What is it about us 30-Somethings

What is it about us 30-somethings?  Or is it Gen Xers?  We can't keep our hands out of every cookie jar we see.  Our parents and grandparents spent their entire careers with one employer. My step-father for example was an IBM lifer.  They put in their time at the office (8-6, 9-5 etc), came home to their families and left their work at.... well, at work.  Their children seem to be wired differently.  I live in Schenectady, NY, the Electric City, so dubbed for General Electric's ubiquitous presence (even in the wake of the departure of its headquarters to Fairfield County) in the area.  40 years ago, I would no doubt be working for GE.  My wife's entire family has GE lineage.  However, in 2009, none of my friends or family (including in laws) works for the erstwhile monolith.  Why is that, I wonder?

Perhaps the series of layoffs, retractions and retrenchment by the Fortune 500 in the last several decades has impacted our perspective.  When I speak to innovation and entrepreneurial activities, I typically point to the uptick in innovation spawned during trying economic times.  Those engineers, scientists and IT geniuses being let go from large organizations will often take technologies they have created and attempt to commercialize them.  We have seen this activity; actually we have lived it for our entire lives as the GEs, Xeroxs and Kodaks of the world have been retrenching for decades.  So, maybe our tendency to maintain several side projects is born out of our fears and experiences.  Perhaps these projects are our way of contingency planning?

I will likely accept a full time position in the next 6 weeks.  However, some of the opportunities I have created in the months subsequent to shutting down our fund will be difficult to ignore. There are a few consulting opportunities, a board position or two and even a movie project (this one I'll definitely maintain) that I simply won't give up.  Kim and I have planned a diversified real estate company for years now.  Although not in our immediate plans, we will be in the real estate business in some way in the next few years.  So, I am clearly one of them.  I would not be happy arriving at the same office, parking in the same spot at the same time greeted by the same people and battling the same challenges for 40 years.  Understand that I make no value judgements here.  It's just not for me.

Of course there is another potential explanation for our approach to our careers; perhaps our unprecedented access to information in concert with our natural ADD-like tendencies dictates a somewhat erratic and unstable approach to our careers.  

I'll let you decide which explanation makes more sense.

Defaulting LPs

In the last post, I detailed some of the challenges facing VCs attempting to raise a fund in a troubling environment.  It is indeed the most difficult fundraising environment in the history of venture.  However, another phenomena is occurring in the industry that can also be directly attributed to the meltdown in our capital markets: the phenomena to which I elude, defaulting limited partners.  New funds aren't the only ones struggling to pull in capital.  Existing funds are seeing record numbers of defaults from LPs.  What are some of the implications you ask?

Well, the timing of capital calls has at once become more and less strategic.  Typically, VCs call capital as they need it.  I have always referred to it as a Just In Time system for cash flow management.  We do this for several reasons.  First, investors find 10% at close and the balance over the investment phase of the fund more palatable.  Second, we are not money managers.  We don't want to be moving capital around in various money markets.  More importantly, we take capital as we need it to effect the IRR.  VC performance is measured by IRR (Internal Rate of Return).  It is important to note that IRR is effected by both the timing and size of cash flows. As such, we typically take capital as needed and disperse returns immediately following an exit.  To illustrate my point, go out and google IRR calculator (there is actually one built into Excel) and play around with a series of cash flows (both outbound and inbound).  Try two scenarios, each with the same numbers.  The only difference between the two scenarios should be the timing of the flows.  It is very easy to turn a 27% annualized return into 13% without changing the numbers.  Ok, that was a long digression.  Back on point.  Strategic capital calls typically relate not to the market conditions but rather to the opportunities created by the VCs and the capital requirements of portfolio companies.  However, in the current economic climate, VCs must first think how a call may impact its investors.  So yes, the timing of the calls is still strategic but certainly not core to the mission of the fund.

Another interesting phenomena has emerged.  A secondary market for LP interests in funds has popped up.  Virtually every category of investor is hurting today.  High Net Worth Individuals are either sitting in cash or on their hands.  The institutions that typically make up the vast majority of LPs are getting hammered; we're talking insurance companies, college endowments, pension funds and banks.  So, if an LP defaults who among the LP base will scoop up the positions?  Those with significant capital are in a position to accumulate shares of funds for a song.    Perhaps there is a business there?  Maybe I'll raise a fund focused on buying interests in other funds from defaulting LPs?  Interesting.

Raising a Venture Fund today

We have touched on money raising from the perspective of the entrepreneur.  Having just been through the process of attempting to raise a fund, I know first hand some of the challenges fund managers face.  I think the unique challenges we face in this environment suggest a post is in order.

 

We are in the midst of the most severe economic conditions of my lifetime.  Spurred on by a housing bubble and subsequent collapse, absolute abuse of what was intended to be an insurance instrument (Credit Default Swaps), an ever tightening credit market and public equity markets that are on the verge of collapse, investors are reevaluating typical risk-return profiles.  A high net worth investor that was worth $50M a year and a half ago, may now be worth $20M.  She may not be on food stamps but I know from experience that she is pissed!  It is nearly impossible to convince that investor to consider what is inherently an extremely risky proposition.   So, challenge # 1, investors have less capital overall which reduces the amount available for alternatives.  That leads naturally into challenge #2; the few investors with cash have more options than ever.  LPs that dabbled in venture and those that barely qualified as accredited investors are on the sidelines.  Those left are really in the catbirds seat.  There is a natural flight to quality in tough times.  First time funds, those with mediocre track records, significant management turnover, poorly defined proprietary dealflow and aggressive management fees/carry splits will find it difficult to find investors.  For example, I pitched a very wealthy investor that liked our offering.  However, he loved another opportunity in Israel and another in the UAE.  Did I mention that he is based in Boston?  He asked me why he would seriously consider a 7-figure investment in an Albany-based fund given the opportunities that cross his desk.  We were being compared to the best opportunities around the globe and admittedly, we didn’t hold up.  Challenge #2, extremely tight markets weed out the marginal players on both the LP and venture side.  Only the best of the best will emerge.

 

If you look at the performance of Venture as an asset class, you will see that we really haven’t delivered returns commensurate with the risk profile.  The PWC Money Tree report indicated solid returns for the early stage venture class.  I know this well as I featured it prominently in my investor meetings.  The overall venture class returned roughly 17% over the last 10 and 20 years.  Those numbers are very strong on the surface especially as they compare to returns in the public markets.  However, if you peel the onion a layer or two you will quickly see that the top quartile funds delivered the vast majority of the returns for the asset class.  Don’t get me wrong, I love venture but I’m typically not a big Kool Aid consumer.  We are in a risky game.  If we are to exist long term we have to appropriately compensate LPs.  That will straighten itself out soon.  Many funds that shouldn’t exist won’t exist.  The funds equipped for the long term will emerge strengthening the industry as a whole and normalize returns.  Challenge #3, too many funds popped up during the boom creating downward pressure on industry returns.  Given the inherent riskiness of the asset class, we need to do a better job of delivering returns that appropriately compensate investors for taking on the incremental risk.

 

Let me add an addendum to Challenge #3.  The trend in the venture world is for 2^nd and 3^rd time funds to move downstream, raising larger funds targeting later stage investments.  After a successful first fund the LP base will often seek to invest larger dollars in the next fund.  As such, a team that had successfully deployed $75M in a first fund raises $225M in a second fund. If the focus of the first fund was early stage, the second fund will likely move toward expansion capital. Why is that you ask?  Well, unless they want to ramp up the team significantly, they need to deploy larger dollars (3x in this case) into each deal.  By moving downstream and deploying more into each deal the team can maintain their existing head count while tripling the management fees.  Essentially, the partners can grow wealthy through management fees which really goes against the model.  The model is for VCs to make their money on the back end through their carry participation.  By paying out huge salaries, the VC’s incentives are no longer in line with the interests of the LPs.  Also, early stage and expansion stage are different businesses requiring different skills.  A team that excels in early stage deals may struggle with later stage companies.  That phenomena can certainly impact industry returns.

 

The lack of exit events and dwindling liquidity mechanisms account for the 4^th challenge.  For VCs and their investors to make money, portfolio companies need to find liquidity.  Sarbanes Oxley has effectively killed the IPO market.  I can’t remember the last venture-backed IPO.  Tight credit markets have adversely impacted M&A activity.  LPs are aware of this conundrum (actually they are living it).

 

The 5^th Challenge is known as The Denominator Effect.  Institutional assets have dwindled in the past year; a result of the turmoil in the capital markets, real estate etc.  As such, the overall portfolio value is down significantly.  Institutions have pre-set allocation targets for each asset class.  The value of each class forms the numerator in the allocation percentage calculation and the overall portfolio value forms the denominator.  Because you can’t mark the venture portion of your portfolio to market, it has to be valued at book value.  So, if every other asset class goes down in value and the venture portion stays the same (in absolute, not relative terms) then the allocation goes up.  Today, many institutions that considered new venture investments can’t because they are over allocated, a function of the denominator effect.  Institutional commitments encompass the vast majority of the LP base for most funds.  Lack of available capital from institutions is a challenge that is virtually impossible for a fund to overcome.

 

I’ve laid out a few of the challenges VCs face while raising a fund.  These are fairly ubiquitous; others may be unique to individual funds.  So, if you are an entrepreneur struggling with the fundraising process please understand that the VC across the table is probably suffering from a similar fate.

 

 

My Value Proposition

What am I doing here?

There are dozens if not hundreds of VC blogs out there.  Most in this group are very strong and fairly detailed.  In fact, when I meet with entrepreneurs, I often refer them to four or five as reference material.  The blogs and the information now at everyone’s disposal has really been game changing in many ways.  Entrepreneurs can have a glimpse behind the curtain to gain significant insight into how we think.  I will avoid making any value judgments here; just pointing out the evolving reality.  The point is many of these blogs are very detailed. For example it is very easy to find a detailed exposition of the Venture Capital Method of valuation, key elements of your pitch deck, option pools etc. 

So, with all of that information available (a fairly complete catalogue, really) I see very little point in going deep on any singular topic.  Why add to the redundancy?  Rather, I see this blog as more of an observation platform.  If I have a meeting with an entrepreneur and a theme emerges, I may decide to speak to the topic on this blog- exhibit A the PA Trip, exhibit B, Peak Pitch.  If I have a conversation with one of my VC friends about raising money, I may touch on the topic in a post.  If I’m screwing around on Facebook and begin to think through the history of social networking, I may (and did) do a post.  I’ll leave the heavy lifting to the experts.