VC Investment in AI
Based on an Extract from Lux’s letter to LP, by @wolfejosh
The influx of capital into the AI sector is a microcosm of the broader venture capital (VC) industry, where the pursuit of exceptional returns increasingly pushes the limits of what seems feasible. Over the past two years, the U.S. VC landscape has seen an average annual investment of $125 billion. To align with the robust liquid performance of NASDAQ over the last 20 years, these funds collectively must target a benchmark return of 11% compounded annually. Given the typical seven-year holding period and factoring in management fees, VCs need to achieve at least a 3x gross multiple on invested capital, equating to around $375 billion. With VCs typically holding 60% equity at exit, this translates to a need to generate $625 billion in market capitalization.
However, the reality is stark: only a few companies can realistically hit valuations of $20-$30 billion or more, and an even smaller subset of VC firms have the privilege of investing in these top-tier opportunities. While select firms will continue outperforming, the broader trend will likely see VC returns normalizing below the 11% target, reflecting the natural mean-reversion following years of outsized gains.
The surge in VC funding is also injecting volatility into the valuations of primary investments, a trend that will likely spill over into the secondary market. While secondary transactions are currently limited—comprising entire GP portfolios, continuation vehicles, and strip sales of portfolio companies—there's potential for this trickle to turn into a flood. Many General Partners (GPs) may struggle to protect their stakes in the most promising companies due to insufficient reserves and pressure to return capital to LPs. As more secondary supply emerges, we anticipate more significant discounts and increased volatility, presenting strategic opportunities for well-capitalized investors.
Our take on #VentureCapital right now is to step back from #ArtificialIntelligence and scout more companies in #House, #Food, #Robotics, #Manufacturing, #Energy, #Defense, #Technology, and #Innovation. These sectors represent fundamental pillars of the economy that are ripe for disruption and growth, offering robust opportunities for returns while mitigating the volatility and saturation currently observed in the AI space.
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