- LPs are the pension funds, family offices, and endowments perched atop the tech hierarchy.
- Hundreds have been defaulting on their positions, according to one VC who is buying up those stakes.
- VCs don't like to talk about defaults because it gives a bad market signal and risks a domino effect.
During the middle of 2023, Sara Ledterman, managing partner of 3+ Ventures, was calling around to emerging managers to ask about the health of their portfolios when she discovered something alarming: Some of the limited partners (LPs) who had committed to fund their investments were walking away.
"Some of them just decided there's not really a repercussion for defaulting, so they just defaulted," Ledterman found.
LPs are the pension funds, family offices, and endowments perched atop the now fragile tech hierarchy. When they renege on their commitments, venture firms can't fund startups, which in turn have to lay off staff or go out of business. Venture firms unable to generate good returns will not be able to raise a new fund and will become zombies.
"There's a domino effect across the market," Ledterman said.
Ledterman won't name name's but using Pitchbook data and her own market research, she estimates 3,200 funds have gone dormant over the past 14 months. A BI analysis found 8,538 VCs stopped investing in the last two years, leading to what some VCs have warned will be a "Zombie reckoning" in 2024.
Most of those firms are simply not able to raise a new fund, but Ledterman says she knows of 740 VCs who have LPs in default because of high interest rates that make risky venture investments less attractive, a frozen IPO market, and an excess of first-time venture funds formed during the boom years that have underperformed.
"There are a lot of factors together that just made this the perfect storm," Ledterman said.
Taking over distressed stakes
Not one to let an opportunity go to waste, 3+ Ventures is raising $300 million to buy around 70 positions from distressed LPs.
Ledterman believes she has an advantage over investors who come in at the beginning of a fund cycle because she has more information about how companies are performing. If a startup is doing exceptionally well, 3+ Ventures could exercise its pro rata rights to increase its stake.
"We have transparency," she said.
Ledterman is one of the few VCs to speak openly about buying distressed stakes so it is not clear how many other firms are employing a similar strategy; BI spoke to another firm that did not want to be named that is raising capital to take over upwards of a 100 zombie firms in the coming years.
In other asset classes like private equity or real estate, no one would blink twice over buying distressed stakes. This is capitalism, after all. But in the outwardly more friendly world of startup investing, VCs say they are reticent to be seen as sharks taking advantage of a tough market.
"No general partner will openly speak about defaulting limited partners, because it will give terrible market signal," said one VC who declined to be identified.
VCs also do not want to be seen as encouraging LPs to default.
"The secondary market is very hot," said Matt Krna, founder and managing partner at Two Meter Capital, which manages the portfolios for secondary buyers. "But if you're a VC, you don't want the optics of LPs selling down their stakes and bailing out of funds, so it all has to be done discreetly."
There is also the awkward reality that it sometimes makes financial sense for LPs to default on their positions if the fund already deployed most of its capital during the peak of startup valuations and LPs do not see much promise in the portfolio, according to Krna.
"It's good capital after bad," Krna said. "You see those are dollars you are not getting back."
At 3+ Ventures, Ledterman wants to make clear she believes she is helping rather than hurting.
"There is a value in what we're doing and our position isn't to come in and be predatory," Ledterman said. "These are good assets sourced by tier-1 sponsors, held by owners needing liquidity."
Do you have information about a zombie VC fund? Please contact reporter Ben Bergman at bbergman@insider.com or securely on Signal at 626-720-7152.
