Harvard Business School Working Knowledg e Archive

Locating Venture Returns

Syndications, pressure from limited partners, and due diligence to the extreme all point to new times for the venture capital industry. What's next?

A panel discussion on the venture industry past, present, and future unearthed an interesting trend: The increasing interest of public limited partners in private equity could be adversely affecting the industry.

The discussion was held February 7 at the 10th Annual 2004 Venture Capital & Private Equity Conference, held at Harvard Business School.

David Aronoff (HBS MBA '96) general partner at Greylock Capital, said the motto in VC used to be "Undersupply of capital for oversupply of good ideas." But now capital markets are increasingly willing to take on risk with VCs, and this situation has turned.

With so many limited partners today wanting a part of VC's potentially lucrative returns, there's the possibility that the money they're putting in this sector is artificially inflating it.

The panelists all pointed out that given the poor returns recently, LPs have good reason to drastically reduce their exposure to this area; but they don't for fear that they'll miss the next wave of high returns.

Larry Bettino (HBS MBA '89), managing director at Warburg Pincus, said, "There is no chance that a significant number of venture capital firms that raised capital over the past five years are going to generate the type of returns that were typical five years ago. When the majority of the industry is not producing the stated rate of return that's being promoted, something's wrong that has to be corrected."

Angelo Santinelli (HBS MBA '89), general partner at North Bridge Venture Partners, pointed out that with the dot-com implosion many firms had left the market and many more are likely to leave as the situation is played out. It hasn't happened yet because "LPs are still willing to put money into firms without track records," Santinelli said.

When the majority of the industry is not producing the stated rate of return that's being promoted, something's wrong that has to be corrected.
Larry Bettino, Warburg Pincus

In 1982, he continued, if you had an excellent track record, it could take up to a year and tremendous difficulty to raise a fund. Now people with zero experience can raise a $250 million fund in no time, and have all that money invested somewhere in a year-and-a-half.

Michael Krupta, managing director at Bain Capital Ventures, mentioned that in the past ten years a venture capital "industry" has been created where formerly there wasn't one. Panelists were uncertain whether mainstreaming was the best thing to have happened to their sector.

More money than deals
The supply of decent deals for the tremendous amount of funds available is misaligned. Fund general partners (GPs) on the panel said that even if the LPs are honestly told there's no place else to profitably invest their money, the LPs will just find another VC firm that will take their money rather than taking that as a hint to reduce their exposure to this type of investment.

All agreed that there will be a correction, but it will probably happen over a long period of time. As one of the panelists said, "It's not like equities. You can't just pull your money out of a company."

But it is inevitable that the amount of money being put in VC will eventually be reduced when the true market value of VC-financed successes are measured using pre-1997 experiences as guidelines, rather than the inflated prospects of the recent boom.

Also, as was underscored in another session on mezzanine finance, limited partners are only beginning to realize that they need to diversify their private equity portfolios. With poor recent returns in VC, LPs are looking at other alternative asset categories such as mezzanine and buyouts. Such changes also point to the maturing of the industry and increasing commoditization of private equity capital.

In commenting on disclosure issues, the panelists said that given this rather "awkward investment hiatus period," GPs have worked harder to provide more information to the LPs on investments. But in some cases this has backfired.

One example: When an LP was given financial information that was then shared with a competitor, the firm didn't end up getting a deal. All agreed that there is an increased need to educate LPs on such issues. They recommended calibrating any shared data.

To avoid such headaches, some firms just avoid this investor category altogether. David Aronoff of Greylock Partners said his firm has a policy of not working with public investment funds, and this has been a positive selling point for their other investors.

No easy way out
One effect of the recent sluggish M&A and IPO markets is that firms are no longer counting on easy exit strategies. Instead, they are going back to basics and focusing on profits. Now when a venture firm makes an investment, it's a big deal. Nothing is taken for granted anymore in the due diligence process.

Also, there has been an increase in what Aronoff called "boot-strap" deals, where the owners have already worked out many of the kinks in their innovation before seeking VC's funding. With so many entrepreneurs burned by the technology bubble, they are being much more careful to ensure their concepts are functional, realizable, and needed in the marketplace.

Another change from a few years ago is that VC firms are syndicating on deals with other firms they work well with to help the success of these ventures. During the dot-com period there were so many new firms that VCs often found themselves linked up with firms they didn't know or have good synergies with.

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.