The Case for Evergreen Funds

Venture capital looks like a business poised to eat its own young. So why is George Needham sending his first-born son to see old friends in the business?

“Venture capital is going to be a tremendous asset class in the next 10 years,” says Needham, chairman and CEO of the Needham Group, a holding company that includes the boutique investment bank that bears his name.

Despite his long-term optimism, Needham also agrees with the growing chorus of voices that says the venture industry needs to be fixed. “It’s broken, in the sense that it has not generated adequate returns to its limited partners,” he says.

Is there any other “sense” that matters?

The poor performance of venture funds over the past decade calls for drastic change, says Harold Bradley, chief investment officer at the Marion Ewing Kauffman Foundation. Not only does the industry need to get smaller—perhaps down to $5 billion a year in fund-raising—but Bradley says it needs to remember its purpose. He says a mere 25% to 30% of the venture business remains focused on building successful companies. How to get VCs to focus on building companies? Bradley says just getting smaller won’t do it. He wants to see funds re-orient to longer-term horizons. To him, that means adopting an evergreen structure.

“My goal is to found successful companies and grow them,” Bradley says. “I think a lot of the economics are not aligned in this direction. Evergreen funds have better alignment with limited partner and entrepreneurial interests.”

Why Evergreen?

Evergreen funds at their simplest are open-ended. They don’t end every 10 or 12 years. They tend to include only a few limited partners as investors. In fact, most evergreen funds are probably family funds, a la Venrock when the Rockefeller family was its sole investor. The best example of an evergreen fund that is not a family fund is Sutter Hill Ventures. Sutter Hill has eight limited partners (it started with six), and 10 general partners, as well as a chief financial officer who is also a managing director.

Evergreen funds put limited partners and general partners on the same side of the table economically.”

Paul Wythes

Evergreen funds barely exist in venture capital today. Sutter Hill provides perhaps the only example of an evergreen fund active in Silicon Valley. An East coast counterpart is General Atlantic, the $13 billion growth equity fund, though it no longer does conventional venture capital investing.

Tom Simpson of Northwest Venture Associates argued in these pages in December 2007 that evergreen funds have several advantages: “The manager of an evergreen fund is not hamstrung by the need to raise new funds periodically. He or she is motivated to invest committed capital on a patient, careful and considered basis, and to pursue liquidity events when it is optimal for a given portfolio company rather than for fund-raising purposes.”

Simpson says he wishes he’d known about evergreen funds before he raised his three funds, from 1995 to 2000. He says they seem to resolve an important issue in venture capital: VCs want quick hits to prove they deserve a new fund, in a market where quick hits look increasingly unlikely. “Why should the model be predicated upon near-term exits?” he asks. “The model ought to be more patient.”

Simpson, though, is unlikely to try to raise an evergreen fund. Being based in Spokane, Wash., puts him on the fringes of venture activity. Nor has he been successful enough as an investor to draw interest. His last fund-raising effort was in 2006, when he failed to attract enough interest in a late-stage, non-tech fund. Also, his third fund, an SBIC, performed on sad par with many funds raised in 2000. It did invest in World Wide Packets, acquired by Ciena in 2008 for $300 million. But this June, the Small Business Administration took over the fund after the value of its investments fell below a required “capital impairment” threshold.

Simpson says his belief in evergreen funds stems from seeing the current “misalignment of interests” that VCs, investors and entrepreneurs face in the current structure. For one thing, entrepreneurs generally need more time to grow a successful company than a 10-year fund allows, he says.

Thinking Long-term

The evergreen model is both more patient and more flexible than traditional funds, says Pat Hedley, a senior vice president at General Atlantic, who has been there since 1987. Hedley says “with a fund you have to invest and get liquidity and then you go on to the next fund. We can be a lot more long-term oriented.”

The evergreen fund, by having only one annual management fee, not multiple fees, should slim down the fat fees now common to the venture capital industry. “Right now, it’s a money management business and a management fee business,” says John Mumford, founding partner of Crosspoint Ventures. Mumford and his partners handed back their billion-dollar fund to limited partners in 2000 because they didn’t like the long-term investing climate. But even in their big years, he says he personally never took more than $500,000 in annual management fees.

The limited partners have to realize that the great returns they hope to get in venture will probably only come if they take a long-term view to holding on to the portfolio stocks the general partner invested in.”

Bill Hambrecht

Evergreen funds put limited partners and general partners “on the same side of the table economically,” says Paul Wythes, who founded Sutter Hill Ventures in 1964. Wythes, now retired, says that general partners in evergreen funds cannot get rich off management fees, so they must succeed as investors. And that, he says, is why there are so few evergreen venture funds.

One VC who likes the concept is Pitch Johnson, the founder of Asset Capital Management and the first investor in Amgen. He thinks evergreen funds create the patience necessary for longer-term investing. (Johnson’s fund operates more like a traditional family fund, rarely taking outside capital.) In a market where startups need an average of nearly 11 years to reach liquidity through an IPO, he expects evergreen funds to gain currency.

Renowned investment banker Bill Hambrecht, chairman, CEO and founder of W.R. Hambrecht & Co., says evergreen funds would engender long-term investing practices, and that would benefit limited partners. “The limited partners have to realize that the great returns they hope to get in venture will probably only come if they take a long-term view to holding on to the portfolio stocks the general partner invested in,” Hambrecht says.

Hambrecht points to 1986, when Adobe, Linear, Microsoft, Oracle, and Sun Microsystems went public and delivered 30% compounded returns for decades. Any fund manager that hung onto its shares in those companies obviously did far better than those that sold the stock immediately after the lock-up period.

“The really smart venture investors held onto those stocks after they went public,” says Hambrecht. He says investors need to realize that the IPO is not the end of the game.

Dave Sweet, Sutter Hill’s chief financial officer, says another advantage of evergreen funds is that they help to avoid fund conflict. For instance, Sutter Hill may invest in Small Startup along with Conventional VC Fund IV and Traditional VC Fund 8. Small Startup may need more money in its follow-on round than Conventional VC reserved from Fund IV, so Conventional VC must invest from Fund V. But the investors in Fund V are not all the same as the investors in Fund IV, and Fund V wants to focus on different sectors than Fund IV, so Conventional VC decides not to re-up.

Kauffman’s Bradley, meanwhile, argues that evergreen funds will avoid the “IRR problem,” where firms raise new funds based on high, yet unrealized, internal rates of return. Bradley thinks this causes premature exits, as GPs sell companies too early because they want to beef up their three-year record in hopes of improving their odds of raising a new fund.

Brown Spots

Evergreen funds tend to be subject to Darwinian forces. if you’re good and people believe in you, then you end up having more sophisticated money.”

Harold Bradley

In a way, though, evergreen funds have an IRR problem, too. How do you value investments in an open-ended fund? Tom Beaudoin, a partner at WilmerHale in Boston and chairman of its fund formation practice, notes that hedge funds use an evergreen structure, but their investments typically are in assets with a publicly available value. Then there’s an evergreen fund’s end date. Sutter Hill’s is in 2032. Beaudoin says that favors “almost exclusively the GP only, and disfavors LPs, because LPs have less ability to take their money out.”

Not so, says Sutter Hill’s Sweet. On a practical basis, Sutter Hill distributes stock or cash with every liquidity event, just like a conventional fund. “We reward investors all along, depending on the economy and how things are going,” Sweet says. Also, the fund restructures every four years, at which point investors can leave or lower their investment levels. As for values, he points out that Sutter Hill does set values, but those values are audited by an independent accounting firm. He also notes that GPs restructure their percentage of the fund at the same time as LPs, and they don’t want to overpay for their shares, either.

Limited partners hold mixed views of evergreen funds. Kauffman’s Bradley clearly is enamored of them. In addition to aligning GPs, LPs and entrepreneurs more closely, he thinks evergreen VC funds make the most sense for investing in things like green energy and biotech, with their long investing cycles. He also thinks the evergreen structure forces GPs to perform better as business creators or risk losing their capital. “Evergreen funds tend to be subject to Darwinian forces,” he says. “If you’re good and people believe in you, then you end up having more sophisticated money.”

Barry J. Gonder, general partner at Grove Street Advisors—a fund-of-funds with $6 billion under management and an advisor to CalPERS, the world’s largest pension fund—thinks evergreen funds make sense, particularly for university endowments and foundations. “It’s a great concept,” he says.

But Gonder adds that evergreen funds present major structural problems to LPs. He says it’s difficult to value the unrealized investments, given that liquidity seems unclear and potential due diligence issues like when the star partner might retire. Because his own fund of funds has a 12-year term, he says it would not invest in an evergreen fund.

Evergreen funds are also a bit like a four-button suit coat. “LPs are more comfortable with things they’re familiar with,” says Kelly DePonte a partner at the placement firm Probitas Partners. “They don’t know evergreen funds. It’s more of a stretch and a risk to them.” DePonte also thinks evergreen funds favor GPs, who no longer have to go through fund-raising every three or four years.

But denying a GP money for a new conventionally structured fund does not get an LP out of the capital calls for the first fund. An evergreen fund that reassesses its capital needs every few years creates the potential for an LP to stop giving money earlier than with a conventional fund.

Nothing is perfect, of course. Nothing is perfect, of course. Sutter Hill’s Sweet says evergreen funds eventually become more complicated to manage than conventional funds.

An evergreen fund favors almost exclusively the GP only, and disfavors LPs, because LPs have less ability to take their money out.”

Tom Beaudoin

Taxing Issue

Sweet details what he sees as the main drawback of an evergreen fund: tax complications when a new investor joins. The fund’s portfolio has a value agreed upon by the LPs and the GPs, and each investor holds a percentage of the overall fund value. If one of the LPs leaves, the shares need to be purchased. If a new investor does the purchasing, things can get complicated.

As Sweet explains it, if a company had an original cost of $10 and a fair market value of $30, the new investor pays $30 for it. But if that company goes public at $30 the day after a new investor joins, the investor shouldn’t have to pay taxes on $20 in profits it did not receive. To keep a new investor from having to pay taxes based on the original costs of an investment, an evergreen fund must file form 754 exceptions with the Internal Revenue Service.

WilmerHale’s Beaudoin says evergreen funds don’t resolve the biggest complaint that he hears from limited partners: being forced to stick with their funding commitment for the life of a fund. He says what LPs really want is the ability to walk away from a fund, perhaps offering a severance payment.

Some of Beaudoin’s objections come down to this: the exotic nature of evergreen funds makes them hard to figure. With such a limited pool of examples, it’s hard to bet an industry on them. Even Kauffman’s Bradley concedes very little data exist for evergreen venture funds.

Besides, legitimate potential exists for other things to solve the ills of venture capital, such as smaller funds. Alan Patricof, founder of Apax Partners and Greycroft Partners, sings the praises of small funds, arguing that the only way for a VC to get rich with a small fund is through carried interest—and that aligns the interest of the GP and the LP.

Then there’s inertia. Some top-tier firms seem to have perfected turning around hit companies in five years. Why should they abandon the lucrative multi-fund structure they have now? Nothing short of a concerted LP revolt will change that. If the industry looks healthy in a few years, after the shake-out ends, no revolt will happen.

But if venture continues to create no green for investors, perhaps we’ll see something new. Something evergreen.