Crowded Market Has LP Looking Off the Radar Screen’ for New Funds –

Mike Kelly started Hamilton Lane’s venture capital business unit in 1999, left it in 2001 to focus on the client side of the business, then rejoined it earlier this year. Having a long history as a limited partner in venture capital and private equity, Kelly has a long-term view of the industry. Before joining Hamilton Lane, he served as a financial analyst for InterMountain Canola. While he’s never one to turn a blind eye to a new venture firm with promise, what he sees today is a venture capital industry still crowded with too many players and not looking after it’s own health very well.

VCJ: What aspects of being a venture capital LP most concern you today?

Kelly: One is getting sufficient access to the best opportunities, however one is to define those. We would look at a combination of trying to get into brand name established groups as well as trying to find unique first-time opportunities. The other area is an assessment of performance. Whether it’s looking at your current portfolio and trying to benchmark how you’re doing relative to something else, or when evaluating a new opportunity trying to get a handle on whether or not the performance you’re looking at is good relative to other opportunities you’re seeing.

VCJ: Is it harder for funds-of-funds to get access to the best VC funds today?

Kelly: For some institutions, whether it’s a big fund-of-funds vehicle or a big public pension fund, opportunities to get good access to good venture funds is very difficult. With fund sizes going down and a long history of LPs having been there with the well-established funds and lots of new institutions coming to the marketplace, there’s a lot of competition to put a lot of money to work into a small space. Venture will always be an important part of the financing spectrum but will likely remain in a pretty small space as well. It’s just different from the buyout size. Either you have a long, established relationship with a group or you’re bringing a unique advantage as an LP to that group, as far as trying to crack into the big, established names.

It’s also important to try to find new groups that are off the radar screen and try to build those relationships. There are groups that we’re looking at in the process, but it’s early on. We haven’t put a lot of money to work in venture over the last couple of years, I’d say, despite a lot of groups coming to market raising funds. We’re still seeing hundred-plus trying to raise money every year. I’m not sure how many of those are successful though.

VCJ: What is it about an up-and-coming venture firm that makes it worthy of your attention?

Kelly: The core areas we’re looking at are the team, the strategy and the track record. Within the team we want to have a skill set that combines venture capital investing with operating skill sets. You want somebody who understands both what it’s like to be an entrepreneur as well as what it’s like to deal within a pretty large corporation and know how they work, how they buy products and how they make decisions internally. A large part of what you are betting on in a developing venture group is the team, how they make decisions and how they will remain cohesive and develop as a firm.

Most of the time what you see when a group implodes is not that they couldn’t find good deals but that they couldn’t deal with each other, basically. They can’t build a sustainable organization. You do also want to see that they’re investing alongside other established groups and that they’re in the deal flow and that they have relationships with groups, so that on subsequent rounds they can also bring in the right players.

VCJ: Do you expect there will be a significant die-off among venture funds?

Kelly: You’ll continue to see that. There are too many venture funds now, but it’s a slow dying-process. Groups will continue to seek to raise a new fund and either never raise it or raise a smaller amount and kind of limp along for a long period of time. You’ll continue to see individuals spinning out of firms-both new firms and pretty established ones. You’ll even see some brand names disappear at some point. It’s just a matter of how long it takes. It will take, who knows, another five years maybe, for the overcapacity to work its way through the system.

VCJ: Does the current flurry of IPOs present the danger of another bubble developing?

Kelly: What’s going to determine the bubble is the fund-raising side over the next 12 to 18 months. Institutional investors are often targeting a number of funds that they view as the groups they need to invest in. Given the shrinking fund sizes and limited access, when they can’t get a substantial amount or any amount in those funds, the question becomes: What do they do? If they drop their standards to just invest in virtually any venture capital fund, groups will get funded that shouldn’t and they, in turn, will chase deals that shouldn’t get funded. And you’ll see the same cycle we saw five years ago.

If, however, the LP side shows some restraint and just invests fewer dollars into venture capital, then there will be less of an issue for a bubble. I suspect there will be some significant run up in the short run at least. There are still venture firms out there that have capital to invest in what is likely their final fund. They’re going to try to chase some deals they probably shouldn’t. You hear now about certain companies in some certain spots getting bid up at some pretty high valuations but it’s not as consistent as what we saw five years ago.

VCJ: Will top-tier firms continue to freeze out public pension funds over disclosure issues?

Kelly: It will happen. It won’t be consistent. A lot of that has played itself out. Some venture funds will take the position that they can choose among a broad range of investors so that if they don’t want to disclose anything they won’t. A broader number of groups will take the position that the disclosure issue is unlikely to go any farther than it is now, that no one is going to be forced to reveal portfolio company information. Most groups will take the position that it’s a normal evolving part of where the industry is maturing and that people are going to have to understand how to deal with it and most will find a way to deal with it and not just bounce people automatically. There will be a number of people that will just because they can.

VCJ: What new ways are LPs looking for to assess venture performance?

Kelly: One of the big issues is if I’m looking at a new fund, everybody has this big black hole for the past five years as far as performance. Rather than try to figure out if negative 30% is better than a negative 40%, what people are trying to do is understand the investment process and thought process to make sure they understand which groups followed their strategy and just got caught up in an awful time vs. groups that went and did dumb things, made bad investments and strayed from what they know.

Groups that had always been investing in telecom stuck with it and there wasn’t much they could do; they got hit by that bullet. Groups that had never invested in telecom that jumped in or groups that had invested in telecom and then switched to Internet investments showed a lack of discipline that makes you worry.

Venture’s a lot more difficult to apply metrics to than corporate finance. One of the things you look at is do you just do a public markets proxy and try to determine how much you can expect from venture based on what’s happening in the NASDAQ world? We internally are looking at a variety of different options to come up with some customized metrics that our clients can use and, therefore, bring more value for when they are presenting to their boards or CFOs who can look at the public markets. We’re starting to roll those out to our existing clients and over the next six to 12 months we’ll continue to provide new products.

VCJ: How has your client list changed over the past four or five years?

Kelly: Our client base has both grown and diversified. In the early years of our existence we were almost solely public pension funds. We’ve expanded to corporate pension funds, foundations and endowments, the unions. Actually the bulk of our client base right now is non-U.S. institutions. I think we’ll see the vast majority of growth come from outside the United States given that most of the institutions that would likely be private equity investors in the U.S. market already are. So what you’re seeing is more of a transfer of market share when you get a new client here.

VCJ: How are your non-U.S. clients geographically dispersed?

Kelly: Probably more in Europe, but we also have clients in the Middle East and Asia. Europe is probably the biggest growth area at this point just given the interest from groups there to invest here in the U.S. and there being more similarity between there and here. We do have a fair amount of activity in Asia and the Middle East.

VCJ: Are you more interested in first-time funds than you have been in the past?

Kelly: It’s probably the same. One thing that’s interesting about us is that we’ve always looked at first-time funds. Our original mandate was to look for new and unique opportunities. We cut our teeth on learning how to evaluate first-time funds, which is a lot different. We always look at first-time funds and probably do between one to three a year broadly across private equity.

VCJ: How has the composition of a new venture capital firm changed?

Kelly: There are more people who want to become venture capitalists, so you are seeing both people spinning out from existing venture funds as well as a fair number of people coming from either the operating side or the investment banking side. A lot of people are coming out of the operating side.

We’re seeing a lot of life science funds being raised by former executives at pharmaceutical companies and M.D.s coming together. On the IT side we’re also seeing a fair number of entrepreneurs. We’re seeing groups that are one-man shops to two or three people getting together.

There are surprisingly more first-time funds that we’re seeing now than we were seeing previously. It was surprising how many we saw in the 2001 to 2003 time frame when the environment was pretty awful for fund-raising.

VCJ: Are the presence of so many new funds going to be good for the industry?

Kelly: No. Some of them will ultimately be good groups but I don’t think the industry can support the enormous number of groups that are looking to raise capital.

VCJ: Why are so many still trying to break into venture capital if the industry can’t support them?

Kelly: Part of it is that it’s such an interesting and exciting place to be. Successful entrepreneurs are looking for their next challenge. Everyone believes that they’ve got a unique angle and something special to bring to the table and if you haven’t been part of the industry it’s hard to understand what the LP mindset is or what truly is a unique angle.

People for all the right reasons in their own mind are looking to create something new and unique. When you’ve looked across the landscape for a number of years you see the opportunity and may not see something new and unique.

Mike Kelly

Born: New Jersey, 1966.

Education: Bachelor’s, Trenton State College, 1988; MBA, the College of William &

Mary, 1991

Work History: InterMountain Canola, 1991-1994; Hamilton Lane, 1994-present.

VCs Worked With: Austin Ventures, Columbia Capital, Morgan Stanley Ventures, NEA, Oak, Prospect Ventures Sevin Rosen, TL Ventures and others.

Personal: Married (Gretchen) with one son (Kyle).