Igor Sill: Investing in Venture Capital—Limited Partner or Fund of Funds?

Investor confidence in venture capital is at an all-time high. The unusually strong IPO market and its pent-up pipeline is due, in part, to the tremendous success of LinkedIn’s recent public market debut. The professional social network’s shares skyrocketed to a high of $92.99 per share from its opening of $45, establishing a market value of $8.9 billion virtually overnight. The markets have reinvigorated investor confidence in venture-backed companies to the levels of 2004, when the IPOs of Google and Salesforce debuted. This strong IPO pipeline in conjunction with Microsoft’s acquisition of Skype for $8.5 Billion represents a significant liquidity window for VCs and LPs. Though venture returns have been relatively meager over recent years, VCs have been busy re-focusing their firms while continuing to invest and develop their existing portfolios.

A global revolution is changing the way serious alternative asset class investors view the venture capital industry. Discarding the old rules, a new, younger group of VCs are re-inventing the venture capital model. The traditional seed and early-stage venture capital investing model has changed radically and investors are seriously re-assessing the allocation method they once used 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.

‘Fund of Funds’, each invest in a different type of 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 $500,000 upwards to $10 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, 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 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 $1 billion, and today the endowment is worth nearly $17 billion. Swensen 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.

Huge problems still remain to be solved and massive opportunities loom as major corporations, mid to small businesses all seek competitive advantages via new technologies. The emergence of Software-as-a-Service and cloud computing are major tectonic shifts occurring in the global software ecosystem. Technology’s self-renewing cycling of new wave innovation continues, driven mostly by cost improvements, easier use and vastly greater efficiencies. 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. 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. Eighty percent 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 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 one percent 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 market valuations. Do some serious research here, as the term “success has many fathers” applies in spades to promotional materials.

There are essentially three high potential appreciation types of technology investments which venture capitalist traditionally focuses on: seed & early, development stage and late-stage expansion. And, within these three categories, there are three sub classes: disruptive innovation, enabling technologies and special situations. Market trends and dynamics coupled with technical challenges are very often industry specific. Understanding these issues is critical to the successful mentoring and value creation guidance of start-ups.

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.

The author, Igor Sill, is a Silicon Valley venture capitalist and founder of Geneva Venture Partners.