Swashbuckling venture capital is slowly becoming boring old private equity

The venture capital business model has, historically, looked something like this: investors would identify promising startups, they would invest some amount of money in these startups, and a few of the startups would (hopefully) either get acquired or go public at a much higher valuation, generating outsized returns that more than paid back the entire value of the fund. Venture funds typically charge their limited partners (LPs)  “2 and 20,” or a 2% management fee as well as 20% of the fund’s profits.

One constraint of this business model has been total market size: startups are relatively small companies (at least compared to their publicly traded peers) in which investors typically deploy relatively small amounts of capital (excluding, of course, outliers that can raise $6.5 billion or whatever), and only a minority of these startups will generate outsized positive returns. The result: effectively deploying capital becomes more difficult as a fund’s size grows. $100 million is easy to deploy across several early stage deals. $5 billion? That’s much tougher. With regards to compensation, venture funds face a tradeoff: more assets under management pays higher management fees, but it can create a drag on performance that reduces profit potential.

Another issue facing venture capital lately has been fewer exit opportunities. Companies are increasingly choosing to stay private longer, IPO activity since 2022 has been sluggish at best, and regulators have shown increased scrutiny toward mergers and acquisitions. The result: global VC exits by both volume and total market value hit five-year lows in 2023, impacting venture returns.

But what if there were a solution that could solve venture capital’s size constraints and liquidity problems? It turns out, there is, and it’s called “private equity.”

Unlike venture funds, which write small checks to small companies, PE funds typically take much larger controlling stakes in mature companies, where they look to improve operating leverage before either selling them (often to other private equity firms) or taking them public. If a venture fund were to, say, make private equity-like investments, it could presumably deploy a lot more capital, allowing the fund to charge a lot more in management fees, and the company would have a new pool for potential buyers of its portfolio companies as well: other PE funds.

Lightspeed Venture Partners, a Menlo Park-based venture firm with $25 billion in AUM, appears to be doing just that. The venture firm is looking to raise $7 billion across three new funds, and ~40% of that funding is going to investments that look a lot like private equity. From The Information:

Close to 40% of the new money will go to an opportunity fund that will make follow-on investments in its portfolio companies and buy shares in late-stage startups such as Stripe and Rippling from existing investors. In some cases, Lightspeed will seek controlling stakes in aging enterprise software startups and try to prepare the companies for a sale or public listing.

Assuming a 2 and 20 structure, a $7 billion fundraise represents $140 million in annual management fees — not a bad payday. Additionally, its investment strategy aligns well with current market conditions. Lightspeed’s line of thinking probably goes something like this:

“There are several late-stage private companies with investors that want to offload stakes on the secondary market. Why not raise a fund to buy some of those stakes, potentially at a discount, if those funds need to return capital to their LPs? And while we’re at it, we might as well go full-buyout mode and acquire controlling stakes in some mature companies, too.”

While 60% of Lightspeed Venture Partners’ new capital will go toward funding investments in growth-stage and early-stage startups, this ~40% is “venture” capital in name only, not that that’s a bad thing. At the end of the day, investment groups are in the business of making money, and if private equity practices present a more lucrative investment opportunity than traditional venture, I believe we’ll see other large venture funds building out private equity-like vehicles, too.