LPs and the Venture Capital Asset Class: A Candid Conversation

Reprinted from the Winter 2010–2011 issue of the Venture Capital Review.

In the summer of 2008, I began a two-year Kauffman Fellowship with the Center for Venture Education. This Program enrolls about 25 individuals near the beginnings of their venture capital careers and, on a quarterly basis, immerses them for three days in discussions with legends in the industry to learn about venture or lead them in introspective sessions where Fellows can learn about themselves to better navigate their career paths. My Class 13 entered at a heady time for venture capital. Returns were good. Money flowed into the asset class. Limited Partners (LPs) had no real concept of illiquidity.

As we graduated from the Program in the summer of 2010, just two years later, times were very different. In 2009, we saw venture capital (VC) fundraising dollars fall over 38 percent to $16.3 billion across 150 funds, down from the $26.4 billion collected by 213 funds in 2008. 2010 witnessed even a further decline from prior year’s numbers, with 157 funds raising just $12.3 billion.1 These last two years are the slowest years for fundraising since 2003. Perhaps this is not so surprising, given that the 10-year returns, a common measure of health in any industry, have turned negative—as of December 2010, 10-year returns for venture stand at -2.0 percent.2 Fund sizes are shrinking, both monetarily and staffing-wise, and the balance of power is shifting in many cases from general partner to limited partner. It seems that fund managers may be abandoning the VC industry. Or are they?

For graduation, each Fellow completes an independent Field Project. My colleague, Dr. Lin Yan, and I found it a unique opportunity to develop a greater understanding of one of the most important relationships we will have in our careers as VC—that of the limited partner and general partner as it relates to fundraising. We were specifically interested in better understanding how LPs are viewing their continuing investments in our asset class given the huge shifts in the micro and macroeconomic environment of late and dismal 10-year returns.

To do this, we interviewed 22 LPs representing most of the major categories (fund of funds, foundations, endowments, pension funds, international, and advisors) with the goal of uncovering their true thinking—thoughts that are not currently being expressed in the press or at conferences and that only one-on-one conversations can bring to light. The LPs oversaw or advised on a wide range of asset sizes with varying amounts dedicated to venture. On average, assets under management were $32 billion with 23 percent allocated to VC.

Our interviews centered around three main themes:

• Overall observations about the VC asset class, returns versus benchmark expectations, and what those mean for allocation to the class going forward
• Components of ideal GP funds and qualities of managers
• Observations about GP structure and successorship

LPs’ Thoughts on the VC Asset Class

Half of the LPs remain bullish on venture capital, or will be more so going forward. However, there is much more emphasis on illiquidity premiums and investing with the best managers today than in the past. They will invest opportunistically rather than based on a specific allocation. A comment on the bullish front was: “It is the best time to go in when everyone else is leaving,” while on the bearish side we heard: “The absolute returns have not been exciting for illiquidity. We need to see exits for a mentality shift.” Of those LPs who remain neutral on the opportunity, one interesting comment was: “I won’t risk my job to invest more in VC,” even though he was “cautiously optimistic.”

LPs use various public indices as their benchmarks and add a premium to account for the illiquidity of venture. For example, they may use the S&P, NASDAQ, or Russell 3000 indices and add anywhere from 250 to 800 basis points for their VC investments’ return hurdle. We found that the LPs use both absolute and relative benchmarks equally depending on circumstances, and measure both IRR and multiples. They expect 12-20 percent absolute IRR and a 1.7x to 3x multiple return in VC. About one-third of the LPs interviewed met or exceeded their benchmarks over the last 10 years, which also means that two-thirds did not.

We were curious as to why the sentiment in the LP community, when heard from the podiums at conferences or in the blogosphere, seemed so negative towards VC overall? After all, at least through the statistics of September 2009 (the most recent data we had at the time of the interviews), the 10-year returns for venture were better than those of most public indices plus the illiquidity premium some had set. Comments around this were particularly insightful: “Beating a negative public market return with a slightly less negative VC return is not impressive.” As well we heard: “Psychological factors are at play. Even though LPs may have beaten their relative-to-public-market benchmarks, the real liquidity crisis of late made us realize that those illiquidity premiums weren’t high enough.” Before this last decade, no one had really ever experienced true illiquidity.

To invest in venture, one should also understand the performance of other alternative asset classes in which an LP could choose to invest capital, as this is where the true competition for dollars will come from. Figure 1 demonstrates that buyouts have outperformed VC returns for the last 10 years. The range of returns between top quartile and median funds are also much larger in VC than buyout, emphasizing the need to get access to and invest in the best managers. As one LP put it: “The price of picking the wrong manager in venture is very expensive, as the distribution of returns is huge.” When looking at the impressive performance of VC in 20- and 15-year returns, one can further understand the overall dissatisfaction with more recent performance.

Figure 1. Venture Capital Performance versus Buyout Performance.3 Buyout has outperformed VC returns in the last 10 years; great divergence between top and median performers.

As to the causes of the poor performance of late, most LPs believe internal factors are most to blame and do see groundwork being laid going forward to help returns (figure 2). Some of the major internal factors mentioned include overfunding and investing in mediocre managers who became passive with portfolio companies. Of the former, one LP observed: “If greater than about $15 billion (per year) goes into the VC asset class, returns suffer. It dilutes access to great returns and great ideas.” Of mediocre managers, another LP commented again on the divergence in performance between good and bad managers (figure 3). Other internal factors mentioned were: overvalued deals, larger fund sizes (“the larger the fund, the less incentive to focus on returns, and the less churn of older GPs”), and funding of “me-too” companies that were capital inefficient. External factors included: no IPO market, Sarbanes-Oxley rules, and limited coverage of small-cap companies.

Figure 2. Reasons for Venture Capital Performance in the Last Decade and What Changes to Expect Going Forward.4 Most LPs believe internal factors were most to blame for the poor absolute returns of the last decade and see right-sizing going forward.

Figure 3. Venture Returns by Vintage Year Median, Upper, and Lower Quartile 1984–2009.5 Large differences in performance between funds in the top and bottom quartiles of the distribution.

Going forward, the signs for improvement include: capital efficiency, better asset managers (“the unwatched masses are getting out of the business”) and smaller funds. In this kind of environment, valuations have declined, which should also lead to better returns. One LP summed it up by commenting: “Less total funding leads to smaller funds, less number of funds, as well as less total deals funded. Only the best of the best will be left.”

There is also hope that the public markets are opening up, and the backlog of good profitable companies out there can now get exposure and provide liquidity for their backers. There is no doubt that there has been a sharp decline in VC-backed IPOs in recent years. The year 2004 saw 94 venture-backed companies IPO, while 2005 and 2006 each saw 57. There was an uptick again in 2007 with 86. Just one year later, there were only 6 venture-backed IPOs in 2008, and just 12 in 2009. However, in 2010, there were 72, and so the window is indeed cracking open.6

Despite the overall negative sentiment, there is some good news. Of the LPs we spoke with, 50 percent of them will maintain their allocations to VC and 14 percent will increase allocations; 36 percent will decrease them going forward. The focus is clearly on raising the quality bar for fund managers, and funding will occur opportunistically for most depending on that quality. Those decreasing their allocations are doing so based partly on the market and partly by concentrating more money into fewer managers. One LP commented: “We believe that the number of funds and the size of these funds will be smaller going forward. In turn, our investment into this asset class will be smaller as well.” So where will their money go instead? Other alternative investments mentioned that will gain attention include growth equity, middle-market buyouts, and secondaries.

Perspectives on General Partner (GP) Profiles

We asked the LPs to list the traits that are most considered when choosing rainmakers. In descending order, performance, team, and strategy were mentioned most often in describing what LPs look for in choosing top GPs. Other factors include: domain expertise, deep networks within the industry, and deal flow. While all LPs said they would only invest in the best managers, only 18 percent of the LPs are willing to invest in first-time funds. None are interested in first-time managers. Of course, not all LPs can invest in only the best managers. When probed on how they would all therefore achieve this goal, they commented that: “Everyone has the same list of top 6-8 funds [note: we could not get them to reveal the names]. Beyond that, our expertise and relationships come in to identify the next dozen and access them.”

Seeking to get more granular around preferred sector, size, and stage of fund, as well as geography, we mapped out preferences for each. On sector (figure 4), the LPs proportion more to the IT sector (62%) than life sciences (35%) and are skeptical on cleantech (3%). They were evenly split as to whether they preferred sector-focused versus diversified funds. On size (figure 5), they prefer smaller VC funds (less than $250 million), stating that “venture is not scalable” and “incentives are not aligned with LPs in bigger funds.”

Figure 4. LP Preference in Sector of VC Funds. LS = life science, CT = cleantech, IT = information tech.

LP comments for figure 4 included:

• Weighted towards IT over LS investing
• Cleantech viewed skeptically
• Allocations by sector remaining same going forward on average
• Evenly split between those that prefer to invest in sector focused versus diversified funds

Figure 5. LP Preferences in Size of VC Funds. *Two LPs said “larger for GE fund.”

LP comments for figure 5 included:

• “Venture is not scalable”
• “Big funds need big deals and GPs get is distracted”
• “Incentives not aligned with LPs in big funds”
• “Small is better for early stage while later stage should be bigger”

Interestingly, independent research conducted by Lerner, Leamon, and Hardymon confirms that at fund sizes greater than $200 million, the negative effect of size appears and performance suffers accordingly for venture funds (figure 8). As for stage (figure 6), LPs lean towards a late stage or growth equity strategy, believing liquidity comes sooner the later the stage. Here again, LPs were indifferent as to whether the fund is stage-specific versus diversified, as the quality of the fund manager is most important. Geographically (figure 7), while there is a penchant for U.S.-based funds, some LPs are looking to increase their investments in China. There is also a preference for gaining geographic diversity through a U.S. umbrella fund versus a local fund: “The core fund is always the best performer unless there are local feet on the street.”

Figure 6. LP Preferences in Stage of VC Funds.

LP comments for figure 6 included:

• “Valuation fluctuation not as big in early stage”
• “Get liquidity sooner with late stage”
• Majority of LPs indifferent as to whether funds are stage specific vs. diversified as quality of fund manager most important

Figure 7. LP Preferences in Geography of VC Funds. Preference for getting geographic diversity through U.S. umbrella fund versus local fund.

LP comments on figure 7 included:

• “Global funds have a better global perspective”
• “Core fund is always the best performer unless have local feet on the ground”
• “Must be local fund because of cultural differences”
• Majority of LPs invested mainly in U.S. venture capital
• Some LPs looking to increase presence in Asia (China)

Figure 8. Returns for Venture Funds by Fund Size.7 Large differences in performance between funds in the top and bottom quartiles of the distribution.

Thoughts on GP Structure and Successorship

Structure of a general partnership is so varied, and so we wondered how much the LPs paid attention to it and, if they did, what preferences they had towards both economics and governance. We found the LPs split fairly evenly as to whether fund structure is important in their decision-making process, and if so, if equal governance and economics versus unequal is better. As they consistently said, their main focus is on finding the best managers. Beyond that, they let those managers decide how to run the firms. Some interesting comments include: “We will not invest in a fund with one decision-maker. Dictatorships do not work.” Another said: “An equal checkbook does not make sense. Recognize non-rainmakers for the contributions, but don’t reward them equally.” As for consensus building, again there was a split in opinion as to whether that was beneficial or detrimental. In support of the latter, one LP said: “Consensus building does not work since people will be reluctant to kill other people’s deals. There should be a vote as it forces people to become knowledgeable and take a position.”

The role successorship plays in a fund is also an interesting dynamic and one we explored by probing what LPs wanted to see in terms of more senior partners developing the junior team members. The majority of the LPs do believe that GPs must recruit and retain top talent at the junior level of a firm and actively consider succession planning. For example, let junior members build a track record, serve on boards, and have a clearly laid out set of milestones and development path. Actively being mentored, motivated, and promoted when appropriate were also seen as very desirable.

Summary

Net net, our interviews reveal that the VC asset class is here to stay, as LPs who are leaving the class are replaced by those who have always wanted access but couldn’t get access before. The hope is that the total amount of capital flowing in will be right-sized to allow better returns for all.

Venture capital represents alpha and allows diversification for LPs and so remains an important alternative asset. Relative benchmarking aspirations to public equities will likely be raised to account for the reality of illiquidity.

There is consolidation occurring, as many LPs are concentrating their VC allocation to fewer funds. However, it is increasingly challenging to get into top tier funds since VC funds are getting smaller and everyone wants access to those funds. LPs are not interested in first-time managers and only somewhat open to first-time funds, even if they have an experienced manager. There is a preference for smaller and later-stage focused funds. Above all, GPs that have and can continue to provide good returns will survive whereas others will not.

Acknowledgements

The author would like to acknowledge Dr. Lin Yan of L Capital Partners who contributed to the research conducted for the Kauffman Fellows Field Project, as well as to the LPs who participated in the survey.

Tamara N. Elias

Tamara is a physician and Principal at Essex Woodlands Health Ventures, a health care-focused venture capital and growth equity firm with $2.5 billion in assets under management. She joined the firm in January 2007 and is based in the New York office. Tamara represents Essex on the Board of Directors of Millennium Pharmacy Systems. Prior to Essex Woodlands, Tamara spent six years at McKinsey as a senior engagement manager advising pharmaceutical and diagnostic companies in strategic, operational, and business development areas, managing numerous McKinsey and client teams. Prior to McKinsey, Tamara was a general surgery resident at Massachusetts General Hospital in Boston after receiving her medical degree at the Johns Hopkins School of Medicine. Tamara graduated with Kauffmann Fellows Class 13 in July 2010. She may be reached at telias@ewhv.com.

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1 Thomson Reuters and NVCA, “Venture Capital Fundraising Declines Further in 2010,” 17 January 2011.

2 Cambridge Associates LLC, “U.S. Venture Capital Index and Selected Benchmark Statistics,” 31 December 2010.

3 Note: 10-year return data for VC varies from those quoted in the article due to differences in sources as well as time period cited. Author’s table; data from Thomson One; point-to-point return calculations through 30 September 2010.

4 Limited Partners (LPs), interviews by author, 2010.

5 Data from Cambridge Associates, U.S. Venture Capital Index.

6 Thomson Reuters and NVCA press release, “Venture-Backed Acquisitions Break All-Time Annual Record; Driven by Chinese Companies, Number of IPOs at Highest Quarterly Level since 2000,” 3 January 2011.

7 Lerner, Leamon, and Hardymon, 2010.

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