Limited Partners, not Limited Opportunity

Venture capital is an odd duck in the portfolios of limited partners.

One of these vessels is not like the other. Also, the schooner in the foreground is probably a metaphor for private equity or something.

Venture funds have long life spans, they’re marked in mysterious ways, and the returns of the portfolio investments follow the 80/20 rule (though 99/1 may be closer to the truth). They technically fall under the private equity umbrella (they’re private… and they’re equity investments), but require a much different approach or mindset — one not necessarily conferred upon an investor when he or she attains the CFA or CAIA designation.

Last week Bloomberg published an article on how we’re currently in a “steroid era” in private equity. Though that characterization seems to ignore the other eras in private equity that displayed creative usage of leverage, the strategy discussed in the article does allow general partners to 1) move more quickly in making investments, and 2) increase the IRR (internal rate of return) of their investments. This makes everyone happy — just kidding, it creates a misalignment of incentives where general partners may become more focused on the timing and duration of their deals while limited partners may find themselves in funds that generate lower cash-on-cash returns.

The short-term focus on IRR by both sides of the table is detrimental to venture capital. Long-tailed venture funds that are difficult to value do not lend themselves to the short-term IRR game, yet they have the potential to generate astronomical cash-on-cash returns. However if a limited partner evaluates venture through the prism of their private equity allocation, it may look like an under-performer in the short- and medium-terms. There’s also the issue of accessing the persistent top-performing venture funds, which is difficult and/or impossible for limited partners new to the asset class. How then can limited partners approach venture capital in a mindful way without sacrificing long-term value?

Limited partners could adopt separate benchmarks for their venture capital portfolio, ones that only comprises venture funds. This makes sense as the underlying assets in venture funds are extremely different from those in private equity, especially as it relates to growth rates, financing strategies, sizes of the teams, and product offerings. A substantial amount (if not the majority) of venture funds are also reserved for follow-on investments, whereas private equity funds set aside a far smaller amount. Comparisons between these types of funds are not apples-to-apples. As my former colleagues at the Permanent School Fund can attest though, one does not simply “adopt a separate benchmark” without undergoing a multi-year study of the benchmarks available. Which makes sense, given that benchmarks ultimately drive all investment decision-making.

Even if limited partners decide to think mindfully about investing in venture capital, there is still the issue of access. Sequoia isn’t saying “come on in!” to investors beating at the gates of their flagship fund — not to pick on Sequoia, but the persistently high-performing funds just don’t need to add new investors. Without some special relationship to the general partners of these firms, new limited partners aren’t gaining access. How then can limited partners gain exposure to the most interesting entrepreneurs and companies in the universe of investable opportunities, while generating (potentially) the highest cash-on-cash returns?

Here is where the most exciting opportunity lies for entrepreneurial-minded institutional investors. Emerging sub-$100 million venture funds in the seed/series A space provide the chance for limited partners to make small commitments early on to promising managers (or even seed their funds), and to then scale up their commitments over time as the managers raise future funds. Similarly, those funds make smaller initial investments into companies at a lower cost basis, mitigating their downside while maintaining the reserves for their winners. People like Cendana Capital’s Michael Kim and Foundry Group Next’s LD Eakman have established themselves as leaders in the micro venture space, while being very open in providing investors an introductory template to follow (through podcasts here, here, and here, and this blog post here). To borrow Lindel’s phrasing, they’re showing how to best optimize venture capital exposure, and limited partners new to the venture ecosystem would do well to pay attention.

Despite their inherent diversification, finding the best fund opportunities isn’t easy. It’s really hard. Last year the vast majority of venture funds raising capital fell into this micro venture category, and unless you’re taking pitch decks at face value they’re not all top-quartile managers. But for limited partners that understand what a thoughtfully-built venture portfolio can do, they need to source potential investments in ways beyond just talking to consultants and placement agents. For starters, listening to podcasts and participating in the Twitter debates is actually useful in gaining the pattern recognition skills necessary to determine who the intelligent investors are. There’s also definitely a case for the ILPA Institute to add training for its member limited partners on how to best approach and evaluate venture capital managers. I even think there’s a case to be made for developing software to track which seed investors have the highest percentage of investments that graduate to the later funding stages or liquidity events, or other sorts of success metrics (of which I assume Mattermark is capable).

Despite the challenges in venture capital, limited partners will continue to invest in these funds. Whichever way they choose to address the space, it’s apparent that the confusion in how to do so provides a massive opportunity for mindful investors to back the next generation of talents. Which would be anything but odd.

Hey look it’s a baby sequoia tree, I wonder what that’s supposed to represent.

More by Peter Teneriello

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