Venture Capital Bifurcation and Capital-Intensive Innovation Shifts

Key Quotes

"funds that are subscale i have predicted that you would see a 50 involuntary exit or extinction rate they're under reserved they've overinvested they have too many portfolio companies those companies are going to have to come back to the well and raise money and they're not going to be able to find investors there's going to be a lot of down rounds broken fund raises broken syndicates and those guys are going to go out of business and that large lp looked at me and laughed and said josh that's ridiculous it's not going to be 50 it's going to be 90"

Josh Wolfe predicts a significant number of smaller venture capital funds will fail. He attributes this to being undercapitalized, overextended with too many companies, and unable to raise subsequent funding rounds. Wolfe highlights that these "minnows" will face down rounds and broken syndicates, leading to their demise.

"you have this bifurcation that i call the minnows and the megas what i mean by that are a very long tail of subscale funds funds that are basically call it 500 million or under normally that was the fabric size for a venture fund but you have a lot of people that have been tourists in venture they benefited from an environment with low rates and an abundant amount of follow on capital"

Josh Wolfe describes a bifurcation in the venture capital industry between small, subscale funds ("minnows") and very large funds ("megas"). He notes that many smaller funds were populated by "tourists" who benefited from a low-interest-rate environment and readily available follow-on capital. Wolfe suggests these smaller funds are now vulnerable.

"the megas are very large funds andreessen horowitz lightspeed insight these are all funds run by great people but they're playing a different game now the fund size is increasing the total aum is approaching 80 to 100 billion under management they will take a page from the playbook of apollo blackstone carlyle tpg kkr all of whom when public during the 2009 to 2014 period"

Josh Wolfe observes that large venture capital firms, referred to as "megas," are increasing their fund sizes and adopting strategies similar to private equity firms like Apollo and Blackstone. He suggests these mega funds are moving towards becoming publicly traded entities, mirroring a trend seen in the private equity sector between 2009 and 2014. Wolfe believes this shift indicates a fundamental change in how these large venture firms operate.

"the defense space takes a lot of capital and andrele has raised several billion dollars now there are few companies that are competing with them there's a long tail of want to be next gen defense tech companies but andrele is the 800 pound gorilla in next gen prime you do need capital historically if you take rule of thumb of asset management sizes the enemy of performance firms get big they live off their management fees not their incentive fees"

Josh Wolfe points out that defense technology companies require substantial capital, citing Anduril as a prime example that has raised billions. He identifies Anduril as the dominant player in next-generation defense technology, with limited competition. Wolfe also touches on the historical challenge for large asset management firms, where growth can lead to a focus on management fees over performance-based incentive fees.

"we have companies today that are approaching trillion dollars if you're a realist about this fund size increasing is the enemy of returns the incentives for the founders who want to have great investors that can be early stage because i can scale with them over time that's harder to do when you have a much bigger fund"

Josh Wolfe argues that increasing fund size is detrimental to venture capital returns, especially as some companies approach trillion-dollar valuations. He explains that larger funds make it more challenging to provide early-stage support and scale with founders over time, which is a key incentive for founders seeking long-term investors. Wolfe suggests that the focus shifts away from optimal returns when funds become excessively large.

"the other way to think about it is about 30 year companies might be 10x a third might break even and then a third are basically total losers and you end up with a 3x cash on cash more capital intensive on average harder return capital there are exceptions and that's what everybody is trying to do is find the outlier exceptions where they can still use capital as a moat generate deca billions of enterprise value based on billions of revenue but few and far between companies that can do it"

Josh Wolfe outlines a typical venture capital portfolio return profile, where approximately one-third of companies yield a 10x return, another third break even, and the final third are complete losses, resulting in an overall 3x cash-on-cash return. He notes that these capital-intensive ventures make achieving high returns more difficult, and finding "outlier exceptions" that can generate massive enterprise value is rare. Wolfe emphasizes that the industry is constantly seeking these exceptional opportunities.

"the difference in this ecosystem between those minnows and the megas we like the megas we want them to be in the cap table we always say we're contrarian and we want people to agree with us later we want these funds to come in later at a lower cost of capital and higher valuation where we've assumed some risk we've killed those risks product people finance technology market and therefore created value and a later investor should come in and demand a lower quantum of return that is the way that we think about it"

Josh Wolfe explains Lux Capital's strategy in navigating the "minnows and megas" landscape by welcoming larger funds onto their cap tables. He states their contrarian approach is to have these larger investors join later, at a lower cost of capital and higher valuation, after Lux has de-risked the investment. Wolfe believes later-stage investors should expect lower returns due to the reduced risk they are undertaking.

"the other thing we're doing is hiring a young bench of investors who i'm 47 years old my youngest partner is 24 our youngest is lan jane she's a killer amazing network of young bright brilliant math olympiad winners in high school that have gone on to computer science at stanford and mit went to work at open ai at 19 years old and then at 22 years old are leaving and starting a company and our goal is to be the founding investor in those companies that is what has changed is go earlier benefit from this ecosystem where there's an abundance of later stage capital they're in many ways indexing across the venture landscape but it benefits you if you can be an early"

Josh Wolfe highlights Lux Capital's strategy of hiring young, talented investors and aiming to be the founding investor in companies started by emerging entrepreneurs. He notes the firm's commitment to going earlier in the investment cycle, leveraging the abundance of later-stage capital available. Wolfe believes this approach benefits from the venture landscape's overall growth and Lux's ability to identify promising early-stage opportunities.

"we are relatively small 40 plus people 10 on the investment team everybody has