LPs Bullish on Venture

After years of disappointing returns and dwindling fund-raising numbers, limited partners are finally feeling more upbeat about the venture asset class.

That was the general impression from speakers at this year’s National Venture Capital Association conference, held in Boston in April. At the conference, lead investors at two of the industry’s largest LPs described the current investment climate as among the most favorable they’ve seen in years.

“The mere fact that many investors are withdrawing from the asset class or reducing their commitment of capital means that it’s going to be a better time for those who have capital to invest,” says D. Brooks Zug, founder and managing director at HarbourVest Partners, which has invested more than $8 billion in the asset class since the 1980s. Zug rated the current investment climate as a “9” on an ascending scale of 1 to 10.

Zug also based his positive outlook on a comparison to previous venture business cycles. By his analysis, venture cycles typically last 13 to 17 years from peak to peak, with the last three peaks occurring in 1999-2000, 1983, and 1969. Based on these cycles, he predicts the next peak will occur in three to six years, which he says makes now “a terrific time to invest.”

Though he is observing some heating up of pricing in later stage and growth equity deals, he says that positive headwinds outweigh negative ones.

Geoffrey Love, who leads venture investments for the U.K.-based Wellcome Trust, rated the climate for investing in venture funds at 7.5. Positive contributors he cited include a decreased number of venture firms competing for deals and an abundance of industries that are seeing an accelerated pace of innovation.

Moreover, those who continue to invest in venture are likely to be those who are most committed to and knowledgeable about the industry, given that the financial crisis “provoked very tough internal discussions about reasons for being in particular asset classes,” Love says.

The mere fact that many investors are withdrawing from the asset class or reducing their commitment of capital means that it’s going to be a better time for those who have capital to invest.”

D. Brooks ZugFounder and Managing DirectorHarbourVest Partners

“Today, if you have the courage to invest in venture capital, it is a great time,” he adds.

Wellcome’s latest annual report reflects that conviction. The $21 billion trust had $2.6 billion in venture assets at the end of its 2010 fiscal year in September, up 13% from the prior year. Venture is now the largest single component (29%) of its private equity commitments.

Wellcome, in its annual report, attributes its bullishness of the asset class on its observation that “the venture capitalists with whom we partner are benefiting from a scarcity of capital, disruptions to existing business models in many industries and the availability of highly talented labor.”

Current LP rhetoric marks a shift from the much more critical outlook commonplace a couple of years ago, as disappointing venture returns led many to question the future of the asset class. Bill Sahlman, a Harvard Business School professor and panel moderator, got no counter-argument from LPs when he selected the verb “sucked” to describe the last decade of venture performance.

“Bill’s absolutely right. Over the last 10 years returns have sucked. We often use stronger language at our offices in London,” Love says.

Yet for forward-thinking investors, there’s still plenty to like about the asset class.

FLAG Capital Management, in a March report on the venture capital investment environment, observes that “general sentiment in the venture industry has markedly improved as the exit markets continue to open and excitement mounts around innovative new products.”

Today, if you have the courage to invest in venture capital, it is a great time.”

Geoffrey LoveHead of VenturesWellcome Trust

Fundraising data also points to decreased competition for deals. Over the last four calendar years, fundraising has declined, with venture firms raising just $12.3 billion in 2010, down 25% from 2009. FLAG, a venture and private equity fund-of-funds, reports that it expects the pace of fund offerings to increase this year—particularly as investment levels continue to outpace fundraising. Last year, for instance, VCs invested $21.8 billion—77% more than the amount of capital raised—which FLAG labels “an unsustainable condition.”

Other positive signs include an increase in M&A activity and a more welcoming climate for IPOs, as a larger number of companies have gone public and also posted strong aftermarket performance.

“Taken in conjunction with lower fundraising totals and increased investment activity at generally sane valuations, the burdensome capital overhang has been further eroded,” concludes FLAG. “We would like to think it is 1994 all over again.”

That means there’s plenty of upside to come. While sky-high valuations for Facebook and a handful of other hot private companies have inspired talk of a new dot-com bubble, Love and Zug said it’s too early to tell.

Love, whose employer is an investor in Facebook investor Accel Partners, says he’s been hearing criticism about how the social networking company is overvalued ever since its early funding rounds. But since he isn’t privy to its earnings numbers, Love says, it’s tough to make a call on what’s a fair valuation until Facebook gets to the public market. That said, he did acknowledge some concerns about companies reaching enormous valuations while still private.

“If you’re in the public markets and you realize you made a mistake, at least you can sell,” he says. “In the private market, there’s nothing you can do.”

Zug, for his part, called the current situation a “limited bubble,” noting that it appears to be confined to private investments.

“What we all need to do is have our companies ready so that when the next peak comes we’re ready to exit,” he says. “That will be when we really reached the bubble.”