venture capital confidential

  It may sound like alphabet soup, but the relationships between LPs and VCs have big implications for entrepreneurs who are looking for equity funding. LPs are “limited partners,” the institutions and individuals that supply the money for the investment funds raised by VCs. And VCs? They’re the ones who have been saying no to a lot of entrepreneurs lately. Entrepreneurs found out why at this Netpreneur Coffee & DoughNets event held March 27, 2002, where a panel of VCs and LPs discussed how the changing dynamics between the two is affecting the current funding climate.

panelists:
Jack Biddle, General Partner, Novak Biddle Venture Partners
Catharine Burkett, Director of Private Investments University of Richmond
Brian Wade, Senior Investment Officer, Virginia Retirement System
George Wilcox, Managing Director, Bessemer Trust

moderator:
John Burke, Principal, ABS Ventures

Copyright 2002 Morino Institute. All rights reserved. Edited for length and clarity.

Disclaimer: Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, Netpreneur.org or any of their affiliates, agents, officers or directors. The transcript is provided “as is” and your use is at your own risk.

mary macpherson: welcome

Good morning and welcome to Coffee & DoughNets. I'm Mary MacPherson, Executive Director of Morino Institute’s Netpreneur. On behalf of the team, thanks for coming this morning.

          In the early part of 2001, the Mid-Atlantic Venture Association (MAVA) began conducting a survey of the attitudes of its members. As we at Netpreneur watched the survey unfold, we saw an opportunity to learn the degree to which the attitudes of entrepreneurs were in sync with those of the venture funding community. We began conducting quarterly companion surveys of entrepreneurs last summer, and the most recent results of both surveys are now available.

          Those surveys are what sparked the idea for our program this morning. What we had hoped to achieve in doing them was to identify differences between the perceptions of entrepreneurs and private equity funders in our region. The data showed that there is a disconnect between these two groups, in part because many entrepreneurs are not aware of some of the dynamics of the venture industry. We’ll try to remedy that today with “VC Confidential: Understanding What Drives Venture Capital Investing.”

          Before we begin, however, let me acknowledge the volunteers who helped us this morning: Harish Bhatt of SingleSignOn.Net, John Grespin of i-Base Data Services, and Anje Berger of We Grow Companies. We couldn't do these events without the help of our volunteers. Also thanks, of course, to the Netpreneur team members who work tirelessly to make these events happen, to TVworldwide.com, which produces and hosts our video, and Web Surveyor, which we use to conduct post-event surveys.

          Now, without further ado, let me introduce John Burke of ABS Ventures who will lead us through our discussion.

the panel: inside the venture industry

Mr. Burke: Thank you, Mary, and thank you all for coming today. We hope this is going to be a great opportunity for all of us to learn something about a part of the VC process we don't normally see.

          The news is filled with arguments between Limited Partners (LP) and General Partners (GP). Perhaps I should say “disagreements” rather than arguments. For example, funds are giving back or releasing LPs from capital commitments. We tried to bring in some of the LPs from the area who can talk about this, and about how they think through their relationships with venture funds.

          Before we get started, I want to cover a little bit about the process of how a fund works. Jack Biddle, you've raised a couple of funds at Novak Biddle Venture Partners and have been very successful at it. Talk about how that process works, and, if you could, walk us through the fund-raising process.

Mr. Biddle: In the venture business, most of the capital comes from very large institutions. Interestingly, it used to be illegal for institutions to invest in venture funds because it was considered too risky. In the 1970s, the law was changed -- the “prudent man” rule was changed -- and it was deemed prudent to have a small percentage of your portfolio in alternate investments. The fact is that, statistically, the venture business has not been very risky. It has been the highest performing asset class, so a lot of the large insurance companies, endowments, and pension plans typically allocate 5-10% of their portfolios to private equity. Like any business, there are people who are better at it, and those are the institutions that we've worked hard to try to get as investors in our fund. They understand it's a long-term business, and we wanted people who would stick with us during times like these.

          You hear a lot about defaults. We haven't had any defaults. We have a blue chip limited partner base, but it's taken us years to develop those relationships. In a lot of cases, we have investors that we've been courting for six years. It's tough to raise a fund and it's really tough to get the kind of investors who will stick with you in times like today.

Mr. Burke: Before we get into the discussion, why don't we introduce our panel. George, why don't we start with you?

Mr. Wilcox: I'm George Wilcox, Managing Director of Bessemer Trust. We manage about $35 billion for about 1,500 families. A little over $3 billion of that is allocated to private equity and split evenly between venture capital and buyout. We participate in venture capital through our own firm, Bessemer Venture Partners. On the Bessemer Trust side, when we invest in venture capital, we do it through a “fund of funds” approach, which is simply raising a pool of money, and, rather than investing it directly into companies, we invest it into other venture capital funds. We've got a fairly rigorous process for screening those funds.

Ms. Burkett: I'm Catharine Burkett, Director of Private Investments at the University of Richmond. We have a $1 billion endowment of which aggressively about 30% is earmarked for a broad category called “opportunistic.” That includes early stage ventures and things like oil and gas partnerships and subordinated debt funds. We have about 40% of that in the early stage, where we invest only in funds and do not make direct investments.

Mr. Wade: Good morning, everyone. I'm Brian Wade from the Virginia Retirement System (VRS). I'm the Senior Investment Officer there, responsible for our private equity portfolio. The VRS has approximately $36 billion in assets, and our private equity portfolio is currently valued at about $2.2 billion. We have a balance between venture, special situations, and buyouts. I think we're one of the longer-standing limited partners in the asset class. We've been investing in private equities since 1989.

Mr. Burke: Great. When the entrepreneurs in the audience approach a venture capitalist, it's critical for them to understand how you get paid so that they can think through their approach. Jack, could you explain how a venture capitalist gets paid?

Mr. Biddle: Well, the economics has two parts. There's a management fee, which we'll talk about later, usually between 1.5% and 2.5% of your commitment to the fund. You will pay that for as long as 10 years. These are 10-year partnerships.

          The real money in this business comes from the carried interest. Historically, you typically got 20% of the profits on the portfolio, so, if you turned $100 million into $1 billion, you were going to make $180 million. The last few years, the carries for firms like Kleiner Perkins Caufield & Byers have gone to 35%.

          When we had a return environment that was 50%-80% internal rate of return (IRR), it didn't matter. In a 17% IRR environment, however, those management fees will kill your returns, so that's where a lot of the friction is coming from now.

          When I started in the venture business in 1983, our four limited partners were the four largest venture funds in the country. Each had $100 million. The economic model was built along these lines: with $2 million dollars you pay your rent and your salaries and your staff, and you don't make very much money. Now, when you run into $1 billion and you're getting $20 million dollars in management fees, some of these VCs are making $5 million and $10 million salaries with no risk. That's the problem right now.

Mr. Burke: When you started, Jack, $100 million was the largest fund, now we have multi-billion dollar funds. How has that changed your outlook?

Mr. Biddle: I've been pretty public that I don't think the economics work for an investor in a billion dollar partnership.

Mr. Burke: Why not?

Mr. Biddle: Historically a $100 million profit on an investment was a once-a-career event for a rock star venture capitalist. If you're running $2 billion, you have to have 20 of those. Having these companies bought for $2 billion, none of this stuff ever worked. They got shut down. Historically, to make a billion dollars on an investment, you had to invest in DEC in 1954 and hold it for 30 years. It just doesn't happen.

          Our $125 million fund is considered tiny. In fact, a lot of our limited partners were saying that we should raise $400 million to be taken seriously. With $125 million, I think I can make $25-$50 million on a couple of deals and return capital, then have a couple more deals that will generate the profits that people expect.

          The important thing to understand with a group like VRS is that with $36 billion they have a lot of options. They can buy Guatemala. They don't have to invest in venture capital, so we have to outperform the other investment options they have, and that's not easy to do. The returns have been high, it's attracted competition, and competition destroys profits. That's the hard part.

Mr. Burke: What about the LPs? George, you represent wealthy families. How do you look at these $100 million funds in comparison to the multi-billion dollar funds?

Mr. Wilcox: Over the years, we've been in probably 60 to 70 funds. Some of them are the billion dollar funds. We don't mind placing money with the billion dollar funds, because, if they're focused on later stage, the rounds are typically much larger and it's easier to deploy a fund that size. I would agree with Jack that if you're doing early stage investments and you've got a billion dollar fund, you have to have a pretty big staff to be able to effectively screen the number of deals you need to look at and do the due diligence to get that money to work within a four to five-year period. That’s the typical deployment window for a new fund.

          We're not opposed to the billion dollar funds. We're in a number of them and we watch them closely for style or stage drift, which is something that's important to us. When you go into a fund and they say they're software-specific, for example, you want to make sure they're not investing in optical networking companies or otherwise leaving their area of expertise. Funds have to stay focused just like entrepreneurs are expected to stay focused.

Mr. Burke: As an LP, can you pull out of a fund if it is performing poorly and not doing what they said they were going to do?

Mr. Wilcox: Not without some problems. Legally you're bound not to. You make a monetary commitment upfront, and it's called down by the VC over a period of years. You deliver the funds at each capital call, and you are legally obligated to meet them. We've never done it, but there have been a number of instances where, for one reason or another, other LPs have failed to meet capital calls. Typically it's because the LP is distressed, in which case they try to find a replacement. In fact, an enormous secondary market has emerged for private equity interests.

Mr. Burke: Catharine and Brian, how do you look at these large funds?

Ms. Burkett: We are absolutely opposed to the large funds. We do not participate in the large funds, with one or two exceptions for funds that grew over time and have been very successful for us. We definitely have a value bias and prefer the smaller funds, usually a venture capital firm at about its third fund when they're gathering momentum but haven't gotten so big that they're no longer hungry and are still very well disciplined.

Mr. Wade: We're in several of the larger funds. Internally, we made a commitment to actively increase our venture exposure in the 1995-97 time frame, but, as the mega-funds emerged, some of those that we already had exposure to we looked to cut back, or, in some cases, we didn't make follow-on investments.

Mr. Burke: As a result of the performance?

Mr. Wade: As a result of the performance and the issues that George and Jack already brought up.

Mr. Burke: How closely do the LPs look at the investments that the fund has made? Do you only concentrate on the fund level, or do you look at the portfolio companies, too?

Mr. Wade: We definitely review the portfolio companies. We look at it from a macro perspective, but we also drill down to the portfolio companies. We've got software in-house that specifically enables us to monitor portfolio companies.

Mr. Burke: Are any of you LPs at all involved in any of the investment decisions for the fund? Do you look that closely?

Mr. Wade: No.

Mr. Wilcox: No, I think you would be shot down pretty quickly if you tried to get involved in the general partner’s investment decisions. We do monitor the portfolio companies for style and stage drift. If it's an early stage fund and they start making late stage investments, we're going to want to know why. In 1999 and 2000, a lot of later stage funds became seed and Series A round investors, and that's a problem.

Mr. Biddle: Limited partners do get involved at one level.

          We're prohibited from investing dollars from one partnership into deals of another partnership. They each have to stand on their own. The reason is that if you get 20% of the profits but none of the losses, it creates an incentive to put all of your winners in one fund. So, we're not allowed to do what's called “crossover investing” without the approval of our institutional investors. I have a call later today because I have a third fund and we've got $115 million of dry powder. I have a company in my second fund that's doing a financing that will happen with or without us, but I think it's attractive. I have to get their permission to do that.

Mr. Burke: How closely will they scrutinize that decision?

Mr. Biddle: It will vary. I got five emails yesterday from limited partners who said, “We trust you. Use your judgment.” If I call today, I'll probably have a couple of people who will push and make sure that we're not .

Mr. Burke: And ask detailed questions?

Mr. Biddle: Yes.

Ms. Burkett: As to scrutinizing portfolio companies, you're doing it to monitor performance, to make sure that they're doing what they said they were going to do. You're probably also going to be faced with the decision of committing more capital to the same group, who will undoubtedly raise another fund before they're through the 10-year cycle of this fund. It's very, very important to keep that monitoring going so that you can be prepared to make the next decision 

Mr. Biddle: I have two limited partners on this panel. One of them talked to every single CEO of every company we've ever been involved with. Before the commitment is made, there's a lot of due diligence.

Mr. Burke: Was that a first-time investment or a second fund that they were going to participate in?

[continued]

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