Money To Burn: Limited partners are causing a new type of overhang to be visited upon the VC market. And, unlike last time, thislatest incarnation will not be soothed by fund cuts. Instead, it’s going

Venture capital overhang is back, but this time general partners aren’t to blame.

The concept of overhang has been around since before Tim Draper was a gleam in Bill’s eye, and basically means that there is too much money chasing too few deals. Kept relatively narrow, it is the very supply-and-demand imbalance that allows financial markets-both public and private-to function. Once expanded to a certain width, however, overhang can negatively affect return rates to the point of market destabilization.

For venture capitalists, the most extreme case of expanded overhang occurred while they sat shiva for the New Economy. Jesse Reyes, director of research for Thomson Venture Economics (publisher of VCJ), says that VC market overhang at the end of 2001 stood at approximately $98 billion. This is nearly double historical averages (adjusted for market size fluctuations), and was exacerbated by an unprecedented decline in VC disbursement levels. Not surprisingly, returns stumbled. The average internal rate of return (IRR) for a U.S.-based VC fund raised in 2001 stands at 18.2%, with a median IRR of 31.4 percent.

In order to combat the problem, many venture firms began to cut their funds. The first such reduction came in January 2002 from Mohr, Davidow Ventures, which told limited partners that it

would not collect $170 million in commitments on what had been an $848 million fund. By the time that Battery Ventures cut $150 million off its seventh fund earlier this year, venture firms had voluntarily handed back over $7 billion in committed capital.

Add to this the slaying of paper dragons like CMGI @Ventures (a trio of $1 billion funds dedicated to early-stage Internet deals), and Reyes estimates that the VC market overhang has shrunk to $60 billion. “I think that we could get to $50 billion by year-end, which is a historically healthy level, although that assumes that [disbursements] are increasing,” Reyes says. “So a better number right now would be around $25 billion or $30 billion, but we’re clearly moving in the right direction.”

Indeed, general partners have done an admirable job in aligning their fund sizes with the decreased capital requirements of entrepreneurs. This not only applies to fund size reductions, but also to target capitalizations for recent fund-raising activities. The so-called “next generation” of VC funds generally includes vehicles that are less than half the size of their predecessors. Even New Enterprise Associates, which closed on $1.1 billion last December, exercised restraint compared to the $2.3 billion it raised three years earlier.

So far, so good. Well, not exactly.

In order for any capital market cycle to operate properly, all of its capital flows should move in a similar direction. The VC market has three distinct capital flows, but only two-portfolio company disbursements and general partner fund-raising-are sharing a raft. The trifecta would include a decrease in available limited partner capital, but so far it hasn’t happened. In fact, the LP community is moving in the opposite direction.

“The capital usually shrinks on all three levels during one of these cycles, like it did in the late 1980s,” explains Thomas Lynch, senior managing director and head of the private markets group at Wilshire Associates. “In this cycle, the VCs have recognized the changing economics, but LPs just haven’t shrunk. It’s good that LPs are finally strategic investors in this asset class and don’t flee when returns go negative, but it really raises the question of whether or not the venture market is going to be large enough for them.”

In other words, limited partners are causing a new type of extended overhang to be visited upon the VC market. And, unlike last time, this latest incarnation will not be soothed by fund cuts. Instead, it’s going to have to hurt.

How Did We Get Here?

There are a number of explanations for why LP capital flow has continued to grow in 2004, but none of them involves conspiracy. Heck, if the famously disorganized LP community ever were to come together, its first item of business probably would be standardized reporting guidelines, not extended overhang. Instead, this problem has been borne of accident, ego and good intentions.

The typical institutional investor-be it a pension fund, endowment or foundation-follows an asset allocation model that mostly marginalizes venture capital. In most cases, VC is lumped in other “alternative assets” like leveraged buyouts, real estate, distressed debt, energy, lumber/timber and hedge funds. This entire group is often lucky to receive a 5% annual allocation, of which venture capital might represent less than half.

So where does the money go? Public equities, mostly, and the value of such portfolios has been growing steadily for over 18 months. The result has been a significant rise in institutional investor values and, in turn, the amount of funds available for venture capital investing. For example, imagine an $800 million pension system in 2002 with a 2.5% venture capital allocation. This would work out to $20 million. Now take that same pension system in 2004. It hasn’t touched its allocation model, but its blue-chip public equities have bumped the overall system value to $1 billion. In turn, its venture capital fund managers now have an extra $5 million to invest.

Historically, such accidental increases of LP capital flow have been met by similar rises in portfolio company and general partner spending. This time, however, neither portfolio companies nor general partners have gotten over the emotional or financial scars of late 1990s enthusiasm, and have opted for a maintenance of market correction-era economics. LPs also might be feeling some aftershocks, but are not structured to accommodate self-restraint.

There also was some talk that this accidental increase could be offset by a sub-section of LPs exiting the VC market, but that has not materialized beyond a few corporate bailouts. In fact, the exact opposite seems to have happened.

LPs seem to feel that the improving economy could inflate into another bubble, and not in a “what were we thinking” sort of way. As such, the race is on to ride an alleged VC elevator, and many venerable LPs have begun to increase alternative asset allocations. According to a recent report from Greenwich Associates, nearly 25% of all endowments and pension funds-public and corporate-expect to increase their alternative asset exposure over the next two years, compared to just 1% that plan to pull away entirely.

The Illinois Teachers’ Retirement System, for example, last month increased its annual private equity allocation from 3% to 6%, which should include an extra $120 million for VC fund investments, plus additional cash for buyout vehicles, special situation investments, distressed debt investments and subordinated debt investments. Ditto for New York City, which plans to double its $2.2 billion private equity portfolio over the next three to five years.

Other LPs like the California Public Employees’ Retirement System (CalPERS) and the Colorado Public Employees’ Retirement Association (CoPERA) have gotten more creative, and set aside niche capital pools devoted to things like “emerging fund managers.” Some of those sub-programs could pay off, but it’s worth noting that, in this context, “emerging” is fancy talk for “lacks a track record.”

Then there is the issue of institutional investors who plan to invest in private equity for the first time. Most of this money is coming from overseas, although some domestic institutions also are in the mix.

“The degree of [limited partner] capital oversupply is very high right now,” says Peter Wagner, a managing partner with Accel Partners. “You’ve had a combination of a lot of things, including a low interest rate environment, triumph of the allocation model in the U.S., and regulatory changes overseas that has freed up huge pools of capital that previously could not be invested in venture capital.”

Where We Are

In April, Battery Ventures sent fund-raising letters to its limited partners and a select group of prospective buyers. The Wellesley, Mass.-based firm was gauging interest in a $450 million fund, which was a significant step down from the $1 billion it had raised in 2000. Rather than coming back with smaller ask numbers, most limited partners raised their antes.

“They expected that the fund would be oversubscribed, but they never quite expected what happened,” says a source close to the firm. “Who could?” All told, Battery Ventures VII was oversubscribed to the tune of $2 billion. The firm could have ceded to limited partner pressure and raised its fund size, but it ultimately opted to cap the vehicle at $450 million. The result is a proposed across-the-board commitment cut for return backers, which could leave LPs who invested $30 million for Fund VI with just a $15 million commitment for Fund VII.

Similar situations have occurred with other next-generation funds, including those managed by top-tier names like Sequoia Capital and Kleiner, Perkins, Caufield & Byers. Even Charles River Ventures experienced substantial oversubscription for its new fund, to the extent that it thinned the herd by excluding all public investors. Not bad for a firm that was charging a 30% carried interest, had just lost two high-profile partners to retirement and which still has three active funds on the books whose returns are very much up in the air.

And then there is Redpoint Ventures, which is expected to launch its third fund-raising drive this fall with a target capitalization of approximately $400 million. The Menlo Park, Calif.-based firm’s two funds-which total $1.35 billion combined-both feature negative returns, but LP sources say that it also should enjoy oversubscription. “I wouldn’t be surprised if they raise the money easily,” says an institutional fund manager familiar with Redpoint. “Brand-name firms are raising new funds very easily these days, whether they deserve their lofty reputations or not.”

Wilshire Associates’ Lynch believes that most LPs still are trying to squeeze their oversized VC allocations into brand-name funds, but adds that only a select few will be able to do so consistently. This same concern was voice by Lynch’s colleague Rosalind Hewsenian in a recent letter to Wilshire client CalPERS. She wrote: “The [alternative investment management] staff’s observation regarding the polarization of the private equity market fund-raising effort is important and underscores the need for enhancing CalPERS’ position as an investor of choice.”

Where We Go

It seems safe to assume that investors of choice will be scarce and that the have-nots in this polarization will far outnumber the haves. Given that, what are the have-nots to do?

One option, of course, would be to leave the alternative asset class, but only 1% of institutional investors plans to follow that path, according to the aforementioned Greenwich Associates report.

Another is to reallocate within alternative asset portfolios, which could include a shift away from VC funds and toward leveraged buyout funds. Some LPs already have taken advantage of this strategy, particularly since LBO firms seem intent on raising larger and larger funds. Providence Equity Partners, for example, is in the market right now with a $4 billion offering memorandum, about $1.2 billion more than it raised in 2000. A few miles north in Boston, Bain Capital busted a $3 billion target capitalization for its eighth fund by accepting $3.5 billion. It also closed on a $750 million co-investment vehicle for jumbo deals.

To date, however, such reallocation only has had a marginal impact on the continuing clamor for VC fund access. Part of this reluctance is the simple sex appeal differential, as most institutional investors prefer shiny tech gizmos to soot-covered textile factories. More importantly, VC funds typically deliver stronger returns than do leveraged buyout funds. The average cumulative IRR for all VC funds as of Dec. 31, 2003 was approximately 20% higher than that of LBO funds, according to Thomson Venture Economics. Broken down a bit further, the data shows that mega-buyout funds-defined as buyout vehicles capped at $500 million or more-generated average cumulative IRRs of just 3.8%, while the average cumulative IRR for early-stage venture funds was 14.9 percent.

In order to reconcile LP preferences for venture capital with LP penchants for producing extended overhang, many institutional investors-particularly the have-nots-have begun seeking alternative access routes. For example, the past few quarters have experienced a significant surge in new funds-of-funds, even though such vehicles have a reputation for being where dumb money goes to rest. Twenty-five funds-of-funds closed on $4.02 billion in the first quarter, compared to 22 FoFs that raised $2.8 billion in Q4 2003 and just 14 FOFs that secured $1.11 billion in Q3 2003.

“I think that the timing is very good right now for funds-of-funds that can help pensions and other LPs get into VC funds that they otherwise couldn’t access,” says Sallie Shuping Russell, who recently began to raise and manage funds-of-funds for The Quellos Group, after having served as a GP with Intersouth Partners, as an LP with Duke Investment Management Co. and as a fund consultant with Cambridge Associates.

But timing isn’t everything. Funds-of-funds require an extra layer of middle management, and the cost is passed on to limited partners in the form of extra fees and carried interest. These premiums are understandable- fund-of-funds managers have to eat, too-but they nonetheless penalize have-nots. Moreover, fund-of-funds returns are nothing to write your investment committee about. The average cumulative IRR for funds-of-funds as of Dec. 31, 2003 was just 2.2%, with a median average of 2.5 percent. The cumulative distribution to paid-in ratio (DPI) also looks bleak for funds-of-funds as of Dec. 31, 2003, at an average of just 0.68 percent. For comparison, the venture capital DPI average stood at 1.51%, while buyouts came in at 1 percent.

There are a number of theories to explain relatively poor FoF returns, such as that the market experienced rapid expansion just prior to the bubble burst. Perhaps the most salient and troubling rationale, however, involves the forced use of capital. Most FoFs are required to invest a predetermined amount of capital each year, in spite of the VC fund-raising market’s ebbs and flows. The result is that fund-of-funds often invest in sub-par VC vehicles in “off” fund-raising years. VC funds, on the other hand, are under no such disbursement obligations, and therefore can hold back on investing when quality deal flow dries up.

Have-nots surely recognize these long-term FoF return risks, but apparently feel that immediate access to VC funds-whether by direct or indirect routes-is of paramount importance. It’s reminiscent of the very late 1990s, when VCs seemed more concerned with their number of portfolio companies than the quality of those companies. Funds housing such portfolios ultimately got dubbed the “Lost Generation,” and the moniker eventually could be applied to have-not venture returns from vintage years 2003, 2004 and beyond.

The LP community always has included have-nots who bring down overall returns, thanks to an unholy coupling of bad luck and bad investment strategy. Today, however, have-nots are more plentiful, which means that the group’s aggregate performance will drop in inverse proportion to the growth of extended LP overhang.

All available solutions to this problem-short of another bubble-involve at least a partial degree of LP retreat from the venture capital market. Few of today’s LPs seem willing to take those first steps, which means that we can expect reams of regret over the next few years. After all, something is going to have to replace positive returns…

Email: daniel.primack@thomson.com