By Igor Sill
The venture capital industry is undergoing a major change from its elitist past of restricting investor access to “friends of the firm only.” As Wall Street embraces dozens of new initial public offerings (IPOs) of venture-backed companies, hopeful investors are flocking to this asset class. These venture capital investments continue to deliver positive returns at a better rate than public market indexes such as NASDAQ or S&P. The venture-backed technology sector led on trading volume with 44 companies going public last year.
As pensions, endowments, foundations and institutional investors increase their venture allocations, they are now also applying closer scrutiny of reported venture fund performance. These investors are recognizing greater opportunities to generate excess returns but are resource constrained on due diligence, accurate performance comparisons and audit reviews. Many seek advice from independent accounting firms and law firms to decipher reported returns. And many delegate the oversight function to specific fund advisory organizations. A recent study by Casey & Quirk projects that outsourced investment assets in the United States have grown to $510 billion as of this year.
Further complicating the process is the venture industry’s notorious lack of transparency relative to their fund’s actual performance. A venture fund series financing in one invested company may report a value considerably different than the same series investment by a co-investing venture firm. Since reporting of venture equity returns is a relatively unregulated process, some firms tend to self-report questionable quarterly performance to public databases and publications so as to attract further investment capital from LPs. Researching public data results from sources such as CalPERS and other pension investors tends to provide a more accurate picture of actual returns.
Why investors are turning to specialized Venture FoFs
With a growing opportunity for investors to construct optimal portfolios by better assessing risk opportunities across the entire venture capital class, investors are turning to the expertise, knowledge and resources that Fund of Funds (FoFs) firms provide. Simply stated, a Venture FoFs is a multi-manager investment strategy of holding a portfolio of venture capital funds rather than investing directly in venture-backed securities.
FoFs represents a means by which an investor can reach the relatively high minimum capital commitment ($500K+) through pooling their investment with others, thus gaining access and broad exposure to a select group of funds. In addition, a FoFs typically scrutinizes venture capital general partnerships for accuracy of reporting, historical performance and value creation of invested entities, among others. A good FoFs may also provide access to the very best performing, top tier venture funds.
Institutional investors are rightfully concerned with fulfilling their fiduciary duties by selecting specific venture funds and fund managers with proven 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. The goal remains to seize the benefits of higher overall returns coupled with lower investment risk.
Generally, a FoFs has greater leverage in scrutinizing a venture firm’s investment talent while assessing the accuracy of its financial reporting. They’re also assessing more than the reported returns, such as multiples of cash back rather than straight Internal Rate of Return (IRR). FoFs 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, access to top-performing funds, 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 ongoing 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 percent 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.
Though there are pockets of venture investments globally, the epicenter of premier technology innovation continues to emerge from Silicon Valley. This is a very unique place with a supportive ecosystem ready to back entrepreneurs’ requirements for launching startups 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 research and continually spin off new patents along with a steady flow of budding intellectual entrepreneurially driven graduates. Hence, 80 percent of venture capital and angel investors operate in Silicon Valley; and, not surprisingly, 90 percent of the highest venture returns occur here.
In such a fast-paced environment, with over 3,500 venture capital partnerships competing for the most promising startups, 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 top tier performing best venture capital fund managers not otherwise accessible directly.
Selecting a venture firm or fund manager
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 value creation involvement within 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 performance returns.
Do some serious research here, as the term “success has many fathers” applies in spades to self-published venture materials. You may wish to consult with an experienced venture law firm or venture advisor who can draw on substantial limited partner (LP) and general partner (GP) expertise and expose the many significant incongruities and styles in how LPs and GPs generate and distribute returns.
I’ve come to learn that consistent, successful returns are achieved from only a few select venture capitalists who diligently identify and invest in technologies and markets on the leading edge of disruptive innovation. 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. They’ve also built a substantial reputation for value creation and thus are sought after and welcomed into the hot startups by seed angel investors as well as the best founding entrepreneurs.
Some examples of hot startups that may have crossed the risk chasm include:
3Leaf, BlueWolf, Cloud9 Analytics, Cloudscale, CloudSwitch, Cloudberry, Cloudera, Demandware, Good Data, Kenandy, iCloud, Nuxeo, Quantivo, Quora, Palantir Technologies, Palo Alto Networks, Parallels, ParaScale, ProofPoint, Savvis, ServiceMax, SoundCloud, SnapLogic, SutiSoft, Zazzle, Zimory and Zoho, to name more than a few.
Some of these promising startups are already partnering with public traded Software-as-a- Service (SaaS) and cloud computing companies like Salesforce.com, Cisco, EMC, Oracle, HP, etc., but have extended their customer base to an entirely different, much larger market segment. The SaaS subscription model of recurring revenues provides predictable visibility into cash flow, growth rates and a substantially profitable business, generally achieving a premium valuation for venture investors and, ultimately, the IPO market.
There exists a massive market with a strong rising tide in cloud computing and SaaS deployed IT solutions. This is a period of significant transformation that is creating extraordinary venture investment opportunities. A little research and you’ll find some of the very same venture capitalists invested in many of these hot startups. Seems that learning from success tends to create more success.
Igor Sill is managing director of Geneva Venture Management LLC. He is a Silicon Valley venture capitalist and founder of Geneva Venture Partners. Igor manages his own angel investment fund at Geneva Venture Management and is also a Limited Partner in Goldman Sachs Investment Partners, Benchmark Capital, Norwest Ventures, Granite Ventures, The Endowment Fund and ICO Funds through his Family Office. Igor resides in Silicon Valley and has 23 years of tech investment experience. Contact him at firstname.lastname@example.org.