Cover Story: Barely Passing –

Fill in the blank: If my child brought home a report card like this I would ___________________.

a.) Instinctively claim it is not the right report card.

b.) Pray the grades aren’t “on the curve.”

c.) Take comfort in the old adage that C students are the ones who build universities.

d.) In the words of Dr. Phil, “Get real!”

When we asked limited partners to respond to a blind survey asking them about their views on venture capital we didn’t know what to expect, but it certainly wasn’t the grades you see on the opposite page. Talk to your average, over-achieving, button-down, hyperactive, ambitious venture capitalist and your instincts tell you that the person you’re talking with is successful. Words such as “fair,” “adequate,” “passable” or (gulp) “mediocre” just don’t come to mind, do they? Not in describing people who casually toss off references to rigorous analysis, Schumpeter, Black and Scholls algorithms, latency and other academic esoterica.

Maybe it’s time to examine what’s going on in the venture capital industry. Last year, we sat down with four LPs over dinner and they told us about their concerns (see Cover Story, August 2002). We used that list of concerns as the starting point for this story. We asked a globally diverse group of LPs – including endowments, financial institutions, insurance companies, private and public pension funds, and funds-of-funds – to respond to our questionnaire. Despite our guarantee of confidentiality, responses came slowly. Most came only after several follow-up requests for input, without signatures or with the admonition that the information was to be used only if the source was not identified. What the heck? Aren’t LPs the ones with the money? Yes, one nearly apoplectic LP told us, “but these guys [GPs] have a long memory.” The LP, who ultimately decided not to participate in the survey, says he burned bridges a few years ago and is still being penalized by being made LP non grata at several top-tier firms.

Enough brave souls responded so that we have a diversified base of opinions, which we have summarized in the following charts. We are not disclosing the exact number of respondents, in an effort to prevent overly clever readers from backing out the numbers and identifying the “likely culprits.” Suffice it to say we contacted more than 60 LPs and received a generous response that is statistically valid.

To get some sense of how informed the respondents of the survey are, we note that the majority are actively invested in more than 100 venture funds. Some manage private equity assets worth hundreds of millions of dollars while others manage PE assets in the hundreds of billions.

One might suspect that LPs with fewer assets would invest primarily with funds-of-funds, the much-lauded way for a small institution to participate successfully in private equity. Instead, the pattern among our respondents was to establish a relationship with both venture and buyout firms and to stick with those partners across sequential funds. This was true for all respondents, giving rise to an observation that while manager selection has become crucial to the success of a limited partners’ investments, once a decision is made about a partner, inertia tends to take over. For better or worse LPs stick with the same dance partner. The corollary is that once LPs and VCs part ways they rarely get back together.

We asked our participants to define the allocation of their money in private equity investments by three categories, and then we averaged that figure across all of the responses. For the group, 56% of all private equity is allocated to buyout funds, 34% to venture capital and the remaining 10% to special situations.

Time after time we heard from LPs that they are making more money more quickly and with more reliability in buyout funds than in venture funds. They explained that they think that this as a reflection of the current investment environment: There are more assets available at better valuations to be held and re-sold sooner and at a greater profit than at any time in their memories. But VCs shouldn’t worry too much about this. LPs tell us that they can’t put as much money to work in the space as they would like to because there are simply fewer top-tier buyout funds than there are top-tier venture funds.

None of our respondents expects to see the kind of rapid expansion among buyout firms witnessed in the venture industry. This means money has to flow into venture capital or, in the opinion of a small but vocal group of LPs, into direct co-investments alongside private equity partners. This direction, so-called “special opportunities,” may represent the biggest returns and develop into the most lucrative new trend for all of private equity. The other advantage, LPs tell us with satisfied looks, is, “We don’t pay any fees.”

On the topic of venture returns, none of our respondents expects a repetition of returns on investment in excess of 25%. As a group, our LPs are very conservative on this topic. Surprisingly – and in conflict with their anecdotal comments about their ability to make more money in buyouts – LPs reported in the written survey that they expect a slightly higher return from venture capital. Is this a reflection of the smaller amounts they are investing or does it reflect wishful thinking about profits from VC?

We know from the responses that LPs have suspended fears of any apocalyptic failure in the private equity industry. Only a tiny portion of LPs believes that the asset class will beat returns on public equities by a single digit. Essentially, all LPs believe that private equity returns over the next decade are going to be in the double-digit range. At the same time, no one says he expects a return to the triple-digit returns of the mid- to late 1990s.

That’s a lot of background information to keep in mind as we turn to the eight survey questions about venture funds, but we think you’ll see that these considerations shape many of our LPs’ opinions.

Now about that report card …

Investment Drift

Starting on a positive note, LPs gave their VC partners a solid B in response to the question: “How well do VC funds stick to their areas of expertise in funding?” Apparently, the distress that we’ve heard from LPs about so-called sector drift (VCs wandering outside of their areas of experience) has been blown out of proportion. We asked several LPs about our results and have the sense that after a season of annual meetings, LPs are now reassured that VCs are sticking to their knitting, or, if they aren’t, they’re making informed, considered moves that will ultimately benefit both the LP and the VC.

It’s worth noting that we found a total absence of reports about VCs making the kind of improbable leaps between sectors and stages commonplace in 1999 to 2001 vintage funds. We didn’t hear any horror stories, like VC firms shifting from early-stage applications software development to late-stage funding of “we have to sell this at the CEO level” middleware Internet infrastructure companies. There is not even a whisper of concern by LPs that their VC partners have aspirations about funding entrepreneurs seeking to start the “build-out of communications infrastructure” type companies that used to fill the empty glass buildings along Highway 101 in Silicon Valley.

Sadly, that is the end of the good news.

Write-Downs

We move straight from that high point of “no one is doing anything outrageously stupid amongst our partners” into the realm of pretty good. At the top of that list are the responses to the question: “How well are VC firms doing with portfolio write-downs for ’99 to ’01 vintage funds?” This was one of the areas in which we found the greatest diversity of opinions, suggesting that while our grade C was an average, there is a wide spread of performance amongst VCs.

One group of LPs told us that its partners are failing to write down their bad investments, while another told us that its GPs have moved aggressively, if prudently, to write off their mistakes. The largest group says VCs are performing at the level of fair or acceptable. You might think of it as swallowing really distasteful medicine that you know is going to make you better. LPs are, again, after a meeting season of soothing noises, feeling less rumpled about all of the outrageous Internet and communications mistakes that were made. The good C+ grade given here, after all, is a minimal effort away from an acceptable B, and LPs make encouraging noises about this improving.

Capital Deployment

We now move quickly along the scale from our one “they’re doing A-OK” to a long list of questions in which LPs essentially are not happy with the results they’re being presented with. We turn to the question: “How are VC funds performing in their deployment of capital?” Our respondents gave a very clear C average to VCs on that question.

This issue relates to two questions about fees, but we’ll deal with that unpleasantness later. We heard much grumbling about paying high fees to VCs who sit on hard-earned LP money without making enough smart new investments.

As one LP told a group of VCs at a recent conference, “When I have to go to my CFO and ask him to sell public equities at a loss in order for me to make a capital call for a VC firm, you had better have good reasons for pushing me into going to that meeting with the CFO.” The CFOs are pretty grumpy themselves these days and ask tough questions. PE asset managers in organizations of all sizes know they better have good answers for such questions if they want to keep their jobs.

Communication

Which leads us to the next logical question: “How well do your VC partners communicate with you?” The answers to this question were the single most common point of agreement amongst all of our LP respondents, 64% of LPs told us their VCs perform acceptably. Not exactly the encomiums that we would expect, nor is this what we hear from VCs who tell us that they go “above and beyond” in their efforts to inform, persuade and openly communicate with their LPs.

We’re of two minds about what we heard from LPs on this topic. We’re a bit suspicious that LPs just don’t like the way that GPs are delivering their message. We suspect that a lot of VCs, particularly those from the first- and second-fund generation, lecture their LPs rather than openly discuss what they’re doing.

Given those GPs’ weak results to date, the LPs response is to sit in a quiet, controlled-burn mode, telling themselves that there is going to be hell to pay if these youngsters aren’t right this time around. Given that we found most LPs are pretty tough to communicate with in general, there might be room for improvement on both sides of this question.

Portfolio Valuation

On the subject of portfolio valuation, LPs are about ready to tell their VC children to drop their extracurricular sports. About one-third say their VCs are in deep trouble on this topic, that they’re still in deep denial on assets in current funds and not facing the truth. Many LPs have a bitter taste in their mouths over this issue, and a large number think that the medicine is going to make them worse off not better. We suspect that these are LPs who have realized they’ve made a mistake in their choice of one or more of their VC partners. It’s a safe bet that a fair number of first- and second-generation funds will hear “no thanks” from LPs when they try to raise a second or third fund next year.

Succession Planning

No other question split our respondents as evenly as: “How would you rate VC partnerships in terms of their succession planning?” LPs may be widely separated in their feelings on this topic, but they’re not equivocal. Their VCs are either doing well or they’re failing.

LPs have a high level of satisfaction with VCs that have enunciated succession policies, designated heirs and published plans for growth among associates or just-starting partners. The presence of such plans and policies are more important than the answers to the tough question as to whether the next generation can actually perform as well as their predecessors. LPs appear to believe that half of playing a winning game is in the preparation, not on hoping for the off chance of hiring someone who may, or may not, turn out to have a gift for betting on the right companies.

The unanswered part of this question, the big “if,” apart from the comfort level of LPs, is whether those firms with their succession plans in place can repeat past performance. Lots of LPs wave their hands in the direction of Kleiner Perkins Caufield & Byers, Technology Crossover Ventures and Accel Partners, wondering aloud about the next generation. Inertia is carrying LPs forward for the moment, but we suspect that the success (or lack thereof) from funds of vintages 2001 to 2004 will determine whether LPs will participate in another round for today’s top-tier funds. This is one of the just-below-the-surface issues that LPs are tracking.

The Split

To the question of, “How would you rate VC partnerships in terms of their handling of carry?” LPs offer up a C-. Says one LP: “I’m unhappy about the amount of time I’m spending renegotiating clawbacks on carries instead of making money for my constituents.” He says he has a long memory, too, and he’ll remember the offending GPs when they come back to raise new funds.

It’s not that LPs don’t want VCs to make money. It’s not even concerns about the amount of risk involved. What LPs are asking is for VCs to get “some of their own skin in the game.” They would really like it if the VCs voluntarily adjusted the carry to reflect their success, or lack thereof. And given that a few individual LPs have had to get a second mortgage to make a capital call while the VCs have not, even friends-of-the-family type LPs are hot on this issue.

Management Fees

If there is one topic that, to use the vernacular, pisses off a raft of LPs, it is fees. In a world where differences are settled amicably, quietly and behind closed doors, no other issue prompts LPs to be so vocal, albeit off the record. Our respondents gave VCs a D+ when asked about fees. LPs are prepared to have their VC partners keep their powder dry until they have better opportunities. They are downright vitriolic, however, when they have the idea that their VC partners are getting rich from managing LP money. Top-tier firms have all made the appropriate sounds of appeasement on this topic, and the very best simply don’t make their money this way; they don’t charge fees until all the counting is done. But class acts are in short supply in this arena. Many of the worst offenders are among the first- and second-fund firms, but there are many fourth- to sixth-fund firms whose offices would be more austere if they weren’t raking too much off the top of their partners’ money. Heavy six figure salaries are, in the eyes of the LPs, grossly inappropriate.

A big factor that VCs need to consider on this issue is the expansion of public and private pensions and endowments into private equity. Consider the civil servant who earns well under $100,000 a year going to a meeting on Sand Hill Road and parking his Ford Taurus between a Porsche 911 GT2 coupe and a big Mercedes-Benz CL600 sedan. Even after the bubble, life is so good for so many VCs that they have little real perception of the none-too subtle messages that they convey in the ordinary course of their day-to-day conversations. And that is among the mature, first-generation VCs that one LP describes as the people who have “called in to work – rich.”

Then there is the younger generation VCs, the Gap-clothed consumers of $600 to $2,000 bottles of obscure vintage wines who have suspiciously low golf handicaps and look just a little too happy in their exotic vacation photos. These 40-somethings, in particular, prompt loathing among middle-income managers of pension funds and endowments.

Summary

The gestalt at the end of the day is that we’re left with the feeling that LPs are damning their partners with faint praise. They know that venture capital is the best, albeit most high-risk game in town. Over the last two decades they have developed a comfort level with that. Over the 1990s, in particular, they grew accustomed to double-digit returns on their money or better from their venture capital partners.

The relationship was at the wedded bliss stage. Then a bunch of MBA’ed 30-somethings showed up at the party and started to tell veteran institutional money managers how things should be done. Now, of course, the luckiest of that crowd are either living off their ill-gotten wealth or wondering how they’re going to make a real living wage when this VC gig goes fatally south. More troubling to the LPs is that a lot of the 60-something, first-generation VCs who also participated and benefited from the late 1990s boom and bust are simply beyond getting upset over the whole affair.

If truth were told, a lot of LPs are beyond it, too. Many of the LPs parent organizations are so large and have suffered such big losses in public equities that their losses in private equity pale by comparison. Asked about a VC’s loss of more than $100 million on an Internet deal, one LP told us that he would overlook it if the VC could make a convincing case that it was an honest mistake and he wouldn’t do it again.

After all, LPs have this year’s allocation to private equity to invest, and the reasons that made them chose their partners still hold true in most cases. Mutual respect runs deep between these two groups, despite the painful and long-lasting bruises from the last several years. Provided that things turn around, we’re not going to see any drastic changes in the parent/child relationship, despite some grim faces around the dinner table when they look at that report card full of Cs and Ds. LPs love their children and they believe (or want to believe) that the children are going to turn out all right and take care of them in their old age. But that doesn’t mean they aren’t going to stop watching their every move.

For a graphical representation of the GP Report Card, check out the October print edition of VCJ, pages 32-39.

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