Sometimes when you go fishing you end up with a catch that leaves you scratching your head.
We trolled the waters of limited partners for the second year in a row to find out if their opinions about the folks investing their money had improved. They didn’t. (See pages 32 to 36 for this year’s Report Card.)
But that wasn’t the thing that surprised us. It was the response to the following question: “Did you participate in a new fund being marketed by an existing manager in the past year?” A stunning 32 of the 42 LPs who took the survey said they turned down at least one existing partner trying to raise a new fund.
We weren’t sure how LPs would respond to the question, which we asked out of simple curiosity more than anything. But we certainly didn’t expect 76% of them to come back with a negative response. (See Figure 1.)
And this is from a very diverse group of LPs, including governmental organizations, pension funds, corporations, non-profit organizations, insurance companies, funds-of-funds, financial institutions, endowments and foundations. (See Figure 2.)
Considering that more than 65% of our respondents are involved in 50 or more different investment funds (see Figure 3), that means that several hundred venture firms are not having much success raising new funds at a time when, in the words of one
fund-of-funds manager, more than “half of the venture industry is out raising a new fund.”
“There are people out trying to raise money-like one group I know that has been fund raising for over a year now-that just shouldn’t be out there,” an LP tells us. “They just don’t know what they’re doing.”
LPs are not merely telling us that they perceive that VC firms are performing poorly. That opinion is translating into more of them choosing to say “no” to fund-raisers, even if that means ending a longstanding relationship.
And they’re not just dissatisfied with existing managers. In our quest to find LPs to participate in our survey, we were confronted several times with voice messages directed at anyone calling about a potential investment: “We don’t accept phone solicitations for investment.” Being told don’t let the door hit you on the way out is one thing, but finding that no one even responds to your knock is a cold, hard reality that first- or second-time fund managers are facing.
The fact that so many LPs are turning away some portion of their existing investment partners is extraordinary for two reasons. The first is the industry-wide perception that LPs are, as a group, very deliberate folks who apply rigorous due diligence when making investment decisions.
Queries by top-decile firms, of course, are an exception. “When Sequoia calls to ask for an investment for their new fund, your due diligence takes about the length of the phone call,” says Alain Vandenborre, a director at Hamilton Lane.
But for the most part, LPs tell us that it takes several months to a year before they decide whether or not to initiate or even renew a relationship. Ernest Lambers, a senior investment manager for AlpInvest Partners, one of the world’s largest LPs with around $180 billion in assets, describes his firm’s assessment methodology for investing in new funds as a long process. The length depends upon the quality of the information available from a VC firm’s general partners, he says. It starts with an email and then moves forward in a formal evaluation that takes anywhere from three to six months. The outcome of that evaluation may result in actual face-to-face meetings with GPs.
“And once we make such a decision we tend to stick with an investment partner over the long haul,” says a manager of government assets.
To hear that so many divorces are occurring in the industry after such deliberation appears to explain the fair to poor grades that LPs gave to general partners in this year’s Report Card.
The second reason we were surprised that so many limited partners are turning away existing managers raising new funds is that we constantly hear that the universe of LPs is growing, with more pension funds and other asset managers trying to expand into PE for the first time. Our participants confirmed this perception when they said that, as a group, they have increased their allocation to private equity as an asset class. The average allocation, calculated as an average for all respondents, went from 8% in last year’s survey to 8.5% this year. If they’re saying “no” to so many existing managers, where, one is compelled to ask, will they find more capable partners? Especially given that so many top-quartile funds have decreased the size of their new funds.
It made us think of the many times during our phone calls when LPs told us that they were getting out of private equity. Perhaps one out of 20 calls resulted in such a response. Presented with this conundrum, we decided to go back to our LPs and ask what’s going on. We got several different (and surprising) responses.
When we first called the manager of alternate investments at a state government, he told us that he couldn’t help us because his organization, which at one time had an impressive list of VC and buyout partnerships, was winding down its work in private equity funds. We thanked him and quietly went our way. When we called months later to ask what had happened, he said that, “We had a 5% cap on our allocation to private equity back in 2000 and we exceeded that cap.” When that happened the government changed the legislation and reduced the cap to 1%, in an effort to ensure that the cap wouldn’t somehow be exceeded. At that point, he told us, “We had to ask ourselves whether, realistically, we could participate in private equity.” He said that his organization would like to continue working in private equity, but beyond really liquid forms of PE, such as hedge funds, there wasn’t much opportunity for his group to work in the field given its tight statutory restrictions.
Another LP, a major financial institution, told us, “We are in the process of shifting our investment approach in this area to funds-of-funds and discontinuing our historical strategy of direct partnership investments. As a result, our portfolio of direct partnerships is in the process of natural maturation. I expect at least 50% of the funds to mature in the next five years. And, to be perfectly frank, there was not a very thoughtful process applied to its original construction, hence our move to funds-of-funds.”
Those surprising comments fly in the face of the stories we so often hear about maturing investment organizations that pass through funds-of-funds on their way to building their own internal investment management organizations. Apparently some are maturing their way out of private equity, at least as direct investors in venture funds.
A third LP (a pension fund) said he couldn’t participate in this year’s Report Card because, “While we do have some existing, established relationships, we no longer invest in other funds. Instead, all of our focus is on direct venture investing.” We heard this two times.
Finally, we heard general comments from LPs that may explain both their general crankiness about private equity investing and their generally poor outlook on fund mangers. Says an official at a large fund of funds: “The problem with write-offs is ongoing, and we’ve got a long way to go yet.” He was referring to an undercurrent of rumbling we’ve heard since last year from several of the most experienced LPs to the effect that the bad news from most funds investing in vintage years 1999-2001 is that the bad news has yet to be reported. A representative of a multi-billion dollar financial institution says simply, “I refused to participate in an existing fund manager because they had so many struggling companies” in their previous fund.
The best venture firms are way ahead, having already cleaned up their bad Internet investments. These firms know how to bury their bad news by shooting the guilty early or by merging their stinkers into other companies and walking away. But, based on responses to our survey, many LPs are in the midst of learning just how badly the bottom 50% of VC firms-many on just their first or second fund-are likely to perform when the final numbers come in. The return on investment for those funds may come in at a few thin dimes or even pennies for every dollar that an LP surrendered to the fast-talking young men and women from funds focused on the Internet, optical components and telecom.
Other Survey Findings
There were four other interesting general trends that emerged from our research. The first is a general increase in the amount of capital allocated to venture funds. (See Figure 4.) While buyout funds continue to dominate private equity, LPs in our survey increased their allocations to both venture capital and special situations at the expense of buyout funds in the past year. We interpret this as LPs telling us indirectly that venture capital is recovering from the doldrums of the Internet era.
A second general trend-and again somewhat worrisome given what we’ve already said-is that at the same time that LPs are facing problems with past funds, their expectations of returns from future PE funds is creeping upward. The expectation about venture capital returns this year shows a gentle increase, but an increase nonetheless. (See Figure 5.) And that cheerier outlook comes at a time when venture firms are already, in the words of one VC, worried that LP fund managers are making promises for fixed percentages of return to their managers. That’s something most VCs see as tantamount to professional suicide.
Similarly, the expectation for higher returns from buyout funds is gently increasing. (See Figure 6.) The bulk of the expectations lie within the 10% to 15% range. And, despite the relatively larger amount of money going into buyout funds, some LPs are now expecting returns of 20% or more from their investment managers. These rising expectations are a cause for concern. One has to ask what justifies such an increase in confidence.
Finally, we asked LPs how many of them expected their fund managers to invest LP money in China or Europe. (See Figure 7.) Once again, the answers from LPs surprised us. Most said they were more interested in general partners increasing investment in Europe than in catching a fast boat to China with their money. “China is so volatile at present that the risk of China-focused funds isn’t justified,” says Chris Mead, a partner at Pantheon Capital in Asia. “The actual returns from Chinese investments to date are so low that at present it’s almost better to sit and wait for the situation to improve.”
Based on our research, we think it’s fair to say that LPs are becoming more sophisticated, methodical and demanding of their role in the LP/GP structure. At the same time, it isn’t clear exactly how much science and how much magic goes into their manager selections.
Respected LPs told us repeatedly that, “manager selection is everything.” And yet they confess that the data they receive about fund performance is “really bad.” “I’ve seen IRR calculations that are [entirely works] of fantasy,” says Urs Wietlisbach, co-chairman of the Partners Group, a multi-billion dollar fund of funds.
If the data are that bad, how can LPs select the best managers?
LPs appear to have accepted the fact that they need to place a lot of bets in order to end up in the money. Limited partners “are investing in emerging managers because we have to,” says Andrew Lebus, a partner at fund of funds Pantheon Private Equity. “And we have to assess our relationships with more established managers.” Partners Group’s Wietlisbach agrees, saying that LPs must back first-time managers if they want to “catch the second and third funds of new managers” that turn out to be successful.
If LPs are to be believed, they are increasingly turning away existing managers trying to raise new funds (remember the 76%?) and they are more willing to roll the dice on unproven managers because there is at least some chance that they will be successful.