LPs Speak out on Terms, Quartile Rankings

The IBF Venture Capital Investing Conference, held in Redwood City, Calif., in June, featured a trio of panel discussions with institutional limited partners and professionals who work with them. Following are snippets from each of the sessions.

Forget Quartiles

A slot in the top quartile has been a moniker of venture success for so long its impact is taken as a given.

Make the top 25%, and limited partners will take out their checkbooks. If not, be prepared with the sales pitch of the century and a career backup plan.

But quartile ranking is at best a murky indicator of venture performance, according to a panel of limited partners. Due to differences in accounting practices between firms, volatility in valuations, and an up-and-down exit climate, it can not be assumed that over the long term firms in the top quartile will beat out those a few notches below.

“That whole top quartile thing, it’s nice to have, but you shouldn’t have a sense of entitlement,” says Judith Elsea, co-founder and managing director of Weathergage Capital, a Palo Alto, Calif.-based fund-of-funds that specializes in venture capital. “You may be talking to a clientele that looks at absolute returns.”

Michael Kim, managing partner at Cendana Capital, a San Francisco-based private equity fund-of-funds, took the critique a step further, telling panel attendees that “quartiles are meaningless.”

That’s partly because VCs and their accountants take different approaches to valuing investments, he says. There are some accounting firms that base valuation on the numbers used for the last round of funding. Others take the spirit of FAB 157, which says fair value should be based on the price an asset would currently fetch “in an orderly transaction between market participants.”

Moreover, LPs have plenty of other data points on which to focus. For those evaluating venture investments today, Elsea says, “what is different now is we have a lot more data than we have ever had.” For venture, a prospective investor can get a pretty good idea how a portfolio will turn out by year five of a fund.

Quartiles are meaningless.”

Nicole BelytschkoDirector of Private EquityCM Capital

“If you think you’ll be making three or four times your money, where else are you going to make more money?” he says.

Overall, LPs have been seeing more favorable terms and higher GP commitment levels in the last several years, says Anita Ng, senior consultant at Cambridge Advisers. The most sought after funds, however, have been able to maintain more GP-friendly terms. Managers of China-focused funds, meanwhile, have been “coming out with pretty premium terms,” she says.

China-focused venture funds should be particularly motivated to provide more LP-friendly terms, says Nicole Belytschko, director of private equity at CM Capital, a Palo Alto, Calif.-based investment and advisory services company.

Despite how the continued rapid growth of the Chinese economy still presents an attractive proposition for venture capital, other factors, including the high turnover of general partners and the complexity of fund structures for foreign investors, warrant caution.

“There have been a lot of IPOs and exit events,” she says. “But there hasn’t been that much capital given back to limited partners.”

What LPs Really Want

Limited partners know exactly which venture funds they want to back. It’s always the ones who don’t want their money.

Beyond that, however, it’s tough to get a clear read on the criteria that matter most to LPs when vetting a new venture investment.

So says Robert “Mac” Hofeditz, a partner at private equity placement agent Probitas Partners, who says his most recent experience on the fundraising trail showed there’s little consistency among limited partners regarding how to assess the desirability of a venture investment.

Nobody knows what they want. There are 75 different things that LPs are looking for in venture firms.”

Robert “Mac” HofeditzPartnerProbitas Partners

“They want in Accel Partners, but they can’t get into Accel,” Hofeditz says. Beyond that, he observes: “Nobody knows what they want. There are 75 different things that LPs are looking for in venture firms.”

One wrinkle for VCs seeking to close new funds, he adds, is that a very large portion of LP staffers haven’t been in the business long enough to have seen a positive climate for venture capital returns. Thus, the default outlook for the asset class tends to be negative.

Still, for the well-organized and persuasive, fundraising timelines haven’t been too elongated, says Jordan Silber, a partner at Cooley who specializes in private fund formation.

The most efficient can close a fund in the amount of time or even less than it took five years ago. For others, however, it can take up to a year, and Silber says he’s seen the process drag out for up to 18 months. He’s also seeing a lot of derailed fundraisings.

Hofeditz said he sees it taking 12 to 18 months on average, although there are some that can close in as little as six weeks.

Though emerging managers naturally have a rougher time closing, LPs say they remain interested in new funds.

Kelvin Liu, director at Invesco Private Capital, a private equity fund-of-funds, says about a quarter of his firm’s investments are new relationships. Some appear to be working out well, including investments in Foundry Group and Union Square Ventures, which between them have a portfolio that includes Zynga Game Network, Admeld (acquired by Google in June), Twitter and Foursquare.

Georganne Perkins, managing director of private equity investor Fisher Lynch Capital, says her firm is less apt to back newcomers. Over 10 years of investing, she says, she can count only five emerging managers that got funding.

However, contrary to Hofeditz’ general impression of LPs, Perkins has a clear criteria for what she’d like to see in an emerging manager: a successful entrepreneur who invests their own money as an angel for several years and then starts fund that includes institutional backing.

Trouble is, such managers are hard to find.