L.P. Confidential –

It’s never just about the money, just like it’s never just about the power. Instead, it’s about what happens when money and power are infused into a single entity. That’s the lesson the venture capital industry has learned over the past year.

Whether it’s facing pressure to reduce their funds or fees, or a hostile fund-raising environment, VCs have been given sharp reminders that the show is really being run by institutional limited partners. LPs, whose muscles atrophied during the economic boom of the late-1990s, have bulked up like a Major Leaguer on steroids. Not only are they holding the purse strings tighter, they are far more willing to press for their own practical and philosophical interpretations of how venture funds should operate.

Venture Capital Journal convinced four major players to sit down to talk about what they see as the most pressing issues of the day. To pull this off, we promised to hold their names and the names of their institutions in confidence.

Here’s what we can tell you. Each of the participants represents a private organization, and the foursome has a combined 55 years of private equity experience. The participants’ firms manage a combined $20 billion spread over more than 500 private equity funds.

It was late June when two VCJ editors met the LPs for dinner at a popular, upscale Italian restaurant. The tape recorder started as soon as everyone sat down and ordered drinks, and it continued through coffee and dessert. The casual but serious conversation stretched through 2 1/2 hours in a secluded room in the back of the restaurant. The editors-whose names will remain anonymous to avoid any hint of where the meeting took place-asked their guests about such thorny issues as fund size reductions, transparency, corporate governance, securitization and the fund-raising outlook. Some of the answers just might surprise you.

To make the Q&A easy to read, we had to come up with names for our anonymous participants. The Fab Four immediately came to mind: John, Paul, George and Richard (AKA Ringo). The following transcript is edited for length and clarity.


VCJ: The overriding question for LPs and GPs has been whether or not the venture capital market has finally bottomed out. Has it?

Paul: When we came out of Sept. 11, the public market was very low, and I think a lot of the private investments got written off. The magnitude of the write-downs in the third quarter of 2001 was equal to what we saw in the first two quarters. So you were starting to feel like maybe we were beginning to see the bottom. But we haven’t. They continued in the fourth quarter-not with the same magnitude-and they’ve continued this year as well. From what the underlying managers say, it’s challenging to give “up-financings” today. So, I’m not sure of our current position.

John: I think we may be at a local bottom but not the absolute bottom. I would suggest that we have seen a wave of write-downs, but we’ve not yet seen the wave of write-offs.

Richard: I feel that the issues are: Are we in a technology depression, and how long will it last? If you’ve got two more years before there’s any kind of IT spending, you’re going to have a bunch of healthy communications companies that are leaders in their field, waiting for the market to come back. And, if the market doesn’t come back, they’re dead. On the other hand, if the market begins to crawl its way back sometime toward the end of the year, we are either at the bottom now or it’s right around the corner.

Paul: The risk is the second leg down. There are a lot of companies out there now that have their product developed and are trying to make their initial sales in a market devoid of IT spending. The risk here is that the companies being started today that are beginning product development will leapfrog that earlier generation of companies in terms of technological improvements. This generation could miss out, even though thousands of companies got funded.

John: A good example of a company getting leapfrogged is CopperCom [a private DSL equipment maker]. At one point you had at least eight or nine major VC firms who thought it was a huge opportunity, because it had the answer for the new products coming into the computer business for the RBOCs. And then, you had an entire wave of companies go bankrupt. The fact is that your core product right now is dependent on an RBOC deciding to cannibalize its own product lines. So you’ve got a situation where we’ve got a couple other products we’re now betting on. Now, there’s a company you can argue totally was a victim of a swing in the telecom industry.

VCJ: So, are the fortunes of companies like CopperCom essentially forcing VCs to cut current fund sizes in order to move onto the next fund?

George: If you look at the generic venture fund that’s not a top 5% or top decile fund, they generated some spectacular numbers in their 1997 fund. Then, they raised their 1999 fund and rolled it out the door in less than 18 months. They got back and raised a huge fund in 2000, because the 1997 fund was clearly a huge winner. Then they suddenly look back, and the pace has gone down. The 1999 fund is a disaster, and the early deals in the 2000 fund are a disaster before they settled down. And, the 1997 fund is already history.

Then you have a moment of truth when you go back to your investors and say, “I’m raising another fund.” If you’re going slow, maybe that’s not until 2005, and that gives you four years to improve performance. To cut your fund back and say, “No, I’m going to come back in 2003,” is a tough call unless you’re Kleiner Perkins.

Richard: The funds that have made the massive cuts are mostly very sure that they’re going to be able to raise the next fund.

John: You’re going to see a couple of funds at the last moment declare, “OK, we’re done with this fund. We’re going to start a new fund.” There’s an issue coming up that I think people haven’t recognized: The entire venture industry used to randomly raise money roughly every three years. Then came 1999 and 2000, which brought us down to a one-year cycle. Then, the entire industry shifted to a four- or five-year cycle, but we’re still in sync.

Probably less than 5% of the funds that we are in today are in the market this year. Next year, it’s probably less than 10%. In 2004, it looks like over 60% of our funds will be in the market. Now, you can imagine what’s it’s going to be like if 50 top-tier firms are out trying to raise money in the same year. It’s a very important issue for us, because you don’t spread your money evenly across each vintage year. If you do that, you won’t have enough money to cover the good funds in 2004. If you’re one of those funds, you start thinking about how can I avoid being part of the pack.


VCJ: Who is driving fund cuts? GPs or LPs?

George: I think what was driven by the LPs was that GPs were forced to provide a rationale for what they were doing.

Richard: Were you guys putting pressure on funds?

George: A little but not much.

Richard: We were not, but we saw a lot of other LPs who were.

Paul: I think the whole thing was driven more by some of the innovative thought leaders in the business on the venture side looking at their funds and saying, “We’re in a different world.” They realized that they raised their funds in a very different environment with a very different investment base and a different public market where we had big multi-billion-dollar exit events. In today’s market we don’t have those, and the pace is slowing.

In some respects, we previously had been kind of oblivious to the effect of management fees on our returns because there has been such a discrepancy between the rate of deployment and the rate of appreciation of the assets that were mark-ups, and, all of a sudden, you don’t have that. Most of the funds that have cut are kind of post that generation of bad funds.

So they’re still looking at this current fund saying, “We can still make a good rate of return here. We just need to slow down. We need to rationalize the amount of capital that we have. We need to better align the management fee structure so that we can make that rate of return.” Certainly there has been some contention once these discussions have started, with LPs of big funds a little vociferous, maybe. But I certainly didn’t see LPs pounding on the table at the outset at some of these top-quartile managers saying, “You’ve got to reduce your fund size.”

John: I didn’t see a lot of LP pressure. I can promise you we didn’t put a lot of pressure for a very good reason. If we put pressure on the GPs, the risk you’re taking is that they’ll just speed up their investment pace. And you don’t want that. That’s really bad.

VCJ: Do you think we’ll see more cutbacks?

John: I think you’re going to see some. But I think some firms will decide that one way to avoid the bubble in 2004 is to call investors up next summer and say, “You know what, we’ve been running this thing for two years. We’re going to end it now and go into the fund-raising market.”

Paul: There will be funds that have pressure but won’t do it because they’re concerned that they won’t be able to raise that next fund. And, hopefully they’ll work something out with a scale of economics and say, “Maybe we shouldn’t quite take all of the management fee if we’re going to go slow.”

VCJ: How would you react to that?

Paul: Well, you get to vote the next time they come up. As it stands now, we all signed limited partner agreements that had a set of terms and conditions that we agreed to. Unless you have a no-fault divorce escape clause and can convince some super majority of the people who signed one of these agreements that they need to suspend this fund or somehow terminate this fund, it’s the deal that you signed up for. That’s why you should do your due diligence, because it’s a 10-year partnership.

Richard: And what’s the benefit for doing it [forcing a liquidation]? Most of the money is out the door at that point. You’re going to be the proud owner of a bunch of illiquid securities for private companies.

John: You’re going to make your investment decisions based on your assessment of their performance. If their performance is great, it probably doesn’t matter whether they cut their funds or not. If their performance is not really good, it probably doesn’t matter whether they cut their funds or not. So, there’s sort of a small gray zone in which this sort of stuff could make a difference.

VCJ: Some firms, like Kleiner Perkins, have told LPs that they “most likely” won’t call down a certain percentage of committed capital. Does there come a point when you need it to be official?

Paul: One of the things that people forget is that if you go back over the history of the business, there are a lot of funds that never take all their capital. And you don’t know until year seven, eight, nine or 10 that they’re not going to make that last draw. So, all you’re asking for them to do is tell you today whether or not they’re going to do it over the next seven or eight years. If they know today that they aren’t going to do it, it would be beneficial to amend the agreement and reduce the fund size and restructure all of the economics of the fund along that new size.

George: If you are paying management fees on a portion of capital that never gets managed, it seems as though that is somewhat inefficient for the return on the fund. You could fix that fund size and let the fund manager redeploy the capital.


VCJ: Does anyone expect any unique fund reduction structures, or did the debacle of Accel’s attempted fund split put the nail in that coffin?

George: What they were trying to do was crazy.

John: I’m not an investor in Accel, but I’ve got two friends on the advisory board and [Accel] burned some real bridges there.

Richard: I’m surprised to hear you say that, be-cause I thought they handled it in a very professional way.

Paul: The timing on that whole issue was unfortunate because there was an article [on the fund split] that was going to appear. And so, the decision perhaps that they should have made is not to rush to get out there and [instead] to confer with their limited partners. And they made some contact with some advisors, but I don’t think they got enough feedback to really think it was representative of what they should try to do. Unfortunately, they made the decision that they wanted to get it out before that article appeared rather than let the article appear and take their time to decide whether or not this was what they really wanted to do.

VCJ: What will the next generation of funds look like structurally?

Paul: There are certain funds we’re looking at that will have high levels of investor demand if all the right criteria and variables are in place. With a high level of investor demand, it doesn’t necessarily skew the leverage in the relationships between the LPs and the GPs all that much [from the previous situation]. So, I think there is a certain segment of funds that will still command a certain amount of leverage that will allow them to craft a deal that is more favorable than a fund with less of a track record or a shorter track record or a not-as-prestigious track record. But I don’t think that’s any different than the way the market’s been for the last 20 years. I don’t know if there’s a whole new world out there as much as we’re just going to reiterate what we’ve seen historically.

VCJ: Is a 2003 fund going to be able to get a 30% carry?

Paul: There were funds that had 30% carries before 1999, so some will possibly still have it. Carry is a sticky term that moves up quickly but not necessarily down so quickly. Again, investors will have to decide whether or not to go into funds with so-called premium terms. If there are enough investors that don’t want to go into firms with those fund terms, then those firms will have to reevaluate their terms.

John: I think we’re going into a period of time in which there’s going to be more turnover in terms of who is running the top-tier firms than anything we’ve seen before. You’ve got a generation of people that are now independently wealthy. The world has changed, but business is hard again and people react very differently. You’ve got a 40- or 45-year-old who is suddenly worth $100 million, and in one case they want to go mountain climbing, and in another case they want to do deals until they’re 80. I think that you don’t really know how you are going to react until you get there. And in some cases-we’ve got a couple cases-the guy thinks he wants to go mountain climbing, goes for a year but then gets bored and comes back.

Paul: I agree that the issue of succession is huge. Some people are really competitive and will do it for a sense of accomplishment, and some will just peel off.

John: Right now you’re seeing a lot of firms wrestling with who’s going to run the firm going forward and how the pie is going to be divided. It’s a legitimate argument. A bunch of people come together to start a firm, generate a great track record and are able to raise $1 billion based on that track record. Now they step back to just work 35 hours per week. Maybe the last couple of great deals were done by the younger generation, but the issue is still, “Who gets what?” So we really have to evaluate that one fund at a time.


VCJ: Speaking of fund-by-fund evaluation, it is generally believed that there is too much venture capital on the sidelines. Do you feel the market is overcapitalized?

John: Clearly there was too much money in 1999 and 2000. There’s just no question about that.

Paul: It’s still in the marketplace. If you look at the overhang of what’s been committed to funds and what’s been dispersed by funds, there’s a big gap there. The big issue is finding the equilibrium. It used to be that a couple of billion dollars was in the pipeline, and now all of a sudden we’ve got maybe a couple hundred billion dollars in the pipeline. Is that too much, and where does it settle out? I don’t think any of us know. Should it be $50 billion, $100 billion, $25 billion or $10 billion?

John: We’re in a unique period right at the moment, though. If I look at our 2000 funds’ weighted average, right now they’re 23% drawn down. It’s the first time in the history of venture capital when there’s been a lot of money in the hands of the venture industry and it hasn’t let it burn a hole in its pocket. For 25 years, they’ve never done it. Every single time the industry has had too much money, they’ve let it flow out.

Richard: They’ve never hit $100 billion before.

John: It’s very interesting. I take some solace in the feeling right now that most of the excess capital is in the hands of relatively few older people, and they seem to be playing things pretty smartly. I guess I’m pretty naive, but I’m pretty optimistic that the money being put to work now is actually being put to work pretty well.

VCJ: It’s been suggested that the VC overhang is anywhere from $30 billion to $100 billion. How large do you believe it to be?

Richard: Just across our funds alone, we added up $10 billion in capital hanging out in the markets, so there is clearly a lot of money out there. But a much more important issue is how is it going to be spent, and I think it’s being spent very well at the moment.

VCJ: Wouldn’t you also have said that it was being well spent if we had this conversation back in 1999? Were you concerned back then over the large amounts being raised?

John: You had to be concerned. We were all concerned. On the other hand, they were walking in our doors and offering us 100% and 200% returns.

George: And there was the client side, too, for the funds-of-funds, where everyone saw the cash-on-cash returns and wanted in.

VCJ: Are those same clients now asking more questions?

George: When they’re getting great returns, they’re not going to ask many questions. But when they start getting bad results, they want to know more. I think we owe it to them to explain what’s happening, because I think a lot of them probably came into private equity during the boom. And even probably looking back 20 years there really hasn’t been the kind of environment where you have so many funds that are probably not going to make any money. You kind of explain to them exactly what’s going on.

Paul: I think that most conversations have centered on the valuations that people are carrying their investments at, how valuations have been recorded and how they are now being determined. It used to be that valuations were generally financing-event driven, and only in rare instances was there a subjective write-down. Today, though, in the last several quarters, we’ve been in kind of a new environment in which there have been many more subjective valuations and revaluations of companies.

John: I know of six or seven institutions that have been in the market for an advisor to help them initiate a venture capital program. I am shocked that none of those have pulled back. As far as I can tell, I’ve only heard one announcement so far of anybody pulling back on the endowment/pension side. Moreover, I can think of at least five or six states and four or five major international players that are either increasing their allocations or coming into venture capital for the first time.

VCJ: But what will these new entrants invest in? This year has been notable for its lack of quality fund-raising opportunities.

John: Most of the reason the pace of investing from institutional investors into funds is down is the reality that there’s a huge drop-off in the number of name-brand funds in the marketplace right now.

Paul: It doesn’t mean that they’re not interested in the asset class. They’re still expanding their allocations. They’re waiting to invest in what are perceived to be groups with better track records or a more interesting market positioning to come to the marketplace. That’s part of the test. I think what we talked about here was that a number of these funds raised larger funds and are now investing those and won’t be back to the marketplace for a couple years. So, do you fund a group that has maybe a lesser capability or a lesser track record or one that you’re not as confident in, just for the sake of putting money out?

John: Obviously there are some teams that have got traction even in this market.

Paul: Exactly. It’s one of the ways the private market is different that the public markets. The public markets are there every day, so you can pick what stock you want to be in. The private markets aren’t. It’s only what’s in the market at that point in time that you can choose from. If you don’t have the patience to wait and you don’t have a structure that allows you to wait, you know you’re going to put that money somewhere.

John: We’ve done our best to pre-wire the clients. What we’re telling our clients right now is if we have a three-year fund horizon, we’re not going to invest it 30%/30%/40%. It’s going to be more like 20%/20%/60%.

VCJ: It seems like more money was lopped off venture funds in Q2 than was actually raised.

Paul: I guess that’s a good thing if you think the market has too much capital.

Richard: It’s a little bit of a funny number too, because these guys will be back in the market as soon as they’ve invested what they’ve gotten. And, they’ll probably be back sooner than they otherwise would have been.


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.