The volatility of the stock and bond markets are causing Institutional, Pension, Foundation and Endowment investors to rethink their portfolio diversification strategies and seek an alternative path to minimize market disruptions that provide more consistent returns with lower volatility over time. With the unusually strong showing of the Initial Public Offering (IPO) markets just a few months ago followed by a virtual market collapse, the longer term, lower volatility of the venture capital and private equity asset classes have renewed investor interest, says Igor Sill, founder of Geneva Venture Partners…
The tremendous success of Venture Capital funded Linkedin’s public market debut is still fresh on investor minds. LinkedIn shares skyrocketed to a high of USD92.99 per share from its opening of USD45, establishing a market value of USD8.9 Billion, virtually overnight. Other high valued IPO candidates include Facebook, Twitter, Groupon, Zygna, Zillow to name but just a few. The recent market turbulence has reinvigorated investor confidence in venture backed companies to the levels of 2004 when the biggest Internet IPO, Google, followed by Salesforce.com, debuted. This strong IPO pipeline in conjunction with Hewlett-Packard’s acquisition of Autonomy for USD10.8 Billion, Google’s acquisition of Motorola Mobility for USD12.5 Billion and Microsoft’s acquisition of SKYPE for USD8.5 Billion represents significant returns from the high tech sector. Venture Capital returns have generally been highly impressive, though illiquid until significant M&A activity or public markets allow realization of those sky high returns.
As of result of the market’s volatility, a global revolution is changing the way serious alternative asset class investors view the venture capital industry. Discarding the old rules, a new, younger era of Venture Capital Fund Managers is re-inventing the venture capital industry and producing greater overall returns. The traditional seed and early stage Venture Capital investing model has changed radically and Institutional Investors are incrementing their allocations upwards for this asset class. Many are seizing the benefits of higher returns coupled with lower investment risk by utilizing the breadth and depth of expertise, knowledge and resources that an experienced Fund of Funds (FoFs) firm provides.
Simply stated, a FoFs is a multi-manager investment strategy of holding a portfolio of other investment funds rather than investing directly in private equity, shares, bonds, or other securities.
There are different types of ‘Fund of Funds’, each investing in a different type of collective investment sectors, such as Hedge Fund FoFs, Mutual Fund FoFs, Investment Trust FoFs, Real Estate Trust FoFs, and for the purposes intended here, Venture Capital and Private Equity FoFs. Venture capital investments are, by their very nature, a long term higher risk, illiquid asset class. Its historical returns, however, have out-performed other investment types. Via a Limited Partnership (LP) arrangement, an investor is typically committing funds in the USD500,000 upwards to USD10 million range for 10 plus years. Redemption liquidity via after market (secondary) sales are limited and generally require prior approval by the fund’s General Partner (GP), thus are generally considered illiquid during the fund’s term. This suggests that venture capital fund investments are better suited for investors with much longer investment time horizons such as Foundations, Pension funds, Family Investment Offices and Endowments.
The very best Venture funds have consistently out-performed the industry and, of course, it’s everyone’s ambition to invest in the top quartile of these funds. After all, some of the most successful public Corporations such as Apple, Amazon, AOL, Baidu, BusinessObjects (SAP), Cisco, Compaq (HP), eBay, Genentech, Google, Hewlett-Packard, HomeDepot, Informix (IBM), Intel, Linkedin, Microsoft, Netflix, Netscape, NetSuite, Oracle, Salesforce.com, Skype (Microsoft), Starbucks, Sun Microsystems (Oracle), PayPal (eBay), Yahoo, YouTube (Google) and, privately-held Facebook were all financed by Silicon Valley venture capital funds. The LP investors in these funds realized significant healthy returns while Facebook’s investors continue to realize tremendous value appreciation.
David Swensen, the visionary chief investment officer at Yale University, has also realized great investment success in the alternative asset classes. When he arrived at Yale in 1985, its endowment was worth approximately USD1 billion, and today the endowment is worth nearly USD17 billion. Swensen consistently achieves high investment returns with low volatility due to his multi-asset approach to investing via exposure to alternative asset classes. He increased investments in private equity funds, venture capital, real estate and hedge funds, an investment strategy that was met with some initial skepticism.
Swensen is a big believer in asset allocation and rebalancing. “Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve.” In numerous speeches, Swensen has championed such alternative investments. He argues that while beating the stock market is almost impossible due to the overwhelming available information about public companies and the subsequent valuation, astute managers can exploit inefficiencies in the value pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk. He argues that keeping funds in investments that are more liquid is a tactic of short-term players versus that of endowments, which tend to hold until private equities are sold or go public. Swensen says “Investors should pursue success, not liquidity. Portfolio managers should fear failure, not illiquidity. Accepting illiquidity pays outsized dividends to the patient long-term investor.” Over the past 20 years, no educational institution has achieved a better performance record than Yale.
Institutional investors are rightfully concerned with fulfilling their fiduciary duties by selecting specific venture funds and Fund Managers with focused market segment expertise.
Understanding which market sectors are most likely to outperform, coupled with identifying capable Fund Managers to exploit those opportunities are a critical component of the investor’s decision making process.
An example would be the emergence of Software-as-a-Service (SaaS), On-Demand, Cloud- computing, Virtualization, Cybersecurity, Open Source, Mobility and financial markets software technologies. These are major, disruptive tectonic shifts occurring in the global IT ecosystem. Trefis estimates that the cloud-computing market (excluding cloud-based CRM software such as Salesforce) stands at about USD65 billion and that this could grow to more than USD300 billion by the end of 2018. Technology’s self-renewing cycle of new wave innovation continues, driven mostly by cost improvements, easier use and vastly greater efficiencies. Confirming this trend, Leo Apotheker, Hewlett-Packard’s President & CEO on HP’s acquisition of Autonomy, August 19th: “In March we outlined a strategy for HP, built on cloud, solutions and software to address the changing requirements of our customers, shaped heavily by secular market trends that are redefining how technology is consumed and deployed. Since then, we have observed the acceleration of these market trends, which has led us to evaluate additional steps to transform HP to meet emerging opportunities.”
With new regulatory issues requiring compliance, transparency, privacy, security to high computational performance via cloud computing efficiencies, there’s a massive opportunity for a bunch of smart people to do some incredibly great things. There exist a huge community of seasoned serial entrepreneurs with a deep-rooted passion to build new companies. Venture capital enables and to a great extent, propels this entrepreneurial innovation. Understanding how investors gain access to the Venture Capital firms leading funding for these innovations, along with their higher returns, is keenly important.
Many of the brand name Venture Capital firms no longer benefit from their founder’s experience, knowledge, network and impassioned mentoring of promising first time entrepreneurs–they have long since retired from active participation, though their names remain on the Fund’s websites.
Though there are pockets of entrepreneurial ideas globally, the epicenter of breakthrough, disruptive technology innovations continues to emerge from Silicon Valley. This is a very unique place with a supportive ecosystem ready to back entrepreneurs’ requirements for launching start-ups successfully. The weather is excellent, the lifestyle is wonderful, and the scenery exquisite. Stanford University, UC Berkeley, USF and University of Santa Clara provide an abundance of superb research and continually spin-off new patents, along with a steady flow of budding intellectual entrepreneurially-driven graduates. 80% of venture capital and Angel investors operate here, and, where else will patent attorneys, new business formation attorneys, equity attorneys give you their time without payment in advance of receiving venture capital funding? Although the capital markets have been sluggish of late, investment bankers eagerly swarm Silicon Valley in order to underwrite venture backed IPO candidates. In no other locale will you find the combination of all these factors.
In such a fast paced environment, with over 3,500 venture capital funds competing for the most promising start-ups, FoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through the very best venture funds. Essentially, FoFs can offer an investor access to the very best performing Venture Capital fund Managers not otherwise accessible directly. Further complicating the process is the venture industry’s notorious lack of transparency relative to their fund’s actual value. A venture fund series financing in one invested company may report a value considerably different than the same series investment in that same company by another venture firm.
Generally, a FoFs has greater leverage in scrutinizing a venture firm’s financial reporting, its partner expertise relative to market sector focus resulting in a better risk-return ratio than direct investments. They’re also looking for more than the conventional venture model has traditionally delivered – multiples of cash back rather than straight Internal Rate of Return (IRR). They seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles, versus today’s typical 10-12 years. The reasons for the impressive growth of FoFs is that they provide diversity among Venture Fund managers, reduce risk and hold out the promise of net returns higher than the average venture capital return rates. Investors are more willing to invest in FoFs for the benefits provided by this pooled investment structure, continual due diligence and on-going oversight compared to investing in a single strategy venture fund. The most common FoFs fee structure is a management fee of 1% and an incentive fee of 10% above that of the underlying Venture Capital fee structure. The additional fee layer is relatively small with returns generally more than offsetting the added expense. A balanced, properly allocated venture capital/private equity portfolio generally tends to provide higher returns with less inherent risk.
An industry focused FoFs is well experienced in assessing the most promising Venture Capitalists, both the Emerging Venture Fund Managers as well as the historical brand name Venture Capitalists. The brand name Venture firms provide a low-risk foundation for consistent top-quartile performance albeit with higher fees to their LPs. Emerging Fund Managers focused on rapidly growing market sectors offer outsized return potential for their portfolios. But, Emerging Venture Fund Managers who follow a more capital-efficient investment model can deliver industry-leading returns while reducing risk with shortened investment cycles at competitive fees to LPs.
The selection process of either brand name Venture firms or Emerging Fund Managers should entail research of their respective track record of investments, actual hands-on involvement of their investments, the firm or Emerging Fund Managers’ lure and stature within the entrepreneurial community (deal flow source), and most importantly, the ethical reputation and transparency in reporting accurate portfolio valuations. Do some serious research here, as the term “success has many fathers” applies in spades to promotional materials.
Consistently successful returns are achieved from only a few select firms who diligently study, identify and invest in technologies and markets on the leading edge of disruption. They tend to focus on building companies at the forefront of market forces creating outstanding growth and exit opportunities. These particular Venture Capitalists are notorious for sourcing and developing fast-growing companies in large market growth sectors.
Look for a FoFs Manager with investments in venture capital funds possessing the demonstrated expertise, deep experience and qualifying techniques in specific areas of their investment focus. A top tier Venture Capital firm will utilize extensive analytical techniques to evaluate and compare each investment prospect. They will benefit from extensive industry contacts and global business leader connections. These relationships help provide the foundation for executive team recruitment in their portfolio companies, follow-on financings, facilitating strategic corporate alliances, new partnership opportunities and most importantly, exit strategies whether through leading Investment Banking underwriters for IPOs or M&A activity. Doing your homework upfront and placing your bets wisely can result in significant healthy returns whether through a FoFs or direct LP participation in a Venture Capital fund. Of course, past performance is no guarantee of future results.
