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.