The venture capital industry is at a crossroads. Valuations continue to plummet, sizes of financing rounds continue to shrink and exits appear fewer and farther away. Aware of these trends, limited partners have forced venture managers to reduce the size of their latest funds in an attempt to bridge supply and demand in the market.
LPs are also paying close attention to succession planning in their venture relationships, often engaging closely with the managing partners in fund downsizing and partner selection. Beyond these well-publicized trends is a dramatic change in the attitude and behavior of leading institutional LPs. Aware that even drastic reductions in fund sizes and partner ranks may not restructure their venture teams in ways that will return them to top-quartile returns, LPs have started to once again focus their attention on the next-generation of venture managers who are likely to provide them with returns worthy of the risk in the asset class.
In 2001, as the venture industry entered its current slump, LPs turned sharply away from newer venture firms with the belief that only “high roman numeral” funds would succeed in the challenging days ahead. As the thinking went, a combination of brand franchise, experience and deal flow would allow only the long-established venture firms to navigate the rough waters ahead to deliver returns. As allocations to new venture relationships grew scarce, institutional decision makers enjoyed a safer decision by endorsing established firms instead of yet-unknown firms. The old adage of “you can’t get fired for buying IBM” applied to LPs as much as it did to corporate IT buyers a generation prior.
By 2003, this sentiment began a steady reversal. LPs have recently discovered structural issues in established firms and are shifting their attention to emerging managers who may hold the keys to successful returns during the next cycle. Perhaps no institutional investor illustrates this trend more clearly than the Harvard Endowment. This leading venture investor, which first became active in the asset class in the mid-70s, has backed some of the leading names in venture and continued to support these groups fund after fund to the exclusion of newer managers. However, since 2001, Harvard has made only two publicly announced commitments to venture, both to first-time, emerging manager funds.
Many other leading LPs have followed suit. The California Public Employees’ Retirement System (CalPERS), via its relationship with Grove Street Advisors, has followed a similar strategy, increasing its asset allocation to emerging managers, sometimes to the exclusion of more established groups. Today, this trend seems irreversible.
Emerging manager firms are generally defined as those investing from a first- or second-time fund, limited in size to about $100 million or less. Emerging manager teams generally lack a group track record (that is, a track record derived on the same platform by the same people), but they bring individual track records built from institutional investment experiences elsewhere. Emerging managers generally bring several years of venture deal experience built on platforms where financial compensation may not have been commensurate with the partner’s investment track record. These platforms generally include larger firms or corporate investment groups.
Hungry Like the Wolf
The assumption is that while these managers have built their experience, deal flow, relationships and process in the tutelage of other experienced investors, they still maintain the hunger required to deliver returns in the future. Stated simply, these managers have gained enough experience but have not yet made enough money to dull their hunger and ambition.
Most LPs maintain a narrow definition of emerging managers. In an attempt to define themselves as emerging managers with successful track records, high-net-worth investors, operators or entrepreneurs sometimes present a prior investment track record built on the success of small investments made in several successful startups. They synthesize a portfolio of such investments as their “Fund I.” LPs generally understand that such a “portfolio,” even if financially successful, does not adequately represent the discipline and experience built on the basis of traditional limited partners. While technically defined as emerging managers, such managers are unlikely to enjoy the discipline, process, and transparency required to invest fiduciary money on behalf of other LPs.
Marketing the Past
A more difficult definitional filter applies to emerging managers of spin-off groups. Here, a team of successful venture capitalists is marketed as an emerging manager because their fund technically qualifies as a first-time fund. A notable example is Redpoint Ventures, formed by experienced managers from Brentwood Associates and Institutional Venture Partners (IVP). Occasionally, a powerful new team will seek to qualify as an emerging manager in order to attract the attention of limited partners who seek asset allocations to such teams. Again, most LPs generally understand that while the team and fund are new, the historical and financial success of the individuals may act as an impediment to the element of hunger that LPs desire in a team.
Today, LPs seek emerging managers that combine investment and deal experience, a solid and attributable deal sheet, experience in managing institutional LPs and hunger for success in the challenging days ahead.
Attributes of Success
Interest in the performance of emerging managers is not new but quite well documented. Empirical studies since the mid-70S demonstrate quantitatively that newer teams investing out of their first or second fund statistically outperform the returns of their older and larger peers. The reason for this trend is fairly intuitive. Like the operating companies that the funds themselves back, emerging managers are startups in their own right. Taking advantage of focus, small scale, and entrepreneurial ambition, they seek to deliver returns that outperform those of their larger and older rivals. Because of its inherent structure, the venture business naturally rewards smaller, more focused groups.
As the last few years have demonstrated, venture firms cannot scale geographically or financially without challenge. The venture process, more art than science, relies on small teams, practicing the craft of working with entrepreneurs, professional managers, venture firms and corporate partners to achieve success based on breakthrough ideas. This craft does not successfully scale. Smaller, focused and hungrier managers are more likely to outperform their older rivals that have already achieved financial success. Up until the mid-90s, successful venture teams were made up of three to four partners and small funds, which rarely exceeded $100 million. As the market has returned in every way to that period, LPs are seeking to find emerging managers who can demonstrate success on that size platform.
As a counterargument, some cite the consistent return history of established firms. However, the data does not support the “lasting franchise” that many assume in older firms. In fact, 87% of the VC firms with at least four funds produced a top-quartile fund for only two of those funds (see chart, next page). Just 4% of those with six funds or more produced top-quartile funds for only three of those funds. It would appear that venture firms don’t scale in either size or duration.
How To Pick a Winner
How should LPs select emerging manager teams? More importantly, how can LPs select emerging managers who are likely to sustain performance across several future funds so that the LPs feel confident not only in the financial performance but long-term relationship with these teams?
In many ways, selecting and backing an emerging manager is similar to selecting and backing a first-time entrepreneur. The objective is to back managers who are fanatically dedicated to their craft, have the relationships and experience to be successful and who are motivated to be activist investors and company builders in their portfolios.
Determining track record is fairly trivial. Calculating IRRs based on past performance is equally simple. The challenge for limited partners is in determining the level of activism, work and hunger that the emerging managers are likely to exhibit.
For this question, a basic understanding of personal motivations and portfolio company involvement is critical. Is the manager informed of the daily progress and events in every one of his or her portfolio companies? Is he or she aware of the key customer or partner meetings taking place this week in every portfolio company? How many in-person board meetings has the manager missed over the last 12 months? When was the last time the manager had an informal dinner with each of his or her CEOs, vice presidents or directors? How many times has the manager replaced a CEO or vice president? How active is the manager in driving board decisions? Are any of these functions performed by others in the firm, such as principals, junior partners or associates?
Determining personal motivation and hunger requires a dialogue with the manager. What is the manager’s personal vacation policy? What are his or her hobbies and interests? How many homes does her or she own and where are they located? What motivates the manager every morning? What does he or she consider to be the appropriate level of financial success? If they lost their current position, how long could they go on without working? These personal insights help point to the level of motivation and hunger for professional success in the difficult craft of venture capital.
As the asset class stabilizes to normal returns, those without hunger and a deep passion for the craft are unlikely to deliver the hard work and effort required to produce top-quartile returns. By using the framework suggested here, institutional LPs can try to distinguish emerging managers motivated to deliver above-average returns in the next cycle.
Bart Schachter is a founder and managing partner of Blueprint Ventures and George Hoyem is a partner at the firm. Based in San Francisco, Blueprint is an early-stage investor with $200 million under management. Shachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software and communications semiconductors. Hoyem’s investment focus is software, wireless, security, and other IT and communications infrastructure companies.