L.P. Confidential: – Continued –


VCJ: As these 2000 funds continue to be invested, are you asking your GPs more questions?

Paul: I think we’ve always had a high level of scrutiny with the venture fund managers, and we’ve always been really involved. I don’t think it’s really changed for us, although I believe that other investors who were less active and less knowledgeable about the asset class have stepped up their monitoring efforts.

John: The world has changed pretty dramatically, and I think the fundamental issue really is how the GP communicates to the LP. We have a fund that historically was running 30% to 40% health care and laid that out in its 1999 offering memorandum. We invested, but when we came back and looked at it a year and a half later, it had put only 5% in health care and the rest was now in B2B. In hindsight, it was a terrible investment decision, but it was made worse by the fact that they didn’t really talk to us about it until we found out what was going on.

VCJ: Part of that is that venture funds are notorious for their lack of transparency. This issue came to a head when CalPERS put its portfolio performance figures online for everyone to see.

John: But what happened to CalPERS was totally an accident. [The PR people put an investment report from the board meeting on the Web], since anyone can sit in the meeting while the package is discussed anyway. The investment staff didn’t realize it until some people started complaining and the articles came out. As soon as that happened, they pulled it off.

There are two different issues with transparency: First, do we know what’s going on when we invest in a fund? The second is, do we have to in effect publish that to the Web? And I don’t think there is any benefit, or compelling reason, to publishing reports that NEA wrote down an investment in such and such a private company.

VCJ: Don’t people who pay into a pension system have a right to know how NEA is performing since they are the primary investor in NEA’s fund?

Richard: That’s why pension funds elect board members with full discretion and [access to information]. There is a lot of value in keeping the private markets private.

VCJ: Can a third party ever formulate accurate venture return figures?

John: I think the only way you could do that is if the LPs of the world ganged up and exchanged data. At least then you would get an accurate picture of what the GPs are reporting. Getting there is not trivial, and I’m not sure it ever will be. I think that’s the only way to do it. You can’t do it by sending surveys out to VCs. The problem is that if you did it for the top 50, the price tag would have to be that you would give the data back to them for free, and you’ve just torn the guts out of three-quarters of your business.


VCJ: Has a lack of VC transparency ever become problematic for you?

Paul: I think there have been some funds that initially tried to pretend the world hadn’t changed, but it became so clear that the best strategy to work with LPs was to be up front. It doesn’t do you any good to lie to your LPs today and then try to raise money two years from now.

VCJ: Could some funds be lying because they just don’t plan on going back for another fund?

Richard: There are some, but I think they are in the minority. They tend to be smaller, newer funds that are struggling. I think it’s more along the lines that they realize they aren’t going to make it. We even have one that we’re suing for fraudulent activities.

John: The closest we came to a litigious situation was when we invested in a team that was part of a larger organization because there were some synergies, and the team ended up having a falling out with its own organization and the organization tried to fire the team. Fortunately, we had put some language in the agreement that they really hadn’t paid much attention to, so we were able to say to the large organization: “Do you really want to do this, because you’re never going to get another penny.” It was really all a function of a pissing contest between the team and the guys who felt they put the team in business.

Richard: The case I have is far more blatant in that they basically can’t adequately account for all the money they’ve taken down. This is a small fund that no one here has ever heard of-two people, $20 million. Soon they are going to be out of business and maybe in jail. For us, we just want to get our money back if possible.

VCJ: One major private equity lawsuit involves an alleged misuse of crossover funds. Do you get nervous investing in such vehicles?

John: There are a lot of good venture firms that have some clear policies who know how to do it. Generically, the question is: “Do I trust the GP to put more money in the existing company that he knows more than I trust him to invest in a brand new company?” I think it’s interesting because they can commit a better investment decision on the company they know. So, the answer is, yes, I’m very comfortable with the crossover investment as part of the fund.

Paul: I agree with needing a clearly defined set of conditions, but the data we have shows an opposite conclusion in that maybe VCs are too close to their older companies and that performance in crossover investing generally has not been as good as stand-alone portfolios. We generally prefer firms that don’t do it, but nevertheless we do sit on some advisory boards, and we just make sure that everyone follows the conditions and that no one fund is being treated preferentially.

George: In today’s environment, I think the risk is that oftentimes the new fund coming into the deal should be diluting or almost washing out the prior fund’s investment. So the manager is very conflicted because on the one hand, he’s managing a fund being diluted, while on the other hand, he’s also the one driving the dilution. That’s why we prefer to not be part of it. It’s kind of like one fund is selling a deal to the next fund. But if it’s such a great deal and can provide such a high return on investment, maybe the original fund should hold onto it.


VCJ: Speaking of selling, should we expect to see any of you shopping deals on the secondary partnership market?

Richard: We have routinely sold positions in our partnership portfolio over almost all of the years we’ve been in business. These are generally non-performing or non-conforming funds, and my guess is that there will be more of those over the next couple of years due to the psychological factor taking place. There will also be a flight to quality here, with a lot of not-so-certain LPs basically saying, “Get me out.”

Paul: It is interesting to see that there is a constant 3% or 4% turnover of positions, and when you multiply that against a much larger base of capital, you will see much higher volume. The issue that’s going to be talked about is that valuations over the last six to eight quarters have been falling, so even aggressive buyers who have been taking value positions over the last six or eight quarters may watch their stakes go underwater. It used to be that a person bought a secondary position and then took an immediate write-up, but those have now become immediate write-downs. I think the returns on some of the recent secondary-only funds are not going to be as attractive as they were five years ago.

George: I know that there is a major financial institution that has been trying to pare down its portfolio by either selling off some of its fund positions on the secondary market or through some sort of securitization deal, but I can’t figure out why some people have had success with securitizations and others haven’t.

VCJ: Has anyone been really successful with securitization?

Richard: I think that the market is still finding itself a bit on that. Lazard has a huge securitization program, but I don’t know how it’s doing. In general, I still think people would rather do straight secondaries since they are a known quantity.

John: We’ve had the option of doing secondary sales for one of our major clients and have chosen not to -primarily because the people who I think have done the best job of it historically were not people out buying big portfolios. They know something pretty well and just buy when a piece becomes available. You can really make good money off of that, but it’s not a valid business because it’s so hard to do it in volume. Most of the people who are best at these secondary deals buy positions that are two- to five-years old. But the people that are trying to get out now are people that are trying to get out while the funds are still relatively young.

Paul: We’ve seen situations when we clearly say, “Yeah, we’ll buy. We’ll take your existing positions for free and relieve you of your obligation.”

Richard: And you just meet the capital calls?

Paul: Yeah, we’ve actually had some people pay us to take their positions. They weren’t bad positions, but the investors were just that desperate.

John: I don’t understand, though, because they’d be in the exact same position if they just stopped sending money to the GP.

George: Well, it eventually gets whittled down with expenses and you could get hit with legal problems.

VCJ: Would securitization open the venture market to new investors?

John: It might happen, but I think it would be disastrous. The fact is that there is enough money in the private industry from current sources, and it would not be good if someone opened a huge floodgate of other sources. Josh Lerner and those guys at Harvard have a very sophisticated asset allocation risk analysis model that says that if you’re not worried about liquidity in your institution, put 100% of your money in private equity. It’s completely accurate, except that if the entire industry behaved that way it would no longer be true. So if someone suddenly showed up and pumped another $150 billion into the private equity industry, I don’t think it would be a good thing.

Richard: There’s probably already $75 billion too much in there already.

John: You certainly hear it from the endowments, which are furious that the state pension funds are taking up such a large part of the venture industry, because the endowments used to have a lock on it.

VCJ: Is there a new frontier for endowments wanting high-risk investment opportunities?

Richard: Nasdaq.

Paul: Endowments tend to be the leaders in that they were the first institutions in private equity, the first in hedge funds, etc. Ironically, the state pension funds are more stable sources of capital because they don’t have the same liquidity risks-and they are certainly far more stable than the corporate pension funds, which have their own sets of problems. I think the state pension funds are here to stay because you do not see them backing out.

Richard: I think that we’re going to see more and more dollars concentrated into fewer and fewer hands. There is probably a tidal wave of opinion that private equity doesn’t scale, but it’s horse-puckey as far as I’m concerned. It’s because people haven’t figured out how to scale, and once they do I think you’ll see a lot more money concentrated in fewer [private equity] firms. I often roll out a model that basically takes a large mutual fund management company and translates it onto the private equity sector. You’ve got a lot of small, relatively autonomous decision-making teams under a big umbrella providing back office support.

Paul: Do you see it becoming more of a horizontal mix, where there might be a manager for private equity, a manager for hedge funds, for small caps?

Richard: I see it more as [a private equity firm] having five IT teams and three health care teams and others all under one umbrella competing with one another.

John: Take some of the very big groups and that’s where we’ve seen the instability because some of the best new teams are the spinouts. We’re looking at a new group right now that will be front-page news out of Europe in which two-thirds of the next generation of a top team is spinning out. Why? Because they want to run their own firm today and don’t want to wait 10 years. And we’ll write them a big enough check to help them do it.

Richard: Well, there may indeed be some out there, but I suspect that as some of the younger guys get a fuller taste of fund-raising, they’re going to change their mind. They’re going to realize that they have a group that does everything for them, does the marketing for them.


George: One aspect of the business we didn’t talk too much about is distribution. This could change a lot in the next five years with a lot of people trying to access a scarce commodity. Who are going to be the people who provide this access? When I started in this business I was always being told about the “dumb LPs,” but the questions these people are currently asking in investor meetings are pretty intelligent.

John: I think people actually think the fund selection business is easy. You know the investment banks say, “We can just hire a couple of bright guys to do it,” or, “We’re a pension fund. We can just take a couple guys from our treasury department to do it.” If you look at the traditional gatekeeper model and the non-discretionary relationships these guys have, you see that you’ve got $2 billion or $3 billion a year being put out by a team being paid a $1 million retainer, and that’s it.

VCJ: So is it easier for private organizations to pick people off from pension funds?

Paul: Based on just what you see in movement, I’d say the answer would be, yes. We see a lot of people moving from the pension side to what they call the dark side [i.e., private institutional investors]. They move from the good to the bad. That seems to be the trend. You see less people going the other way.

John: In the fund selection business, longevity in this business is a really useful thing: the history of the relationships, the ability to watch the cycles, the ability to watch how things develop and come and go. If you go look at Yale, they have had the same guys for as long as I can remember. But it is very difficult for the states to hold onto people like that.


Paul: I think it is important to ask where we think returns are, where are they going and what do we really think is a justifiable return to keep the asset class sustained. I certainly don’t think we’ll be seeing what we got in the late 1990s.

Richard: Definitely not.

Paul: When we talk to a lot of our investors, we talk about public equity returns in the 6% to 8% range possibly for the next five to 10 years on average. If that’s the case, and you take the adage that you need to have a 500 to 700 basis point premium, something in the mid-teens is a phenomenal return. If you can deliver a mid-teen type rate of return on a consistent basis, it’s a very attractive return. That said, it would still take us back to some of the low points in the industry, like in the 1983 to 1984 time period when a top-quartile return was around 10%, and a median-range return was 3% or 4%. It’s very likely that the median return will be below public market returns, but if people can deliver a mid-teen IRR net-net then that to our thinking will be a very attractive rate of return, for institutional investors looking at this on a relative basis to other asset classes.

George: One of our general partners was told by a state pension fund probably six or seven years ago that if he could generate 15% returns then he’d have a client for life. So I wonder if lower returns are partially a byproduct of the pension funds coming into the market and driving down returns [by overcapitalizing the market].

Paul: In the big buyout marketplace, that’s really where [state pension funds] have parked a lot of capital. So maybe it has driven down returns.

George: If you talk to [state pension funds] now, they are targeting lower rates of returns.

Paul: Exactly.

John: If a 2000 fund has a 10% median return, which I’m not saying it will, I think that’s going to beat the same amount of money put into public equities in 2000 and letting it ride. [Public equities] may make 5% going forward, but they have lost 25% already.

VCJ: Will 2000 funds hit that 10% mark?

John: The 1999 vintage year fund is going to be awful, especially if you stop thinking about vintage years and look at vintage-year portfolio companies. Nineteen ninety-nine and 2000 was just an awful time. The 1999 funds poured all their money out in that period of time, while the 2000 funds put a little bit out there. In our case 75% of the money has yet to be invested. We currently believe it’s not a bad time to put money to work. So the jury’s totally out.

George: And, I think you’ll see a big difference between a fund that was raised in Q1 2000 vs. one that was raised in Q4 2000.

John: We’re seeing huge differences between Q1 1999 and Q3 1999. We have a Q1 1999 fund that’s 3x cash-on-cash [i.e., net return of three times what was invested], which is probably going to be the No. 1 fund for the vintage year.

Paul: When we talk about the 2000 vintage year, there are going to be a lot of funds that don’t return capital, and this is kind of unprecedented. Even back in the tough years of the 80s, it was very rare that you had funds that didn’t return capital.


VCJ: Will their timing be held against them?

John: We took our own data, and we’re now creating a benchmark for our vintage quarter portfolio company investments. We’re literally measuring funds against that, and we’re breaking it down to health care vs. IT vs. later stage vs. early stage, etc.

There’s a firm we’re looking at right now that just knocked the ball out of the park on their first fund. It was a spectacular fund in 1997/1998. They have done a phenomenal job of working with their LPs. They’ve been incredibly honest. Their second fund is two-thirds invested, half of that’s written down, they’ve got a third left to go for new deals. They think they can get it back to zero. We just tore apart their portfolio, and that’s not a bad bet. So, probably they’re going to get a 0% IRR on the stuff done to date, and if they’re lucky a 5% or 6% return for a vintage year fourth quarter 1999 fund.

My guess is that if they do that, they’ll be top quartile. But, it’s still hard to invest with them [in their third fund] right now. The guys who invested in the first fund are all signed up already, but the guys who came in for the first time on the second fund are struggling. And, I think it’s just human nature.

Richard: You do have to try and keep in mind that we’ve experienced an unprecedented dislocation in the industry, and you have to decide whether that’s nonrecurring or whether it’s going to be part of the landscape going forward. Depending on where you come out on those issues, you’re either ready to sign up or you’re not.

John: The guys who took a shotgun to the Internet business in 1995 and ’96 …

Richard: … couldn’t lose.

John: [Those guys] that we all laughed at gave investors 10x returns. And, we still aren’t investing with those guys, because we think, “You guys were lucky, that’s all.”

George: In 1999 and 2000, it was hard to pick a manager, because everybody had a good track record. In two years from now, it’s also going to be hard because there are going to be a lot of good groups who, because of timing, aren’t going to be showing good numbers, especially on recent funds. But people probably are going to have to make a leap of faith.