Navigating VC Challenges in Defense and Hard Tech
Strategies for Enhanced Fund Performance
In the intricate realm of venture capital, nuanced events often hold broader implications. Recent closures, albeit smaller in scale—the likes of Countdown Capital and another firm that I’ve supported for the past year—may not have sent seismic shockwaves through the VC landscape, but they serve as vital case studies worth our attention.
What has caught our collective eye is the less-than-rosy quarterly return revealed by PitchBook's Quantitative Perspectives report. The disheartening -16.8% Internal Rate of Return (IRR) in Q4 2022 for US-based venture capital funds stands as a sobering reminder of the complexities and challenges that can affect our specialized sectors.
While these closures might not have echoed loudly across the broader VC spectrum, they offer invaluable lessons for those attuned to the intricacies of defense, hard tech, and deep tech investment.
Join us in this exploration as we analyze, strategize, and seek to learn from these instances to fortify our path forward in the dynamic landscape of specialized venture capital.
Understanding Market Dynamics
Investors in the defense tech, hard tech, and deep tech landscapes span a spectrum from smaller specialized funds to the towering multistage investment powerhouses. In this arena, smaller venture capital funds encounter unique challenges in the face of the larger funds with greater resources.
Let's look at three challenges that smaller, focused funds may face:
Inaccessibility. Startups in defense tech, hard tech, and deep tech often require larger capital commitments (e.g., an AI startup building a large language model could require tens or even hundreds of millions of dollars to build it). This pushes valuations upwards and make it nearly impossible for smaller funds to participate.
Increased competition. More and more funds are investing in defense tech, hard tech, and deep tech. This makes it harder for smaller funds to differentiate themselves and also has a natural tendency to inflate valuations.
Long capital tie-ups. This effects all funds in these sectors. By their nature, these sectors often take a lot longer to see profitability. Fund lifecycles are often 8-10 years, but these sectors may demand more patience to see returns. This lowers fund metrics--especially DPI.
Navigating these intertwined challenges—balancing accessibility, standing out in a competitive landscape, and managing prolonged capital commitments—is pivotal for specialized funds striving for success in the intricate domain of defense tech, hard tech, and deep tech investments.
A Dose of Reality: Navigating Fund Performance
In the world of VC, a stark reality prevails: not every fund will ascend to meteoric success. VC—much like startups—is a power law game. This holds true for defense-focused venture capital as much as any other sector.
Consider this: as low as 15% of funds, achieve the 3x return mark (sometimes called a “venture rate of return”). Equally telling is the fact that approximately 50% of funds will yield less than a 1x return. These numbers underscore the reality that fund performance isn't a linear journey, and success stories are the exception rather than the rule.
This reality check isn't about singling out any specific funds. I’m not implying that Countdown Capital or Nemesis Technologies underperformed; frankly, I don’t know. I do, however, want us all to acknowledge the broader landscape within which all venture capital funds operate. It's an acknowledgment that the pursuit of success often involves churn.
In the specialized sectors of defense tech, hard tech, and deep tech, this reality amplifies the importance of prudent portfolio management, strategic decision-making, and adaptive approaches. Fund managers are tasked with the challenging but essential duty of identifying and nurturing high-potential investments while acknowledging the variability in fund performance outcomes.
This understanding isn't meant to discourage but rather to underscore the necessity of adopting realistic expectations, strategic adaptability, and a commitment to optimizing portfolio performance—a path that demands continuous evaluation, learning from setbacks, and reshaping strategies for sustained success in the ever-evolving landscape of venture capital.
Recommendations for Enhanced Performance
Forge Strategic Relationships: To be successful in Defense Tech, VCs need to foster relationships within the Department of Defense (DoD) and academia to bolster diligence processes. Imagine how powerful a conversation with Dr. Kate Sixt, the DoD’s Principal Director for Biotechnology would be when conducting due diligence on a Defense Tech company focused on creating a wearable hemorrhage control system to increase the survivability of traumatic battlefield injuries. Or, imagine how powerful a conversation with Dr. John Burke, the Principal Director for Quantum Science, would be when diligencing a QC company. Establishing collaborative partnerships can offer insights, access to cutting-edge research, and validation opportunities. As a freebie, the DoD Office of Strategic Capital can facilitate those sorts of relationships, when a fund chooses to work with them.
Consider Longer Fund Time Horizons: When raising a new fund focused on defense/hard/deep tech, it is worth considering structuring the LPA to account for the longer horizons necessary for research, develop, prototyping, and regulatory processes. Longer timeframes align more closely with the inherent characteristics of these sectors and provide flexibility for patient, strategic capital.
Embrace Domain Expertise: Cultivate a deep understanding of the defense, hard tech, and deep tech landscapes. Hiring venture partners, advisors, or team members with domain expertise can enhance deal sourcing, due diligence, and portfolio management.
Focus on Value Creation: Stress the importance of investing in companies with real value and impactful technology rather than chasing inflated valuations. Encourage a focus on sustainable growth, practical applications, and market viability. Additionally, differentiate your fund by offering considerable value to the founding teams that you back.
Conclusion
These recent incidents serve as poignant reminders of the nuanced landscape within which venture capital operates and offer insights for future success.
I think the key takeaway is that proactive strategies are paramount in enhancing fund performance. Adaptability stands tall as a cornerstone, urging fund managers to remain agile in response to market pressures, competitive dynamics, and shifting investment landscapes.
Moreover, fostering strategic relationships, cultivating domain expertise, and prioritizing value creation emerge as keys to success in these sectors. Building robust connections within defense institutions, academia, and research hubs fortifies diligence processes. Simultaneously, leveraging specialized knowledge and seeking advisors with domain expertise provides a competitive edge in deal sourcing and portfolio management.
Keep building!
Andrew
Afterword
With the pivot of the firm that I’ve supported over the past year, I am now looking for a full-time position with a VC firm. If your firm, or a firm that you know, is looking to expand, please reach out to me and let me know.
Are there good breakdowns right now of VC performance in "deep tech" fields, relative to other types of innovations?