Lipstick on a Unicorn: Continuation Funds and the Art of VC Self-Deception

The venture capital industry is at a critical juncture, grappling with a liquidity crisis that threatens its foundations. Faced with restless LPs and funds stretching well beyond their 10-year lifespans, the VC world has discovered a new magic trick: continuation funds. But let's be clear - this isn't innovation; it's obfuscation. Chris Harvey's LinkedIn post inadvertently exposes the depth of this problem. When only 5% of the total VC market value is being distributed to LPs annually, we're not facing a mere "liquidity gap" - we're witnessing the collapse of a fundamentally flawed system.

Continuation funds, despite their meteoric rise - a 750% increase in deal value over 5 years, hitting $68 billion in 2021 according to Preqin - are not the panacea the industry needs. They're a sophisticated sleight of hand that fails to address VC's core issues while potentially exacerbating them. They are putting lipstick on a Unicorn.

Here's why:

Misaligned Incentives: Continuation funds allow GPs to collect more fees and carry without performance alignment. This creates a perverse incentive structure where fund managers benefit regardless of actual value creation. The conflict of interest is particularly galling. Wait. GPs get to collect more fees and carry without true performance alignment? It's a heads-I-win, tails-you-lose proposition that would make an underground casino operator blush. The University of Chicago Booth paper cited by Harvey shows that 80-90% of LPs in legacy funds opt to cash out rather than roll over. These aren't investors excited about future prospects; they're prisoners making a jailbreak at the first opportunity.

Tax Complications: The potential loss of QSBS (Qualified Small Business Stock) eligibility is more than a minor hurdle. It's a significant tax benefit that can save investors millions. Forcing LPs to choose between liquidity and tax benefits is not a solution; it's a new problem.

Lack of Transparency: Harvey admits that LPs often lack sufficient data for informed decisions. This information asymmetry is not just unfair; it's dangerous. In a 2022 survey by Coller Capital, 85% of LPs reported concerns about conflicts of interest in GP-led secondaries, which include continuation funds. The lack of "sufficient data for informed decisions" by LPs is not a bug; it's a feature - keeping investors in the dark is how this game has always been played.

Kicking the Can: While continuation funds provide short-term liquidity, they don't solve the underlying issue of companies failing to achieve successful exits or live up to the VC Unicorn grift. Data from PitchBook shows that the median time to exit for VC-backed companies has increased from 5.5 years in 2008 to 7.2 years in 2022. Continuation funds risk extending this further, trapping capital in underperforming assets.

Complexity and Costs: The complexity of these transactions is not trivial. A 2022 report by Campbell Lutyens found that the average cost of a GP-led secondary transaction was 2-3% of the transaction value. These costs ultimately eat into investor returns.

Toward Venture Capital 2.0

Instead of these financial gymnastics, let's focus on transformative solutions that could remake the venture capital industry:

Align Long-Term Incentives: Develop fund structures that tie GP compensation directly to actual value creation over extended periods. For example, implement a sliding scale carry that increases with holding period, rewarding patient capital.

Embrace Truly Patient Capital: Create investment vehicles supporting companies for 15-25 years. The success of firms like Baillie Gifford, which held Tesla for 16 years with a return of over 6,000%, demonstrates the power of this approach.

Transparent Value Creation Metrics: Move beyond IRR and MOIC. Develop standardized metrics capturing technological advancements, market creation, and long-term impact. The GIIN's IRIS+ system for impact investing is an interesting model designed for more comprehensive evaluation.

Reimagine LP Relationships: Treat LPs as true partners with more frequent reporting, co-investment opportunities, and strategic involvement. I have yet to meet an LP with no appetite for greater transparency.

Founder-Centric Model: Prioritize founder success over fund mechanics. Implement more flexible funding structures and ongoing operational support. Indie.vc's attempt to create a profit-sharing model, which was a valiant attempt at aligning returns with company profitability rather than exits, offered an intriguing alternative that deserves another look.

Ecosystem Approach: Build and support entire innovation ecosystems. SoftBank's Vision Fund, despite its flaws, demonstrated the potential of investing in complementary technologies and fostering collaboration between portfolio companies.

Redefine "Exit" Strategies: Develop new liquidity mechanisms allowing partial realizations over time. The rise of secondary markets like Forge Global, which facilitated $3.2 billion in transaction volume in 2021, points to the demand for more flexible liquidity options.

In the emergence of continuation funds, I see an industry inadvertently accelerating its obsolescence, creating a massive opportunity for new entrants to reimagine the entire paradigm of funding and nurturing groundbreaking ideas. The industry's wanton adherence to outdated practices, epitomized by continuation funds, is setting the stage for its creative destruction - paving the way for new and refreshing approaches that prioritize long-term value creation, proper alignment of interests, and the patience required to build world-changing companies.

The next wave of world-changing companies is out there, waiting to be built. They deserve a venture capital industry that's up to the task of supporting them - not for a 7 to 10-year fund cycle, but for as long as it takes to realize their full potential. It's time to stop playing financial games and start building the future in earnest. The market has the capital and the brainpower to make this shift. The question is: do we have the courage to reinvent ourselves truly?

References:

Baillie Gifford. (2021). Tesla: Road to the Top.

Campbell Lutyens. (2022). Secondary Market Overview.

Coller Capital. (2022). Global Private Equity Barometer, Winter 2022-23.

Forge Global. (2022). 2021 Annual Report.

Global Impact Investing Network (GIIN). (2023). IRIS+ System.

Harvey, C. (2024). [LinkedIn post on Continuation Funds]. LinkedIn.

Indie.vc. (n.d.). Investment Model.

PitchBook. (2023). Venture Capital Exit Times Analysis.

Preqin. (2022). Continuation Funds Market Growth.

SoftBank Group. (2023). Vision Fund Overview.

University of Chicago Booth School of Business. (2022). Study on GP-Led Secondary Transactions.