The traditional venture capital model does not encourage long-term investing and is inefficient because it requires the formation of a new fund every three to five years, or sooner. Imagine if Warren Buffet had raised a new fund periodically rather than investing solely through Berkshire Hathaway. I suspect Mr. Buffet’s overall returns would have been significantly less had he followed the longstanding venture capital formula.
Berkshire Hathaway is essentially an evergreen fund. An evergreen fund generally begins with a fixed amount of capital, makes an initial set of investments, and subsequently backs new businesses as the early portfolio investments mature and generate liquidity. It is the venture capital industry’s equivalent of the “circle of life”.
The manager of an evergreen fund is not hamstrung by the need to raise new funds periodically. He or she is motivated to invest committed capital on a patient, careful and considered basis, and to pursue liquidity events when it is optimal for a given portfolio company rather than for fund raising purposes.
The typical fund-raising cycle of three to five years encourages investment over that time frame regardless of whether or not the investment opportunities are of high quality and valuations are reasonable. The bias to invest in short bursts does not embrace original, independent investment decisions. I believe the historical pattern of over-investment in “the next new thing”—which results in the creation of numerous “me-too” companies destined for failure—is in part explained by pressure to invest within narrow time frames.
Downside of speed
The traditional venture approach also encourages a “grow fast, get liquid quick” investment mentality. While this strategy is effective for a few select companies, it is not appropriate for the vast majority of businesses. Most would agree that better investment decisions would be made if fund managers focused on long-term, profitable growth rather than on near-term liquidity events. We all know of companies that crashed and burned because they had too much money too early in their development.
This behavior is encouraged not only by the fund-raising cycle, but also by the terms underlying most limited partnership agreements. Funds generally have a four- to six-year investment period during which managers must build their portfolio. At the end of this period, commitments become restricted to follow-on investments and expenses, and management fees begin to decline. Accordingly, managers are motivated to invest quickly or risk the temptation of allocating excess capital to any remaining, troubled investments.
The overall returns generated by the venture capital industry would improve if an evergreen structure were to become industry standard.”
A long-term bias is particularly important in the current market environment, where initial public offerings by venture-backed companies are rare. It also encourages managing portfolio companies to generate substantial cash flows which, absent a compelling liquidity event, could be distributed in the form of dividends. The current venture capital structure does not support this type of decision making nor does it accommodate distributions in the form of dividends.
The evergreen model is also more efficient from a time and cost standpoint. Fund-raising can be a time-consuming process, taking months of preparation and marketing for most firms. That time could otherwise be devoted to managing the portfolio and identifying new investments. In fact, fund-raising results in incremental costs that don’t add tangible value to a limited partner’s investment.
What about liquidity?
A perceived challenge with the evergreen model is that a limited partner’s initial capital commitment remains in the fund for an indefinite period of time. Liquidity is therefore generally restricted to net realized gains.
Limited partners, however, do not always need or want full liquidity in the short run. Essentially, by “re-upping” to an existing manager in a new fund, a limited partner is choosing to roll over its distributions. At a minimum, investors prefer to have the option to get some or all of their money back at certain intervals.
The liquidity desires of limited partners could be addressed in an evergreen fund by allowing limited partners to choose between: (a) receiving their pro-rata share of any distributions or (b) reinvesting their pro-rata share back into the fund. Let’s call this a “Distribution Right.” This mechanism would enable each limited partner to increase or decrease its effective ownership in an evergreen fund based on its specific liquidity needs or its confidence in the fund manager.
Carried interest could similarly be distributed or reinvested in varying amounts. Ideally, carry should be based on realized rates of returns vs. multiples of invested capital. In the typical limited partnership agreement, carried interest is a pure cash-on-cash incentive, is not time based and is not directly correlated with IRR.
The traditional venture approach encourages a ‘grow fast, get liquid quick’ investment mentality. While this strategy is effective for a few select companies, it is not appropriate for the vast majority of businesses.”
For example, a fund manager that generates a 40% IRR and 3x multiple would receive a lower carry than a manager that delivered a 25% IRR and 4x multiple. Ironically, this discrepancy is generally called out as a risk factor in many limited partnership agreements.
It is not inconceivable that an initial public offering of an evergreen fund, at some future point, could be a liquidity option. A seasoned evergreen fund, with majority ownership in multiple, growing and profitable businesses, would be an appealing investment opportunity. It would provide public access to investment managers with a proven track record, a portfolio of investments in attractive private companies, and liquidity. Apollo Investment Corp. (Nasdaq: AINV) is a successful example of public company with a portfolio of investments in middle-market companies.
This model would not preclude a fund manager from establishing new funds with different investment objectives. A venture capital firm could establish a portfolio of evergreen funds diversified by industry, stage of development or geographic focus. It also could be designed to allow new investors to join the fund at specified times up to pre-determined limits.
While new limited partners would buy in based on existing asset values, there would likely be enough market intelligence surrounding the fairness of the valuations based on the reinvestment or redemption decisions of the existing investors and fund managers.
The risk of portfolio companies being orphaned would also be reduced by an evergreen structure. Presently, when a fund manager raises a new fund, the level of attention given to companies in predecessor funds has a tendency to decline. The focus shifts because new funds carry a higher management fee and because the performance of the newer fund will generally have a greater impact on future fund-raising.
An evergreen fund that performs well, and communicates effectively with its limited partners, is likely to grow in size and have access to incremental capital to invest in new companies. This is no different than under the traditional model today. However, I assert that the overall returns generated by the venture capital industry would improve if an evergreen structure were to become industry standard.
Tom Simpson is Managing Partner of Northwest Venture Associates, which focuses on companies in the information and business services, communications and consumer industries. Simpson manages three venture capital funds representing $172 million in aggregate capital commitments. He may be reached at email@example.com.