Limited partners are institutions and individuals who invest in venture capital funds, and I recently surveyed 73 of them to better understand their thoughts on the VC market in 2016. I also had conversations with many more ― including at our recent Upfront Summit ― and what follows is the essence of what I learned:

Dollars into Venture Have Gone Up

As a starting point we know that the dollars into venture have steadily gone back up to pre-Great Recession levels with just under $30 billion committed to U.S. technology venture capital in 2015. While there is much discussion about VCs starting to pull back on their investments into startups, the LPs we surveyed don’t expect to slow the pace of investment into VC funds themselves ― at least not for the foreseeable future.

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But LPs Have Been Putting Out More Money Than They Are Getting Back

LPs have been feeling great about venture capital due to holding valuable paper positions in companies like Uber and Airbnb that they feel confident will drive large cash distributions in the future. But they have been sending VCs way more investment checks in the last 10 years than they’ve gotten back as distributions. In fact, if you add up capital flows of the past 10 years, there has been just shy of $50 billion in net cash outlays.

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And that’s real cash that LPs can’t put to work in other asset classes. So one problem often not talked about is that if LPs don’t get money back and accumulate more cash outflows, eventually they will either have to pare back investments into venture or they’ll have to increase the percentage of dollars they allocate to venture (at the expense of other asset classes).

LPs Still Believe Strongly in VC as a Diverse Source of Returns

The good news for startups is that the LPs are still very big believers in the long-term gains they will get from venture and are still allocating capital to the industry. In our poll of 73 LP funds, only 7% felt they were overweight in venture given the current market climate against 22% of the firms who are actually looking to add exposure.

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And while there is a narrative that most LPs only want to invest in the long-standing Silicon Valley brands, there is evidence that many now understand that it is possible for new entrants to stake out new grounds of differentiation. In fact, 40% of LPs tell us that they’re looking to add new names to their rosters.

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LPs See The Over-Valuations & Don’t Like It

But all isn’t completely rosy. LPs have followed much of press recently about startup over-valuation and over-funding, and they experience these phenomena first hand. Some 75% of LPs polled said they are concerned about investment pace, burn and valuations ― but, for now, only 6% are “deeply concerned.”

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I suspect LPs in the next 18 months will see another phenomenon that they likely haven’t seen much since 2008-09: Markdowns. This strangely may come even more quickly in the more successful funds because any fund (ours included) that still holds some public stock from a recent IPO will likely see immediate write-downs due to public stocks being repriced.

Also problematic for LPs is that VC firms have been “back in the market” raising funds more quickly than they have in the past. A normal VC fund raises a new fund every three years if it is a strong performer but, in recent years, there have been some VC firms that have literally raised new funds inside of 18 months. I suspect those days will end soon. 61% of LPs polled said they felt VCs were coming back to market too quickly.

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The Biggest Area of Concern is in Late-Stage Investments

68% of LPs surveyed expressed caution that that late-stage part of the market is over-valued.

But, of course, for every angle of the market that one person sees caution others spot opportunities. Some LPs have said to me privately that they wonder if later-stage VCs may have a field day in the next 18 months buying up large positions in companies with strong revenue at attractive prices given the new funding squeeze. It’s not an opportunity for the weak of stomach as these deals are hard to get done and even harder to keep on course. But there’s not doubt some will make money.

Another Area of Concern is in the Seed Investor Class

I also have heard LPs express concern about the seed stage. One narrative is that too many funds have been created and, without a strong sense of differentiation, mediocrity will rule. Another big area of concern expressed by LPs is that some seed funds may get “squeezed” in good scenarios and bad. In good scenarios they don’t have funds large enough to follow their winners and in bad markets they can be wiped out by recaps and liquidation preferences unless they save enough reserves to protect their positions.

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The data itself bears out some of these fears. 89% of LPs surveyed expressed some level of concern about the seed market. 65% said they will invest in seed funds but they are very discerning about which ones they’ll fund and 23% are worried about capacity. Anecdotally, most LPs believe the best seed funds still deliver superior returns to other parts of the market, but they simply can’t put enough dollars to work in the handful they truly respect.

A few years ago the best seed funds responded to the challenge of being cash strapped by raising “opportunity funds,” which can invest in their best deals as the follow-on rounds get larger. Of course this brings up a host of complications about conflicts of interest, valuations and whether early-stage investors are well-suited to invest in later-stage deals. But both seed investors and LPs alike agree that as long as these programs are managed sensibly they are useful to exist. A whopping 85% of LPs were favorable to opportunity funds as long as they were done with a pragmatic approach and with favorable economics.

Most LPs Don’t Believe That Traditional VCs are Being Squeezed

One narrative mentioned occasionally by some of the larger funds is that traditional VCs will be “squeezed.” They say that “the big guys are getting bigger and can compete for the full lifecycle of investments” on one side and “the seed investors are out-hustling traditional VC” on the other side. Frankly, I’ve never believed this argument. As a traditional VC, watching the growth of seeds funds has been a blessing because it increases the total number of startups from which we can evaluate. Also, we’ve become very adept at partnering side-by-side seed funds.

And other than a handful of deals that scale in the blink of an eye, I really haven’t felt too much pressure from bigger VCs moving downmarket into our territory. Funds that are more comfortable writing $20 million checks in proven businesses simply don’t want to also have to write checks and compete for less proven deals in need of $4-5 million.

Luckily LPs seem to agree. Only 17% bought the premise that traditional VCs are being squeezed versus 34% who prefer to focus the majority of their efforts of traditional A/B found VC funds. And of course 50% want a good balance across all stages: seed, traditional and growth.

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Perhaps the Biggest Change in the LP Ecosystem is the Number Now Seeking Direct Investments

The booming tech markets and the dollars being allocated in the venture sector has brought about one seldom talked about consequence over the past 3 years ― the sheer number of LP dollars looking for “direct investment” (or dollars going directly into portfolio companies vs. the funds themselves).

Nearly 40% of all LPs surveyed said that direct investments were becoming an important part of their program (17% said they’re very important) and a further 44% of LPs are opportunistically doing direct investments. There are even LP fund-of-funds whose main marketing message when they raise capital is that they provide better access to direct investments.

Summary

LPs remain staunch supporters of the venture capital industry and their investment pace seems likely to hold steady for the next one or two years (barring any unforeseen negative market events).

This support will eventually start to meet headwinds if our industry doesn’t find a way to drive more exits to recycle capital back into the ecosystem. Eventually LPs will become stretched without some cash distributions. I expect the LP conversations in the next 12 to 18 months to be about VC portfolios being inevitably marked down; however, many LPs are long on venture capital for the same reasons I am. Any correction will be followed by the long march of technology disruption and the profits disproportionately allocated to the winners.

The full presentation can be viewed and downloaded on SlideShare.

 

Mark Suster (@msuster) is a partner with Los Angeles-based venture capital firm Upfront Ventures.