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
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 2nd and 3rd 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 4th 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 5th 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.
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