Thursday, November 01, 2007

Venture Capital and Emerging Managers

I recently wrote a post, Portfolio Math, that examined the hit rate and return on invested capital required for the venture capital industry to be viable. The post led to excellent feedback from venture investors, entrepreneurs, and, interestingly, limited partners in various venture capital funds.

The existential question the comments begged appears to be, is it worth investing in the venture asset class?

The current LP position appears to be rather axiomatic:
  1. average venture asset class returns are a nonsensical number
  2. why? less than 20% of the firms drive greater than 80% of the returns
  3. it is borderline impossible to get into the top venture funds
  4. blind allocation to the asset class - ie if Sequoia says no give it to someone who will say yes, is now recognized as very flawed logic
The question then becomes what should LPs do. I see 3 possible choices
  1. leave the asset class
  2. be patient and wait for allocation to top tier funds
  3. sponsor emerging manger funds targeting young GPs at top tier funds
The first two choices imply that an LPs allocation to venture will be materially reduced on both an absolute and relative dollar basis. Less money will enter the system and, like most maturing industries (think ORCL in software), the excess rents in the market will be captured by a diminishing number of firms. The competitive position of the top firms will compound over time as competitors drop out of the market as LPs refuse to fund them.

The last choice is also interesting to consider. In the hedge fund industry, it has long been standard practice for LPs who cannot get into Citadel, SAC, and other top funds to lure away rising stars to start their own firms. If the axioms above continue to hold, I would not be surprised at all to see groups of sophisticated LPs lobbying younger GPs to start new funds in order to ensure allocation to talent who can drive returns in a now well-established Pareto distribution market.

Over the next few years, I expect to see more firms fail as LPs refuse to reup, the total dollar size of the industry shrink, and the birth of several new venture firms run by top-tier alums and backed by LPs committed to the asset class but denied entry by the door keepers at the top firms.

After posting the above, someone sent me the following news story:
California State Teachers' Retirement System may once again be reducing its target allocation to venture capital, this time in favor of debt-related investments such as distressed debt and mezzanine, according to the agenda for its Nov. 1 investment committee meeting.

The pension system is mulling changes to its investment policy that would reduce the target allocation to venture capital to 5% from 15% of its alternatives portfolio and raise the target allocation to distressed debt and mezzanine from 5% to 15%, according to the agenda. The proposal would also reduce the upper end of its venture capital target range from 25% to 15% and increase the upper end of the debt-related target range from 10% to 20%.

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