A VC Revolution In The Making

Last night I was invited to attend (thank you Brenda Chia, president AAAIM) the panel discussion “Market Changeup: Fund Management as a Business”, with Priya Mathur (Board director of CalPERS, California Public Employees’ Retirement System; one of the biggest investor in LPs and VC funds), David Fann (President & Chief Executive Officer, PCG Asset Management), Jan Le Chang (Vice President, Centinela Capital Partners), Phil Phleger (Morgan Lewis) and Bob Grady (Managing Director, Carlyle Ventures).

Compared to last year (written up here) the opinion of the people at the top of the innovation food chain was remarkably introspective:

Venture Capital is broken in some fundamental way.
So much so that PCG predicts a revolution and a complete redesign of the Venture Capital model, with CalPERS nodding in agreement. CalPERS has gone from a yearly review of their asset allocation to quarterly and is currently debating new hybrid asset allocation models. That means less dependency on VC, and more on other vehicles. At the same time it is looking to reduce its relationships to only the top quartile VCs and getting out of the mid and bottom tier ones altogether. Annex funds, created to fill the void of fleeing late stage investors, are not found to be interesting as the majority of the funds currently in the pipeline will not produce positive returns anyway.

The sentiment from the fund managers was that they are literally “fed up with the rock star parties from VCs that don’t produce returns”. A conclusion clearly not received by all funds as we hear (from a trusted source) that general partners at a downtown Palo Alto walking-dead VC firm are still fetching $1M yearly salaries each, this year.

Everything is going to change.
VC is not dead, but everything is under review. Fund managers are now for the first time talking to each other to fundamentally change the outcome of the game, regardless of the state of the economy. They all admitted that none of the widely used mathematical risk models prevented the precarious situation that now forces even CalPERS to pay close attention to its balance sheet and carefully manage available investment cash.

Limited Partners are looking for full transparency of the VC funds, going as far as wanting to see their balance sheets and who is holding their securities. Under the magnifying glass are VC management fees (no more 25%), splits, as well as exorbitant fees gained through stacked funds. Co-investment with endowment funds are debated as they are too over-allocated in the equity vehicle to provide sustainability. We may see more monolithic investments in VC as a result.

All fund managers think cleantech and health-tech are interesting asset classes, but think the fleeing from technology is somewhat worrisome, they have become weary to over-allocate anywhere. Globally, no economy has proven to show any disparate advantage, the asian and china plays fell equally as hard as the US and elsewhere.

Moving forward, but not so fast.
New VC funds will need to come up with a better story. The creators of the new VC funds will likely be experienced operators (just like at the start of technology evolution), removing the pure money managers who failed to add substantial value. They are expected to, as a team, have demonstrated an ability to warehouse deals before, deliver a unique value proposition to the investment climate and provide substantial value to the disruptive proposition of their portfolio companies.

CalPERS is eagerly looking to invest in emerging money managers who in due time (2-3 years expectancy to close a new fund) can expect their renewed support. So far, in the first quarter of 2009, 3 new funds have been invested in (compared to 47 all of last year) and no significant uptick is expected until this summer.

Clearly fund managers are licking their wounds, in a holding pattern for some positive news on the economy and perhaps some much needed regulation with regard to transparency. Rest assured, no fund manager seems to debate the value of venture capital as an investment vehicle, it is here to stay.

Help is on the way.
The great outcome for entrepreneurs is that fund managers (as we predicted) from now on will pay close attention to the type, behavior and performance of VCs that allows entrepreneurs to build new companies more effectively.

Good times are coming.

Georges van Hoegaerden is the Managing Director at The Venture Company (www.venturecompany.com) in Palo Alto, focused on helping companies with technological and market insight, organizational development, team building, selling and managing growth. This post originally appeared on his blog.


  • Absolutely the most rational piece that has been written on the reasons why the VC industry will need to incorporate some changes going forward. So few of the postings about current issues in venture investing bother to note what a poor investment venture has been for so many investors since the bubble burst. There appears to be a great willingness to blame everyone else and a staggering host of outside forces for the current slowdown without being even the tiniest bit introspective.
    Like in the other highly-paid sectors of financial services, the time has come to be grateful for the bounty of the past and recognize that much-deserved change is coming. Markets don’t stay inefficient forever.

  • I have an MBA in finance, but was an entrepreneur before b-school. I used to sit in VC/PE class and shake my head. Finance has this false notion that its a science and that all you need to do is make the right models models models and Boom, you’ve earned your pay. Ex-bankers would laugh at “marketing and management” as fluff. Meanwhile I thought Finance was the fluff. Building a model is easy compared to identifying what people value and will pay for, and running a team that could slay this monster every single day.
    Financial services just well rewarded because they look after society’s money and investors want don’t want them to be unhappy. Unfortunately I have no doubt that misaligned incentives will re-install irrationality once things start getting better.

  • Sam, the reality is that entrepreneurs need great financiers and vice versa. Over the last 10 years the majority of VCs have turned entrepreneurialism into a sub-prime asset class, that consequently attracts only those entrepreneurs that submit to sub-prime tactics.

    Fund-managers like CalPERS are painfully aware of the performance issues, which is the first step to recovery. The second step is to understand why things went wrong, and for that they would need to understand the restrictions VCs put on entrepreneurs today. The third step is to formulate a better asset allocation plan for the fund-managers. I plan on presenting all of those issues to the fund-managers soon.

    What is illuminating to hear is that the needs of the fund-manager and the entrepreneur line up perfectly, yet the intermediary (the VC) seem to pursue its own agenda. That realization is starting to sink in.

    Think of it like nature’s pyramid. The fund-manager is the apex predator (no pun intended) that requires healthy sub-species (LP, VC, entrepreneur) to exist. When the apex-predator can’t find enough food, it will move to other places where it can. We have a great opportunity demonstrating to them where better tasting food can be found.

    But don’t blame the apex predator for being a lion, we need him to be. As LPs, VCs and entrepreneurs we just need to execute on each of those core competencies, and do what we do best.



  • Georges

    I agree that the problem lies in the intermediary (VC) and that this is a classic Agency problem.

    My point I’m trying to make is at the heart of the problem of VC today is the creeping domination of VC firms by professional finance-types (aka ex-bankers) with a false entitlement mentality. I was heartened to read that “The creators of the new VC funds will likely be experienced operators (just like at the start of technology evolution) , removing the pure money managers who failed to add substantial value.”

    I’m a finance professional today, but perhaps due to my prior career as an engineer, I believe finance is just a joke. Engineering is based on physical laws. 10 times out of 10, gravity will work. Finance is based on economics, a bunch of assumptions about “rational” human beings and historical P/E values and discount rates. Humans are irrational and history is no predictor of the future.

  • […] A VC Revolution In The MakingWhy Time and Newsweek Will Never Be The EconomistPHP and the Cloud © 2009. Michael […]

  • Georges:
    Great article and responses. I need a few explanations of your terms.

    What do you mean when you say: “VCs have turned entrepreneurialism into a sub-prime asset class”

    I also do not fully understand what, “Limited Partners are looking for full transparency of the VC funds, going as far as wanting to see their balance sheets and who is holding their securities.” means.

    Thanks for the clarification.

    P.S. By the way I was pointed to your article through a copy that was posted by Nahum Goldmann (with full attribution) in an HAE-run finance group I moderate, harvard_startups – http://finance.groups.yahoo.com/group/Harvard-startups/message/15211

  • Steve, thanks. Subprime VC is extensively explained at my blog at venturecompany.com/opinions

    The fundmanagers and LPs are going to request more more than a list of outstanding moneys, but will implement new transparency rules, requiring the VCs to show how they are distributing the money and also how and where the draws are held.

    More details to follow soon after I’ve conversed more on this topic with specific fundmanagers.



  • […] “The venture industry is not broken, but some of the participants in it are.” PEHub had an interesting take on this matter a few months ago: “New VC funds will need to come up with a better story. The creators of the […]

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