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.
Biddle, General Partner, Novak
Biddle Venture Partners
Catharine Burkett, Director of Private Investments University of Richmond
Brian Wade, Senior Investment Officer, Virginia
Wilcox, Managing Director, Bessemer
Burke, Principal, ABS
Copyright 2002 Morino
Institute. All rights reserved. Edited for length and clarity.
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
and welcome to Coffee & DoughNets. I'm Mary MacPherson,
Executive Director of Morino
Institute’s Netpreneur. On behalf of the team, thanks for coming
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.
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.”
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.
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.
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.
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.
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
Mr. Biddle: Limited partners do get involved at one level.
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
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
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?