Fund lifetimes tend to be consistent (about a decade), and the multiples in venture tend to be huge. IRR is more complicated, harder to compare across different funds, and it–very annoyingly–changes literally every day. But it is a better measure of performance, especially when the supply of money is reduced due to rising interest rates.

One of the consistent themes in our conversations with investors is: “how will liquidity work in a market with far fewer IPOs”? Investors are seeing a sharp decline in liquidity events and increasingly questioning when they will see returns even as startups continue to be as successful and profitable as ever. The value is there, certainly, but the cash is not.

Somewhat counterintuitively, the bullish secondary market is heightening these concerns. Mark Zuckerberg famously hated the idea of an IPO but was effectively forced into it by employee demands for liquidity; keeping the team motivated required building an offramp for the equity rewards. Today, however, a robust secondary market is creating plentiful pre-IPO liquidity options for founders and employees, increasing concerns that IPOs may not rebound to prior levels.

Furthermore, VC fundraising continues apace. Coupled with longer liquidity intervals, this trend means that investors must devote a greater share of their portfolios to venture, because their ability to recycle cash returns from old funds to new funds is limited. With interest rates up (2x in fifteen years in a savings account, remember?), there is also more competition for high-IRR returns.

The upshot? Fund managers need to think a bit more like finance geeks and less like entrepreneurs. It is no longer just about “make graph go up” but about when those returns can be realized, via what mechanics, and in what kind of environment. This isn’t necessarily a bad thing, especially for those of us running speciality funds at the seed stage. One of the many great things about fintech is that we have both very robust M&A opportunities as well as a recovering IPO market, not to mention that seed stage investing allows for far greater flexibility in allowing for lucrative exits. There is certainly an argument that this dynamic favors seed stage specialist firms in sectors dense with acquirers, and I expect to see more specialized firms that invest earlier.

Founders likewise should expect more pressure from later-stage funds on liquidity. This dynamic may be some time in coming, especially as the nascent recovery in mid- and late-stage funding will mask it for a few years, but it is coming. Just like how we entered an era defined by the increasing importance of revenue back in 2023, we are entering an era of an increasing focus on liquidity in 2024. Be ready for more impatience in the board room and less willingness to pass up near-term liquidity opportunities. When making business plans (especially expensive ones), consider the time horizon of your investors’ capital in addition to the pure business logic. As always, founders who take the time to consider their strategy from multiple perspectives (business, end-user, investor, employee) will outperform.

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