Roger Ehrenberg: Why VC Returns Will Get Worse & Why LP Incentive Structures are so Broken | E1117

Intro (00:00:00)

• Roger Ehrenberg discusses his shift from pure Tech to Venture and the potential changes in the venture capital industry.
• He emphasizes the importance of incubation, pre-seed, and seed stages in venture capital.
• Ehrenberg highlights the challenges of deciding between distributing and holding investments.

Seismic Shift from Banking to Venture (00:00:55)

• Ehrenberg describes the shift he observed when moving from banking to venture capital.
• He notes the euphoria and intense competition in the banking industry during that time.
• Ehrenberg felt that the culture on Wall Street was corrosive and that his learning curve had stopped.
• He spent the next five years immersing himself in the early-stage technology world.
• During this period, he developed his hypothesis that very early, concentrated investment in big data infrastructure would be transformative.

Easy Money in Venture (00:03:01)

• Ehrenberg discusses the recent period of easy money in venture capital.
• He acknowledges that it may not have been real money and that most often it was not.
• Ehrenberg draws a parallel between the current situation and his departure from investment banking, which coincided with the peak of the market.
• He believes that the intersection of macro circumstances in the industry and an emotional pull for change aligns with these cycles.
• Ehrenberg emphasizes the advantages of being on the buy side during challenging times, especially with a long-time horizon.
• He mentions an observation by Justin Ish from Shaw about the correlation between difficulty in investing and ease in fundraising.

VC as a Commodified Asset Class (00:04:38)

• Venture capital has transitioned from a boutique high margin business to a commoditized low margin business.
• The asset class is being flooded with capital, leading to compression of returns.
• The industry is barbell-shaped, with large asset gatherers on one side and boutique investors on the other.
• Incubation, pre-seed, and seed will always occupy a different place in the VC universe.

Future of VC Fees (00:06:56)

• Boutique players face challenges competing with large corporations that offer lower fees.
• Large asset gatherers need convexity in their portfolios to justify their huge asset bases.
• Boutique investors should focus on areas that are not getting the attention of the hype themes of the moment.

Rise of Sovereign Wealth Funds in VC (00:08:28)

• New sources of liquidity, such as sovereign wealth funds and multi-billion dollar family offices, are now major players in venture capital.
• The increasing supply of capital from these sources is causing a shift in the venture capital landscape.
• Venture capital is becoming more like private equity, with higher levels of capital supply and institutional investment.

Role of Performance in VC Fees (00:11:00)

• The best-performing venture capital firms will continue to charge premium fees, even after accounting for their fees.
• There will be a normalization of fees in the venture capital industry, with smaller, longer-dated, higher-return managers commanding premium fees, while more mature strategies will see fee compression.
• Some limited partners are more concerned with not underperforming their peers than with achieving high absolute returns.

Broken Incentive Structure in LPs (00:14:11)

• Traditional LP structures are broken.
• LPs have enabled the dumbing down of venture and the creation of too many venture firms.
• Venture firms have raised billions of dollars without returning capital, and their managers are still getting paid high fees.
• As traditional LPs become diluted, new LPs with a focus on fair fees and returns are emerging.

Future of LP Structures (00:16:16)

• Corporates are fair-weather and cyclical LPs.
• Sovereigns and the largest wealth accumulators are developing durable asset allocation strategies that include venture capital.
• Endowments are a large part of the LP landscape, especially in the US.

Incentive Programs for Endowments (00:18:18)

• Endowments face structural incentive problems due to their public good nature and scrutiny.
• Working for an endowment may not be profit-maximizing, but it offers valuable learning experiences, great teams, and a sense of mission.
• Some institutions, like the University of Notre Dame's investment office, have a strong mission and attract talented individuals who prioritize the institution's goals over higher salaries.
• Fee structures are less important for endowments compared to providing a fertile learning environment or a sense of mission.

Lack of Liquidity in VC (00:21:08)

• Venture capital lacks liquidity due to long-term lockups and limited choices.
• Investing in venture capital can be beneficial for perpetual institutions with long holding periods and a focus on compounding the endowment base.
• Allocating a smaller portion (5-7%) of the endowment to venture capital and focusing on manager selection can provide convexity in returns during liquidity cycles.
• The challenge lies in managing the liquidity profile during liquid times to capture the compounding returns of the best managers.
• Some endowments may overlook the non-consensus and contrarian approach that led to successful compounding in the past, such as Yale's investment strategy in the 1990s.

Knowing When to Get Out in VC (00:23:36)

• The element of picking a class to invest in is more challenging today compared to the past.
• The asset class itself is not performing as well as it used to.
• It's possible to construct a less higher returning but less volatile portfolio by investing in more institutionalized mid and late-stage companies.
• Risk-adjusted returns of 12 to 15% are considered good, while below 10% is not worth the risk.
• Mid and late-stage companies are more liquid compared to early-stage ventures, making them a different asset class.
• Andreessen Horowitz will continue to thrive due to its ability to provide 12% returns, which is attractive compared to the 6-7% net returns from other investments.
• A premium of 500 to 700 basis points for illiquidity is acceptable for certain institutional investors.
• The speaker expresses concerns about liquidity in the current market, particularly with regards to M&A and IPO markets.

Creating Liquidity through Continuation Funds (00:26:23)

• Continuation funds are a significant source of liquidity for venture capital firms.
• Existing portfolios raise money from new investors at current valuations, providing fresh capital and an offramp for existing investors seeking liquidity.
• Continuation funds can be a pragmatic strategy for managers with stacked funds containing valuable assets and limited partners (LPs) needing liquidity.
• The scale of continuation funds is uncertain, but smaller funds with strong private portfolios can attract investment.
• Continuation funds address the liquidity needs of firms with pre-IPO or growth-stage assets in illiquid markets.
• Some firms are willing to accept discounts to generate liquidity for their LPs.
• Continuation funds cater best to software-as-a-service (SaaS) companies due to easier asset pricing.

Pricing Challenge in Continuation Funds (00:29:50)

• Net new investors in continuation funds are the price setters, not the existing managers.
• Continuation fund investors work with the manager to hire a firm to value the portfolio.
• The buyer and seller need to agree on a price based on the third-party valuation.
• Existing managers aim for the highest price to satisfy their LPs and maximize their crystallized carried interest.
• Continuation fund managers want a lower valuation to reduce their basis in the portfolio.
• Finding a market-clearing price that is fair to both parties can be challenging.
• There is a significant gap in how managers value their portfolios.

Valuing Books in VC (00:31:39)

• Managers have been slow to adjust valuations down in response to market conditions.
• The continuation fund discussion is relevant because of the differing liquidity needs of managers and investors.
• Continuation funds can take advantage of the desperation of managers who need liquidity and the undervaluation of private markets compared to public markets.

Strategy for Continuation Funds (00:33:39)

• The best firms and funds may not be interested in continuation funds because they have strong portfolios and don't need immediate liquidity.
• Continuation funds may be more attractive to managers who haven't delivered much DPI and are struggling to raise new funds.
• The most promising targets for continuation funds are early and mid-stage firms that have great portfolios but missed the IPO wave of 2016-2020.

Timing of IPOs in VC (00:36:20)

• IPO readiness process takes about two years.
• Once ready, it takes 9 to 12 months to complete the IPO.
• Best time to do an IPO is when the company is ready and the market is favorable.

Challenge of Secondary Liquidity (00:37:37)

• Selling a part of a position in a private company during a bubble is difficult.
• Mindset should be similar to public company readiness framework.
• Objective assessment of a company's IPO readiness can prompt partial selling of a position.
• USV has successfully sold a part of their position in some IPO winners.

Decision to Distribute or Hold IPO Positions (00:39:18)

• Sold a portion of Wise's position to generate recycling capital and return half of Fund II.
• Sold Simple to BBVA, generating liquidity that was invested in the Trade Desk Series B.
• Lack of small M&A deals makes recycling capital difficult.
• Recycling is crucial for optimal fund deployment and avoiding the need for SPVs.
• Early-stage recycling is a struggle due to the long timeline before investment opportunities arise.

Impact of IPOs on Fund Reputation (00:43:00)

• Roger Ehrenberg, co-founder of IIA, discusses the challenges of managing VC portfolios and the decision-making process behind distributing shares of successful companies.
• Ehrenberg emphasizes the importance of being thoughtful and analytical when making decisions about when to distribute shares, considering factors such as market conditions, the impact on the firm's brand, and the potential for future returns.
• A successful IPO early in a fund's lifecycle can significantly impact the fund's reputation and ability to attract investors.
• Ehrenberg and Brad Feld co-founded IIA in December 2009 and committed to an investment in Fatter Collective based solely on a PowerPoint presentation.
• Ehrenberg and Feld both sat on the board of Fatter Collective, co-led the seed round, and bridged the company three times before they raised their Series A.
• Ehrenberg admires Fatter Collective as the poster child for the boutique artisan style adventure.

Rich Investors as Better Investors (00:51:38)

• Rich investors make better investment decisions on liquidity because they don't need the money as much.
• Sequoia made the franchise 40 years ago, so setting up an Evergreen structure makes sense for them.
• Once Sequoia proved their ability as great stock pickers and partners, they had the confidence to take a deep breath and consider the optimal liquidity strategy for public markets positions.

Challenges in VC (00:53:59)

• Investor psychology is one of the most under-discussed aspects of the VC industry.
• Young investors today are facing challenges as their portfolios are taking a hammering and companies are getting down rounds.
• It's important to have a strong partnership, deep respect, intellectual rigor, and honesty to deal with investor psychology challenges.
• Solo GPs should seek mentors to help them process and learn from their investment decisions.
• Sequoia's superpower is processing investment decisions honestly and learning from what happened.
• Success doesn't necessarily get easier to attain in venture capital.

Success & Hard Work in VC (00:57:38)

• Success in VC requires continuous hard work and dedication, even for those who have achieved significant success.
• Despite financial success, successful VCs like Doug Leone and Roger Ehrenberg maintain a strong drive and motivation to keep working and building.
• The motivation to continue working in VC often comes from a love for the work itself, collaborating with founders, and building new things, rather than financial necessity or ego validation.

Needle-Moving Moments with Wealth (00:59:54)

• Roger Ehrenberg discusses the key moments that significantly impacted his mindset on wealth.
• The first moment was when he received a $320,000 bonus on Wall Street, which made him realize his potential to earn a substantial amount of money.
• The second moment occurred five years later when he was given a special equity program worth over $6 million, which further boosted his confidence and sense of accomplishment.
• Ehrenberg expresses gratitude for his success and acknowledges that his journey was not preordained.
• He reflects on his humble beginnings, having less than zero when he got married, and marvels at how far he has come in just three years.
• Ehrenberg anticipates future needle-moving moments in his life and looks forward to them.

Raising Kids in a World of Wealth (01:04:16)

• Roger Ehrenberg discusses the challenges of raising children in a world of financial abundance.
• He emphasizes the importance of remaining true to family values and ensuring that actions align with words.
• Ehrenberg highlights the significance of being present and involved in his children's lives, despite his high-powered career.
• He credits his wife's role as a clinical psychologist and her flexible schedule for their ability to prioritize family.
• Ehrenberg believes that his and his wife's groundedness and consistent actions have kept their children grounded.
• He acknowledges that raising children with ambition and hunger in a world of financial abundance is an ongoing conversation and requires constant vigilance.

Lessons in Parenthood (01:09:46)

• Roger Ehrenberg believes that having children is a significant commitment and should not be taken lightly.
• He and his wife waited until they were ready, both in their personal relationship and their relationship with themselves, before having children.
• They prioritized family and invested in it as the top priority in their lives.
• Despite his business activities and achievements, he always optimized for family.

Sustaining a Successful Marriage (01:10:35)

• Roger Ehrenberg emphasizes the importance of picking battles in a marriage.
• He and his wife have been together for a long time and know each other well, but there are still things that annoy each other.
• Over time, they have learned to let go of the small, unimportant things that used to irritate them.
• Another important aspect of a successful marriage is not having the mindset of winning or losing against your spouse.
• It's essential to fight fair, be mindful of saying hurtful things, and take a breath before saying something you might regret.
• It's better to have difficult conversations later, after things have cooled down.
• Roger Ehrenberg acknowledges that these things are hard to do but emphasizes that they are essential for a long-lasting and successful marriage.

Quick-Fire Round (01:13:47)

• Roger Ehrenberg, an experienced investor and entrepreneur, owns a sports team and has observed that there's room for improvement in their management.
• He predicts that the pricing of sports teams will continue to rise due to institutional capital, but return expectations may decrease as more teams become suitable for private equity investment.
• Ehrenberg emphasizes the importance of long-term thinking and withstanding short-term challenges to achieve significant returns.
• He anticipates a recovery in IPO markets by 2025, with a full return in 2026.
• Ehrenberg expresses concern about the potential impact of Trump's election on the M&A environment due to possible changes in the leadership of the FTC.
• He stresses the value of differentiation and risk-taking in fundraising, rather than following conventional approaches.
• Ehrenberg believes that founders benefit from having experienced venture capitalists as mentors, especially for emotional support and guidance in the early stages.
• He acknowledges that VCs may overvalue their contributions and should practice humility and recognize their limitations to avoid hindering progress.
• Ehrenberg envisions his sons taking over the day-to-day operations of their family business in the future, while he assumes a chairperson's role.
• He is involved in diverse business ventures, including real estate, affordable housing, food and beverage, and the revitalization of Detroit.
• Ehrenberg sees potential in the Great Lake States and considers it a favorable region for business, particularly in light of climate change.
• Despite his multiple commitments, Ehrenberg manages his investments personally and does not experience significant stress.