The Rise of Funds of Funds Another Sign of The Times

The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.

 

Source: Dow Jones Private Equity Analyst

We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds  managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.

In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).

Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.

A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments.  In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape. 

Venture Fundraising in 2010

2009 was clearly a difficult year for venture firms – continued turmoil in the public markets and the broader economy prolonged the dearth of venture-backed IPO and M&A activity, extending the liquidity drought for venture firms. Illiquidity negatively impacted fund performance, and more importantly the confidence limited partners (investors in venture capital funds) have in the asset class. The drop in confidence is most evident in their commitments to venture funds, which in 2009 fell significantly. According to Dow Jones, “overall VC fund-raising fell 54.6% to $13 billion across 120 funds from the $28.7 billion collected by 204 funds in 2008. It was the slowest year since 2003.” Here are a few things to watch for in 2010 in terms of fundraising:

Commitments to Top Tier Funds:

Fundraising totals for 2009 would have been worse had it not been for New Enterprise Associates (NEA) closing its thirteenth fund with $2.5 billion in commitments. While the fund took longer than expected to close, the fact that it was eventually able to do at a such a large size shows that institutional investors still have an appetite for firms like NEA that have a record of consistently delivering top quartile returns. This will be a theme going forward – we will see the most sold performers (firms such as Sequoia, Kliener Perkins, Matrix, Battery, etc.) continue to be able to raise capital, but fund sizes will still come down. If for some reason we see a top firm unable to get close to its fundraising target, it would be a sign that limited partner perception of the asset class is worse than feared. The shockwaves would be felt across the venture universe.

 The Numerator Effect

Over the past couple of years, the “denominator effect” has been a central issue for most large institutional investors / limited partners. Some quick background for the unfamiliar: If you think of an institutional investor’s allocation to venture capital as a fraction, the denominator is the total value of their total investment portfolio. The numerator is what is invested in venture capital. Stocks and bonds are traded daily, whereas venture capital is only valuated quarterly. When stock prices fell during the recession, it brought down the value of the overall portfolio, or the denominator, but at the same time, the percent actually invested in venture capital went up because the value of venture portfolios 1) are reported on a lag and therefore had yet to be written down in line with the public markets, and 2) didn’t declines as much relative to marketable securities.

In 2010, what we have already seen is that the denominator has rebounded – in line with the stock market (for example, the NASDAQ was up around 40% in 2009). However, the numerator, or value of institutional investors’ venture portfolios has remained suppressed – again, because venture capital valuations are reported on a lag. The real value of the numerator won’t be known until final year-end 2009 data is taken into account, which won’t be until April. Once that happens, institutional investors will really be able to get a true sense of where their allocations stand. This means that the second half of 2010 should see more commitments than the first half.  

 Attrition:

Early in 2009, PE Hub’s Dan Primack released a list of “The VC Walking Dead.” These were venture capital firms that were officially in business but which no longer had enough cash to add new portfolio companies. Presumably that meant they will no longer try or be able to raise subsequent funds.  Expect the list of firms that fall under this category to grow in 2010. The bar for venture firms will be much higher going forward. The amount of capital committed to the asset class will probably never (or not for a really long time) return to the levels of 1999-2000, or even 2007 for that matter. It’s the general consensus that there was too much capital in the venture industry and limited partners weary of the asset class have every reason to be extra judicious with their commitments. That spells bad news for undifferentiated firms, inexperienced firms, and firms with poor track records.