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Investing Directly as an LP or via Fund of Funds?

This article, penned by Igor Sill, a Managing Director of Geneva Venture Management, was originally penned in the uptick following the 2008 crisis when investor interest in Venture Capital again started taking stage amidst high-profile names such as LinkedIn, Facebook and Twitter. It seems apt to re-air Igor’s discussion of how investors can approach investing in private companies and early-stage companies in light of the recent explosion of online portals (of which ACE is one) and the re-imaging of direct investing in a fee-free model. Perhaps we will be able to track him down for a follow-up on this article, which first appeared in VC Experts article database on “Venture Capital and Private Equity.”

“Investors should pursue success, not liquidity. Portfolio managers should fear failure, not illiquidity. Accepting illiquidity pays outsized dividends to the patient long-term investor.” -David Swensen, CIO of Yale University

Venture Capital is Undergoing a Radical Shift

A global revolution is changing the way serious alternative asset class investors view the venture capital industry. Discarding the old rules, a new, younger era of Venture Capital Fund Managers is re-inventing the venture capital industry. The traditional seed and early stage Venture Capital investing model has changed radically and Institutional Investors are seriously re-assessing the allocation method they once used for this asset class. Many are seizing the benefits of higher returns coupled with lower investment risk by utilizing the breadth and depth of expertise, knowledge and resources that an experienced Fund of Funds (FoFs) firm provides.

Simply stated, a FoFs is a multi-manager investment strategy of holding a portfolio of other investment funds rather than investing directly in private equity, shares, bonds, or other securities.

There are different types of ‘Fund of Funds’, each investing in a different type of collective investment sectors, such as Hedge Fund FoFs, Mutual Fund FoFs, Investment Trust FoFs, Real Estate Trust FoFs, and for the purposes intended here, Venture Capital and Private Equity FoFs. Venture capital investments are, by their very nature, a long term higher risk, illiquid asset class. Its historical returns, however, have out-performed other investment types. Via a Limited Partnership (LP) arrangement, an investor is typically committing funds in the $500,000 upwards to $10 million range for 10 plus years. Redemption liquidity via after market (secondary) sales are limited and generally require prior approval by the fund’s General Partner (GP), thus are generally considered illiquid during the fund’s term. This suggests that venture capital fund investments are better suited for investors with much longer investment time horizons such as Foundations, Pension funds, Family Investment Offices and Endowments.

The very best Venture funds have consistently out-performed the industry and, of course, it’s everyone’s ambition to invest in the top quartile of these funds. After all, some of the most successful public Corporations such as Apple, Amazon, AOL, Baidu, BusinessObjects (SAP), Cisco, Compaq (HP), eBay, Genentech, Google, Hewlett-Packard, HomeDepot, Informix (IBM), Intel, Linkedin, Microsoft, Netscape, NetSuite, Oracle, Salesforce.com, Skype (Microsoft), Starbucks, Sun Microsystems (Oracle), PayPal (eBay), Yahoo, YouTube (Google) and, privately-held Facebook were all financed by Silicon Valley venture capital funds. The LP investors in these funds realized significant healthy returns while Facebook’s investors continue to realize tremendous value appreciation.

You Must Allocate to Alternatives in Your Portfolio

David Swensen, the visionary chief investment officer at Yale University, has also realized great investment success in the alternative asset classes. When he arrived at Yale in 1985, its endowment was worth approximately $1 billion, and today the endowment is worth nearly $17 billion. Swensen increased investments in private equity funds, venture capital, real estate and hedge funds, an investment strategy that was met with some initial skepticism.

Swensen is a big believer in asset allocation and rebalancing. “Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve.” In numerous speeches, Swensen has championed such alternative investments. He argues that while beating the stock market is almost impossible due to the overwhelming available information about public companies and the subsequent valuation, astute managers can exploit inefficiencies in the value pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk. He argues that keeping funds in investments that are more liquid is a tactic of short-term players versus that of endowments, which tend to hold until private equities are sold or go public. Swensen says “Investors should pursue success, not liquidity. Portfolio managers should fear failure, not illiquidity. Accepting illiquidity pays outsized dividends to the patient long-term investor.” Over the past 20 years, no educational institution has achieved a better performance record than Yale.

For more specific discussions of how to allocate to alternatives see this post and this one too.

Picking the Right VC or PE Fund Manager in Light of Macro Trends

Institutional investors are rightfully concerned with fulfilling their fiduciary duties by selecting specific venture funds and Fund Managers with focused market segment expertise.

Understanding which market sectors are most likely to outperform, coupled with identifying capable Fund Managers to exploit those opportunities are a critical component of the investor’s decision making process.

Huge problems still remain to be solved and massive opportunities loom as major corporations, mid to small businesses all seek competitive advantages via new technologies. The emergence of Software-as-a-Service and Cloud computing are major tectonic shifts occurring in the global software ecosystem. Technology’s self-renewing cycle of new wave innovation continues, driven mostly by cost improvements, easier use and vastly greater efficiencies. With new regulatory issues requiring compliance, transparency, privacy, security to high computational performance via cloud computing efficiencies, there’s a massive opportunity for a bunch of smart people to do some incredibly great things. There exist a huge community of seasoned serial entrepreneurs with a deep-rooted passion to build new companies. Venture capital enables and to a great extent, propels this entrepreneurial innovation. Understanding how investors gain access to the Venture Capital firms leading funding for these innovations, along with their higher returns, is keenly important.

Many of the brand name Venture Capital firms no longer benefit from their founder’s experience, knowledge, network and impassioned mentoring of promising first time entrepreneurs–they have long since retired from active participation, though their names remain on the Fund’s websites.

Though there are pockets of entrepreneurial ideas globally, the epicenter of breakthrough, disruptive technology innovations continues to emerge from Silicon Valley. This is a very unique place with a supportive ecosystem ready to back entrepreneurs’ requirements for launching start-ups successfully. The weather is excellent, the lifestyle is wonderful, and the scenery exquisite. Stanford University, UC Berkeley, USF and University of Santa Clara provide an abundance of superb research and continually spin-off new patents, along with a steady flow of budding intellectual entrepreneurially-driven graduates. 80% of venture capital and Angel investors operate here, and, where else will patent attorneys, new business formation attorneys, equity attorneys give you their time without payment in advance of receiving venture capital funding? Although the capital markets have been sluggish of late, investment bankers eagerly swarm Silicon Valley in order to underwrite venture backed IPO candidates. In no other locale will you find the combination of all these factors.

Advantages of the Fund of Fund Approach

In such a fast paced environment, with over 3,500 venture capital funds competing for the most promising start-ups, FoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through the very best venture funds. Essentially, FoFs can offer an investor access to the very best performing Venture Capital fund Managers not otherwise accessible directly. Further complicating the process is the venture industry’s notorious lack of transparency relative to their fund’s actual value. A venture fund series financing in one invested company may report a value considerably different than the same series investment in that same company by another venture firm.

Generally, a FoFs has greater leverage in scrutinizing a venture firm’s financial reporting, its partner expertise relative to market sector focus resulting in a better risk-return ratio than direct investments. They’re also looking for more than the conventional venture model has traditionally delivered – multiples of cash back rather than straight Internal Rate of Return (IRR). They seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles, versus today’s typical 10-12 years. The reasons for the impressive growth of FoFs is that they provide diversity among Venture Fund managers, reduce risk and hold out the promise of net returns higher than the average venture capital return rates. Investors are more willing to invest in FoFs for the benefits provided by this pooled investment structure, continual due diligence and on-going oversight compared to investing in a single strategy venture fund. The most common FoFs fee structure is a management fee of 1% and an incentive fee of 10% above that of the underlying Venture Capital fee structure. The additional fee layer is relatively small with returns generally more than offsetting the added expense. A balanced, properly allocated venture capital/private equity portfolio generally tends to provide higher returns with less inherent risk.

An industry focused FoFs is well experienced in assessing the most promising Venture Capitalists, both the Emerging Venture Fund Managers as well as the historical brand name Venture Capitalists. The brand name Venture firms provide a low-risk foundation for consistent top-quartile performance albeit with higher fees to their LPs. Emerging Fund Managers focused on rapidly growing market sectors offer outsized return potential for their portfolios. But, Emerging Venture Fund Managers who follow a more capital-efficient investment model can deliver industry-leading returns while reducing risk with shortened investment cycles at competitive fees to LPs.

The Process of Selecting a Fund of Fund

The selection process of either brand name Venture firms or Emerging Fund Managers should entail research of their respective track record of investments, actual hands-on involvement of their investments, the firm or Emerging Fund Managers’ lure and stature within the entrepreneurial community (deal flow source), and most importantly, the ethical reputation and transparency in reporting accurate market valuations. Do some serious research here, as the term “success has many fathers” applies in spades to promotional materials.

There are essentially three high potential appreciation types of technology investments which Venture Capitalist traditionally focuses on: seed & early, development stage and late-stage expansion. And, within these 3 categories, there are 3 sub classes: disruptive innovation, enabling technologies and special situations. Market trends and dynamics coupled with technical challenges are very often industry specific. Understanding these issues is critical to the successful mentoring and value creation guidance of start-ups.

Consistently successful returns are achieved from only a few select firms who diligently study, identify and invest in technologies and markets on the leading edge of disruption. They tend to focus on building companies at the forefront of market forces creating outstanding growth and exit opportunities. These particular Venture Capitalists are notorious for sourcing and developing fast-growing companies in large market growth sectors.

Look for a FoFs Manager with investments in venture capital funds possessing the demonstrated expertise, deep experience and qualifying techniques in specific areas of their investment focus. A top tier Venture Capital firm will utilize extensive analytical techniques to evaluate and compare each investment prospect. They will benefit from extensive industry contacts and global business leader connections. These relationships help provide the foundation for executive team recruitment in their portfolio companies, follow-on financings, facilitating strategic corporate alliances, new partnership opportunities and most importantly, exit strategies whether through leading Investment Banking underwriters for IPOs or M&A activity. Doing your homework upfront and placing your bets wisely can result in significant healthy returns whether through a FoFs or direct LP participation in a Venture Capital fund. Of course, past performance is no guarantee of future results.



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