Every individual in the venture capital industry rises each day with a singular focus: to discover transformative startups that disrupt markets and usher in a new era of wealth for clients, founders, investors, and employees.
This relentless pursuit is embedded in the venture capital business model. Given the risk inherent in this field, where certain investments will fail, the success stories must yield exceptional financial returns — over tenfold the original investment. These "fund returners startups" carry an overall expected return from the fund of approximately 25% p.a.
The venture capital landscape is characterized by asymmetrical wagers, governed by a power law that transcends the familiar Pareto (80/20) ratio. An analysis by Horsley Bridge, titled "In Praise of Failure," of more than 7,000 firms invested in from 1985 to 2014, reveals that 60% of venture capital returns derive from just 6% of portfolio companies.
Part of this phenomenon is that just over 50% of the investments return less that the amount invested. Another conclusion is that some 20% produce a return of up to 2x the capital invested.
Despite their significance, there's a distinct lack of discussion about these 'non-star' businesses that either fail, becoming fund write-offs, or yield relatively insignificant returns. Nonetheless, they consume considerable attention and time from those involved in venture capital.
The Messy Middle
"The Messy Middle" is an insightful book by Scott Belsky, Behance founder and Adobe's current CPO, delves into the trials and tribulations of entrepreneurs. The narrative often centers around the inception and culmination of startup journeys: from humble 'garage' beginnings to the triumphant IPO stage.
However, the media tends to overlook the taxing, prolonged interim: years filled with strife, challenges, incremental victories, and continuous growth. This phase, filled with constant setbacks and optimization of success, is what Belsky terms the "messy middle" - a phrase we've adopted at Astella to describe companies residing in this nebulous zone.
Currently, Brazil is experiencing an unusual macroeconomic phase, following a period characterized by excesses, propelled by historically low interest rates. This era saw inflated valuations, escalated round scales, and numerous instances of forceful growth. Consequently, a significant proportion of fund managers now have numerous companies in their portfolios that haven't yet reached the development milestone necessary for the next funding round, despite conventional timelines suggesting such progression. This situation, with so many companies in limbo, marks an unprecedented event in recent venture capital history and presents a series of opportunities.
What unique opportunities does this moment offer?
Jan Voss, head of the alternative investment area of a European family office, recently shared an insightful analysis on fresh investment opportunities in companies caught in the "messy middle." He proposed three categories:
I) 'Distressed' companies: These are entities with high potential and a degree of product-market fit (PMF), but they lack the ability to achieve breakeven. Some may have previously raised funds at exorbitant valuations, complicating the next round of funding.
II) 'Stable growers': These are companies that have established PMF and, in some cases, are profitable. However, their growth rate is comparatively slow, making it challenging to adhere to the conventional VC pathway. Such companies are prevalent in any fund's portfolio, and we often advise them towards strategic M&A transactions. As they achieve a certain size, these stable growers gain more market liquidity, enabling them to secure superior advisors for a dignified exit. Typically, this threshold is annual sales around R$10 million. Below this, acquisitions tend to focus more on the entrepreneurial team and technology, rather than the company and its client base, often leading to a significant discount.
III) 'VC Orphans': These mature companies have been operational for several years. However, their investors lack the capacity for further funding as they've practically exhausted their funding lifecycle. Many stable growers become orphans, finding themselves in a sort of 'leftover' state - outliers within a fund's portfolio.
What opportunities do we see?
We perceive various innovative investment theses targeting companies currently in the "messy middle," revealing exploitable opportunities suitable for diverse ecosystem players.
Possible opportunities include:
- Corporations acquiring stable growers at historically low multiples.
- PE Funds purchasing stable growers and orphans based on a consolidation and efficiency thesis, potentially taking listed tech companies private, as happened with Zendesk via a private equity fund acquisition.
- Activist VC funds investing in 'distressed' companies, reshaping the capital structure to meet current needs and rectifying discrepancies, thereby reenergizing the acquiree through a down round. We are witnessing this adjustment on a notable scale: in 2023's first quarter, 18.7% of rounds had lower valuations than the company's preceding round (data from Carta’s State of Private Markets).
- VC Funds generating opportunistic rounds for their portfolio's star performers, enabling these standout companies to consolidate firms exhibiting any of the 'messy middle' profiles.
- Other Playerss, such as funds of funds or family offices, could demonstrate more flexibility in establishing special vehicles. An intriguing case was Spectra, a Latin American alternative investments specialist, who partnered with Invest Tech to create a R$300 million "Continuity Fund." This fund invested in three promising companies from one of their more mature portfolios, likely stable growers that didn't align with the original fund's duration expectations.
Every founder must grapple with the harsh investment reality within the innovation sphere. Once a company ventures down the VC path, there are three primary outcomes:
1) A titan emerges: A new 'gorilla' that revolutionizes its country and market segment, culminating in an IPO or a billion-dollar acquisition. Less than 6% of invested businesses attain this echelon.
2) Partial success: The company's growth falls short of expectations, making fundraising increasingly challenging. Founders may decide to sell the company, providing liquidity for themselves, their partners, their team, and their investors. Roughly 30% of invested businesses encounter this outcome, with varying scales of exit. Interestingly, some companies languish at this stage for years before uncovering a path to significant achievement, often via an unexpected route, with frequent near-failure experiences where survival itself is a victory.
3) Failure: The company exhausts its cash reserves, rendering payroll untenable, and opts to shut down operations and liquidate remaining assets. Sadly, this fate befalls more than half of early-stage invested businesses.
At Astella, we abide by a mantra that celebrates entrepreneurs as the heroes of our era, acknowledging that even heroes can stumble. We commit to supporting them through thick and thin, emulating the traditional wedding vows of "in sickness and in health." We hold our relationships and our reputation in the highest regard, recognizing that the finest advisors and investors often surface during the most challenging times. As John F. Kennedy aptly stated, "Success has many fathers, but failure is an orphan."
Fred Wilson, a prominent VC over the last decade and Series A investor in companies like Twitter, Twilio, Coinbase, and Cloudflare, concurs:
"I spent the majority of my time on that long tail. This is irrational behavior if you think about fund economics, but I believe it is rational behavior if you think about firm reputation. The best thing you can do for this long tail is find a good home for the portfolio company."
As fund managers, we continually think outside the box, asking:
- What unique, hidden investment opportunities are suited to the moment but might yield exceptional, unforeseen returns and prosperity?
Simultaneously, we aid entrepreneurs in discovering the best possible outcomes until their journeys reach fruition.
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