The Current State of Venture Capital: The Distortions Caused by 'Venture Banking' and the Path to Regeneration

Below, based on the discussion 'Is there a future for venture capital?', we will explain the current state, challenges, and future direction of venture capital (hereinafter VC). First, we will summarize the key points of this article, and then proceed with the following structure.

1. What is the 'disease' of venture capital?

1-1. Background of the discussion and participants

This discussion is between Peter, who leads the insights team at Carta, a famous platform in the startup ecosystem, and Dan Gray, who leads the business valuation service Equidam. Both have been observing the realities of startups and LPs/GPs for nearly 20 years and share the awareness that 'something is strange about recent VCs.' At the beginning of the discussion, Dan mentions his background in venture building and accelerators, and Peter, while praising his sharp analysis as a writer, poses the major question: 'Is VC broken?'

1-2. Distortions caused by a 'too-long bubble'

Dan points out that the circulation of funds driven by low interest rates, cloud SaaS, and digital advertising over the past decade or more acted like a 'money printer,' bringing massive capital inflows to VCs. As a result,

• Becoming spreadsheet investors: Chasing only metrics like revenue growth rates and TVPI (Total Value to Paid-in), while essential technology and founder strengths become secondary.

• Reverse infection of relationship-first ideology: During boom periods, the market heats up because 'investors with good relationships evaluate each other.' However, when things cool down, having connections is not unconditionally valued, and in fact, it can even be a negative factor.

He states that such 'toxic' behavioral patterns have spread throughout the VC industry.

2. Venture Banks vs. Authentic Venture Capitalists

2-1. Terminology definitions

• Venture Capital (VC): An investment form that originally provides capital to 'emerging technologies' that are too high-risk for traditional finance to touch, aiming for large returns by dramatically increasing corporate value.

• Venture Bank: A concept born in recent years, referring to mega-funds that, backed by massive AUM (Assets Under Management), treat the circulation of funds itself as a business, operating on the logic of 'just pour in massive amounts of capital' and 'if you keep supplying capital, growth will accelerate and exit will become easier.'

Dan criticizes that 'Venture banks prioritize maximizing fee income by pouring in funds using their scale, optimizing for scale itself rather than the essential growth of the companies they invest in.' On the other hand, traditional VCs were supposed to 'pursue results (exits) and focus on discovering excellent technology and nurturing companies.'

2-2. Exchange of opinions among participants

Peter: 'When large-scale funds worthy of being called venture banks enter even seed or early stages, the market balance is distorted, and small-scale GPs cannot compete in terms of price during bidding.'
Dan: 'Venture banks with massive capital are reaching into the seed stage just because they want to distort the market to suit their own convenience. They are simply playing a completely different game than traditional VCs.'

3. Expansion of capital inflows and stagnation of performance

3-1. The reality of net cash flow

Dan emphasizes that while capital inflows into VC (total LP commitments) have increased significantly over the past 20 years, 'the cash flow returned to LPs (returns) has hardly increased at all.' In other words, 'the capital being deployed is enormous, but the amount actually earned and returned is flat or trending downward,' which he calls the 'financialization of VC.'

3-2. Fee-Driven Mechanisms

• Management Fees (Fixed Income): Typically, about 2% of investment commitments are paid to the GP as an annual fee.

• Carried Interest (Profit Distribution): A performance fee where the GP receives about 20% of the profits once a certain yield (hurdle rate) is exceeded for LPs.

Dan points out that as fund sizes grow, fee income increases, and GPs have 'become more dependent on stable fee income than on carry.' As a result, he states that they have shifted toward optimizing the 'financial function itself'—collecting and deploying large amounts of capital—rather than taking risks to pursue results.

4. Portfolio Strategy: Concentrated vs. Diversified Investment

4-1. Traditional Concentrated Strategy

Many GPs have built portfolios based on the idea of 'making a small number of large investments in carefully selected companies from seed or early stages, hoping that a few will grow 10,000x.' This is the method of aiming for the so-called 'Power Law.'

4-2. Advocating for a Diversified Portfolio

Dan presents a mathematical perspective, noting that 'the probability of a single seed-stage company becoming a unicorn is only about 2–2.5%. If you invest in 20 companies, the probability of LPs getting a 3x return is extremely low.' He argues that it is easier to aim for a stable 3–4x return in the long term by investing in 40–50, or even 100 companies.

• Benefits of Diversified Investment:

  1. Hedging against failure probability (even if nearly half go to 0x, if a few grow significantly, the overall portfolio can offset the losses)

  2. Easier to achieve early returns to LPs (DPI: Distributed to Paid-in)

  3. The bell curve of average returns shifts to the right, raising the industry average

On the other hand, the reality is that 'when persuading LPs, if you say "invest in 100 companies and aim for 3x," most LPs show no interest.' This is because LPs also believe that 'only by targeting companies that grow significantly can you obtain the promised TVPI or IRR.' This creates a major mismatch between GPs and LPs, which is considered the root cause of why they cannot break away from 'concentrated investment.'

5. Secondary Markets and the Reconstruction of Liquidity

5-1. The Significance of Secondaries in the Post-IPO Era

In recent years, the number of 'permanent private companies' like Stripe and SpaceX has increased, limiting exit options through IPOs. From an LP's perspective, this highlights the issue that 'even if an investment grows, it cannot be cashed out unless it goes public.' This is why secondary transactions are attracting attention.

Dan points out the 'adverse selection' problem in secondaries. That is, the suspicion that 'the current owner wants to sell because there is likely some cause for concern' is a factor that pushes transaction prices down to a significant discount.

5-2. The Importance of Early DPI Strategy

On the other hand, Dan states that "returning cash to LPs (DPI) early is of the utmost importance from the perspective of IRR and cash flow." Specifically,

1. Selling off some positions early
   Identify companies with a high probability of success, and even before an IPO, lock in at least some profit to return to LPs.

2. Avoiding 're-risking'
   When large amounts of capital are injected in later rounds, 'the company's risk jumps back up to seed levels,' so it is better to cash out before that happens.

3. Maximizing time value
   From the perspective that 'returning 1x in 5-7 years contributes more to an LP's fund cash flow than returning 2x in 14 years,' early DPI should be prioritized.

This presents a practical approach to breaking away from the traditional culture of 'you won't get returns unless you hold until the IPO' and circulating capital more efficiently.

6. The Divergence Between Valuation and Price

6-1. The 'Definition' and 'Reality' of Valuation

Dan explains the difference between valuation (the 'appraisal' of company value) and price (the amount the market actually pays) using an 'antiques show' as an example.

In the VC world, there are many cases where valuations are determined by 'reverse calculation,' such as 'we can go public at this many times the valuation in Series A.' Dan criticizes this as an act akin to a 'space-time trip' that merely preempts future valuations. In reality, the price fluctuates depending on who bids and how much at the time of the next round or IPO, and valuation does not directly translate into the actual price.

6-2. The Importance of Entry Price

Some say that 'entry price is not important,' but Dan vehemently denies this.

Specifically, he warned that if you are investing the same capital, 'acquiring at a lower valuation increases subsequent dilution and profits at the time of sale, which dramatically improves returns to LPs,' so misreading price sensitivity leads to losses for the entire fund.

7. The Mismatch Between LPs (Limited Partners) and GPs

7-1. The Diverse Orientations of LPs

According to Dan, LPs can be broadly classified into two types.

1. Return-oriented LPs
   Organizations that want to reliably recover cash flow in the short to medium term against their contributions. Examples include pension funds that want to realize VC results as quickly as possible (within 5-7 years) through DPI and increase IRR.

2. Financialization-oriented LPs
   Those whose own compensation is tied to 'TVPI or IRR' and who pursue 'high-multiple valuation markups.' This is often seen in endowments and large institutional investors, where the focus during the fund period is on exposing themselves as capital providers or information distributors, with a stance that 'as long as someone succeeds, it's fine' regarding actual returns.

Because the intentions of LPs are polarized in this way, GPs often fall into a dilemma of 'which side should I talk to in order to raise funds?' As a result, they are forced to build fund strategies that match the 'story' the LPs want, and a structural problem has become apparent where they end up focusing on 'talking about the ideal returns the LPs want' rather than the original goal of 'discovering and supporting high-quality technology'.

8. How to Overcome Cultural and Functional Challenges

8-1. Valuation Transparency and Common Standards

Dan argues that "open standards should be introduced for valuations." In other words, the valuation of each portfolio company presented by a GP should be disclosed in a common format so that other GPs and LPs can compare and verify them. However, he also noted the cultural and interest-based hurdles, stating that "it is highly inconvenient for just one firm to do it, and it will not work unless the entire industry agrees to it."

8-2. The Need for Financial Literacy Education

Furthermore, he points out the problem that very few LPs or GPs understand 'portfolio theory,' 'behavioral finance,' or 'venture-specific mathematics.' Peter also expressed concern, saying, 'It would be good to have a curriculum or certification system for practitioners specializing in VC, but unless the LP side values it, it will become a mere formality.'

8-3. Dispelling 'Old Dogma'

Toward the end of the discussion, it was emphasized that 'it is necessary to remove industry folklore and dogmas (conventional beliefs) surrounding VC.' As specific examples, he cited semi-mythical discourses such as 'entry price is meaningless/portfolios should be concentrated' and 'one should not enter highly competitive areas,' and called for them to be critically re-examined.

9. Detailed Chapter Breakdown: Explanation of Key Topics and Quotes

9-1. What is the 'Financialization' of VC?

• Definition of Financialization: The transformation of culture and behavioral patterns resulting from increased capital inflow into VC, where 'fund management itself (fees/markups)' is prioritized over investment results.

• Specific Example: In a 'money printer' environment created by 'low interest rates + cloud,' GPs focused on 'how quickly they can create the next round and raise the next fund.' They began using 'capital circulation speed' as a KPI rather than the intrinsic value of the portfolio company.

9-2. LP-GP Mismatch

• Polarization of LP Orientation:

  1. Pension funds that prioritize short-term DPI

  2. Endowments that prefer high-multiple markups

• Impact of Mismatch: GPs search for 'fund designs that appeal to both types of LPs,' and as a result, they fall into strategies that simply 'unnecessarily increase fund size and ride macro trends.'

9-3. Portfolio Size and Returns

• Mathematical Basis: The probability of a seed-stage company becoming a unicorn is about 2.5%. Compared to the total return probability of investing in 20 companies, it is 3 to 4 times easier to achieve returns by investing in 40 to 50 companies.

• Real-world barriers: LPs prefer the 'story of targeting power laws through concentrated investment' and dislike diversification strategies. As a result, many GPs are bound by the dilemma of 'you must invest in a concentrated manner, otherwise you cannot persuade LPs.'

9-4. Secondaries and Re-risking

• Re-risking: When a startup conducts a large-scale late-stage funding round, the "expectations" and "milestones" imposed on the company increase, and it once again bears "seed-stage level risk." At this timing, early investors should consider an "early cash-out."

• Challenges in the secondary market:

  1. Lack of demand: There is extremely little trading demand for private companies, and many do not participate in auctions (sales).

  2. Adverse selection: The seller is highly likely to have some kind of anxiety, so buyers tend to be cautious. As a result, trades only happen at a discount.

9-5. Divergence between Valuation and Price

• Valuation: Experts present a "range" based on the company's future potential and market track record.

• Price: Since it is determined by who buys it and at what timing, it often diverges from the valuation.

• VC misconception: The idea of calculating backward to match a future "next round," such as "Series A should be set at one-fourth the valuation of Series B," is a typical example of "confusing valuation with price."

10. Future Improvement Measures and Best Practices

10-1. Differentiation between Venture Banks and Traditional VCs

1. Redefining Roles:

   • Venture Banking: 'Leveraging scale to circulate capital and generating stable income through fee models'

   • True VC: 'Focusing on results to support innovation and targeting exits'

2. Division of Labor by Investment Stage: Traditional VCs should focus on the 'early exploration' phase, such as Seed and Pre-Series A, while Venture Banks handle large-scale capital, creating a clear division of roles across the entire ecosystem.

10-2. Reviewing Portfolio Construction

• Based on Diversified Investment: Mathematically, handling '40 to 50 or more deals' makes it easier to target a 3x return for LPs.

• Appropriate Allocation of Follow-on Capital: Clarify capital allocation rules for each stage, such as setting a uniform 40% ratio for follow-on investments (reserves).

• Two-sided Approach: Thoroughly implement a PDCA cycle of 'investing broadly with an exploratory and diversified approach in the early stages, then narrowing down to concentrate investment in deals with promising business growth.'

10-3. Cultural Reform of Valuation and Pricing

• Promoting Open Standards: Standardizing industry efforts to increase transparency by disclosing valuation assessment logic among GPs.

• Strengthening Awareness of Price Formation: Breaking away from the old dogma that 'entry price is meaningless' and reviving a culture that 'uses acquisition price as a weapon.'

10-4. LP Education and Mindset Shift

1. Standardization of Financial Literacy: In addition to programs for GPs, develop a dedicated curriculum for LPs to provide opportunities to learn portfolio theory and behavioral economics.

2. Return to a Return-Oriented Mindset: Rather than backing high-multiple bets, cultivate demand for 'solid returns, even if it's just 3x,' to facilitate smoother communication between LPs and GPs.

3. Rebuilding a Long-Term Perspective: 'LPs tend to lose focus beyond the fund duration (10 years), but by building strong partnerships, we can foster a culture that does not pressure GPs into unreasonable capital expansion.'

What emerged from this discussion is the harsh reality that 'venture capital is not broken, but has been distorted by excess capital and cultural dogma.' However, it was also suggested that 'if we clarify our respective roles and review fund design, portfolio construction, and valuation culture, there is room to once again become an entity that supports innovation as a “true VC.”'

1. Restoring market health by differentiating between venture banks and traditional VCs by restoring market health

2. Increasing return probability through the practice of diversified portfolios to enhance return probability and return early DPI to LPs

3. Correcting the divergence between valuation and price to revive investment decisions that use price as a weapon

4. Resolving mismatches through LP education and awareness reform to improve the quality of fund management

If these are put into action, the original mission of VC—'discovering and nurturing emerging technologies'—will regain its luster, and we can expect healthy development of the entire startup ecosystem.

Recommended Articles