Editor’s note: John C. Yates, who chairs the Technology Group of the law firm Morris, Manning & Martin, LLP, writes a weekly column exclusively for Local Tech Wire.I recently moderated a panel discussion of venture capitalists and a chief investment officer for a major university endowment. The discussion focused on the current state of the venture capital and private equity markets. Many of the questions centered around the process for raising money for a venture fund and ways to measure fund performance. The information was enlightening — and somewhat unexpected.
Here are some of the highlights:
1. Is this a good time to start a venture fund?
No, but there are exceptional cases. Endowments, retirement plans and large corporations are often the major source of proceeds for a VC fund. In the past, these capital sources have been deluged by venture capitalists seeking additional and larger funding commitments.
In the current environment, VC funds are shrinking. As a result, the chief investment officers for endowments and retirement funds are facing fewer requests for more money. With fewer hands extended, the investment officers may have more time and willingness to consider proposals from new would-be venture capitalists.
2. What are the key factors considered by a chief investment officer in determining whether to invest in a limited partnership that will be operating as a venture capital fund?
There’s no mystery answer to this question. The investment officer focuses primarily on the people — the managers of the fund. Factors considered by investment officers include the business successes/failures of the general partners, whether the fund managers have worked together in the past (and their track record as a team), and their integrity and values.
The bottom line is that a newcomer trying to start a venture fund may face insurmountable challenges in this environment. Investment officers have reverted to the time tested criterion for selecting VC fund managers — there’s no substitute for experience.
3. If I’m starting a venture fund, how much money should I ask for from the prospective institutional investors?
Most institutional investors want to invest at least $10 million or more in a venture fund. However, they also want to limit the size of their investment as a percentage of the fund’s overall proceeds. Consequently, the small venture fund may face difficulties in raising capital from larger institutional investors. The dilemma is that the institutional investors may want to put large amounts of money to work with the fund, but if the fund is not large enough in overall size, then the anticipated monies to be invested by the institutional investor will exceed their percentage limits.
4.How are institutional investors measuring performance of their venture fund investments?
Generally, institutional investors measure performance by comparing a venture fund’s results with its peer group of related funds. The institutional investor has data on the performance of venture funds throughout the country as well as a scorecard on its own venture fund investments. A VC fund receives a report card on a periodic basis from its investors. If the fund is on the low end of performance, institutional investors are unlikely to provide additional capital in future fund raisings.
5.With the poor performance of many VC funds, what can institutional investors do to minimize the adverse impact?
Institutional investors seem to have adopted a number of approaches to addressing the poor performance of venture funds. First, some investors are obtaining releases from having to make additional funding commitments. In this way, the percentage of the assets of the institutional investor placed in venture funds is reduced — as is the exposure of the institutional investors funds in riskier investment areas.
Second, some institutional investors are requesting (or demanding) that the management and related fees charged by the venture funds be reduced. Although there may be no legal requirement for such a reduction, most funds are accommodating this request.
6. What impact do institutional investors have on the future of
venture capital investments in technology companies?
In the long run, the impact could be significant. Institutional investors are generally reducing the gross proceeds that are available to invest in limited partnerships acting as venture funds. Consequently, there will be fewer dollars available to invest in technology companies.
Also, institutional investors may be making larger investments in fewer venture funds. The result may be venture funds that desire to make larger investments themselves in technology companies — to the detriment of early stage businesses. Startup companies may be further challenged in finding sources of capital and venture funds willing to make early stage investments.
7. How do these trends impact tech companies in the Southeast?
Our region has been impacted harder than many others in the US. Based on an informal survey of the venture community and institutional investors, the Southeast seems to be underserved in many ways in the venture area. First, institutional investors have generally spent less time with venture funds in our region, resulting in fewer dollars being available for investment in technology companies.
Second, we have fewer venture funds in our region than in many other areas of the country. Consequently, we have been unable to attract significant interest among institutional investors.
Third, the Southeast has suffered a reduction in the number of venture funds headquartered in our region. In the late ’90s, many angels in the region established small venture funds. Those funds helped to “seed” many of the Southeast’s leading technology companies. Today, many of those venture funds are folding or discontinuing their investments and merely monitoring their portfolios.
These are challenging times for venture funds in the Southeast. Let’s hope that as the economy turns for the better, our venture community will expand and that institutional investors will spend more time in our region.
John C. Yates Chairs the Technology Group of the law firm Morris, Manning & Martin, LLP, which has offices in Atlanta, Charlotte and Washington, D.C. He can be reached at email@example.com and (404) 504-5444.
This column is presented for educational and information purposes and is not intended to constitute legal advice.