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BGV recently moderated a panel hosted by Marcus Evans on the challenges faced by LPs in constructing an alternative asset portfolio around the Venture Capital asset class.  The panel members included Matt Stepan with CFM, a financial advisory firm with $11Bn AUM, and Freeman Wood with Mercer Sentinel, a leading investment advisory consulting firm.  The full webinar can be accessed at:

https://vimeo.com/marcusevans/review/233650620/3d1129d2c3.


This entry is the second and final part of the blog focusing on the topic of sustaining returns in the Venture Capital asset class over time.

 

Context & Key Trends


One of the myths about Private Equity is that private equity does well in good markets and does worse in bad markets. The data below shows that private equity performance has outperformed public markets in both good and bad markets.

     











 




As we look into the venture capital asset class, we find a similar story.  Since the recovery from early 1999-2000s the venture capital asset class has outperformed the S&P 500, with a constant increase in IRR and multiples across recent vintages (see charts below).



                    



The chart below from Cambridge compares gains in their cohort of top 100 investments. They concluded that “success comes in all sizes”, meaning the group of top performers includes both large and small funds – ranging from small funds- less than 250M, to mid-size funds, and to larger funds – funds more than 750M. In recent years, funds of less than $250M have accounted for a good portion of value creation.

 



Cambridge has also looked into the performance of top quartile US venture capital funds by vintage years across new funds, developing funds (funds that are in their 3rd or 4th fund), and well-established funds. The cohort of top quartile venture funds contains a good mix of new, developing, and well-established funds.




This data runs contrary to the common notion that only well-established billion dollar funds provide good returns to investors. As investors look to deploy into this asset class, there is an argument to be made in having a basket of investments across big and large, new and established funds.  

 

Q&A


The topic we are going to discuss is the best practices our panelists and their clients have used to sustain returns in the venture asset class after they have made the manager selection decision.  

  1. Matt, at CFM what has been your experience with key variables that led to sustaining performance over time with your VC fund investments?
  2. We have seen a few patterns that contribute to persistence of returns over time. These include: a) Relatively modest fund size – Smaller funds focused on a fewer number of portfolio companies with a thoughtful approach to how they deploy their capital.  Larger funds tend to become less nimble.  It is important to be nimble in the VC world because the startups are often going at a sprint and firms need to be able to react to that while being thoughtful; b) We have also seen consistent success from funds where the teams are focused within markets or sectors where they have a deep understanding of the trends transforming them.  Our prototypical funds are ones with 3 GP’s, a team size of 10-15 people, a fund size greater than $100M but sub $300M with a focus on 3-4 sectors that the team knows well; c) From a portfolio construction basis, funds that have a mix of companies that are both solutions oriented and disruptive do well.  Solution oriented portfolio companies with a good operational track record can often get to good M&A exits on an all cash basis.  We have found that a balanced portfolio between disruptive IPO track startups and solutions oriented startups leads to a persistence of returns over time; d) Finally we believe that the personal character of the VC’s is also a determinant.  Often times when companies begin not to perform to expectations, sometimes VCs step away too early instead of taking corrective action.  While it makes sense to spend time with winners, we also believe that fund managers should be thoughtful in sticking with what they have invested in by taking corrective action instead of settling for a suboptimal outcome.

 

  1. Freeman, what are some of the best practices around risk control to protect the sustainability of returns over time that you suggest to your clients when they invest in Venture Capital?
  2. We have a strong belief that establishing transparency is important – in what is being invested in by the managers as well as how those investments are performing over time. Sometimes our clients fall into the trap of a “set it and forget it” mind set because they are dealing with committed capital but we believe that being proactively involved is critical after making the investment allocation.  We advise our clients to perform on-site diligence as frequently as they are comfortable (at least once every 12 or 18 months) to see how the manager is controlling their risks and how the portfolio is performing.

 

  1. Matt, we have seen cases where investors have used various techniques to get to know the manager team using direct or co-investments. Can you comment on how CFM has scaled its venture fund relationship? Have you done direct and co-investments?
  2. We have had the opportunity to do both and have found that co-investments that are follow on investments (Series B and C) work better for us. These opportunities give us the time to get to know the company, the management team and track progress over time before making a co-investment decision.  We have led a few direct investments but we feel that this does not align as well with our expertise and that VC firms are better suited to make such investments.  Finally, we want to be viewed as a partner by VC firms and not as competitors.  For all these reasons we have found co-investments to work better for us than direct investments.

 

  1. Freeman, what is the best way for your clients to get to know a GP at a fund?
  2. It is a combination of upfront diligence before making the investment decision and post investment relationship building. Often a combination of meeting the manager, understanding their expertise/edge, ensuring that there is an alignment of incentives and getting to know the supporting teams, the key processes (beyond the GPs).

 

  1. What has been you experience with trying time investments in the venture capital asset class.
  2. CFM – While industry data over time reveals that vintage year does play a role in investment performance, we have found that a sustained effort over the long term (ten years or more) results in consistent performance. If this is done well then distributions from earlier years end up funding current and future capital commitments.  We have found the optimal strategy is to be patient, invest in the asset class for the long term and apply the best practices that have been discussed today to deliver good returns.  VC investment is a marathon even though at times the VC markets may feel like a sprint but applying a consistent framework can lead to a persistence of returns.  It is important not to get caught in the day-to-day sprint and stay focused on the long term.
  3. Mercer – I agree, timing is a double-edged sword – do it well and it can be lucrative, do it poorly and it can be very painful. Having a commitment and a process for an asset class for the long term enables LPs to smooth out timing differences and get to know the fund managers well.  This is important.  We have found that LPs who invest in different asset classes some times uncover best practices that can be leveraged to help their fund managers improve their performance.  These types of long-term relationships are a win-win for both LPs and fund managers.  
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BGV recently moderated a panel hosted by Marcus Evans on the challenges faced by LPs in constructing an alternative asset portfolio around the Venture Capital asset class.  The panel members included Matt Stepan with CFM, a financial advisory firm with $11Bn AUM, and Freeman Wood with Mercer Sentinel, a leading investment advisory consulting firm.  The full webinar can be accessed at: https://vimeo.com/marcusevans/review/233650620/3d1129d2c3.  This is the first in a two-part blog summarizing the webinar content focusing on the best practices around manager selection in the Venture Capital asset class.

 

Context & Key Trends

Since the 2008 financial downtown, there has been a steady increase in LPs committing higher allocations to alternative assets. In fact, this practice has accelerated since 2016 and is expected to continue to do so over the next 12 months.  In a recent survey by Preqin, almost 65% of the respondents said they expect to deploy more capital in the next 12 months, compared to the past 12 months (see chart below).

 

Global family offices with an estimated $4T are allocating 50% to the alternative asset class.  Within the alternative asset category, private equity (including venture, buyout and growth capital) and private debt have been the biggest benefactors of the shift in allocations.

 

Despite the recent run up in public markets, this sector is becoming structurally less attractive to LPs.  These LPs are responding by raising their allocation to private markets.  Some rotate out of hedge funds into multi-asset funds.  Even Sovereign wealth funds, and pension funds as well, which comprise 5-6% of the allocation to private equity, are expected to go to 10-11% allocation. Within the alternative asset classes, investor appetite for venture capital has significantly increased over the past 12 months, ranging from Family Offices, to Sovereign wealth funds, to Endowments and Foundations. This data is fairly consistent across all geographies.

 

 

Challenges – Manager Selection

While growth in the number of funds has increased- assets under managements and even distributions have increased- this development presents a unique set of challenges. In order to increase their allocation to alternatives, investors must find the right managers and investment strategies to put that capital to work.

 

There is a wide dispersion in the returns from the private equity asset class, heavily dependent on the fund managers.  We believe that manager selection significantly influences the net returns.



Furthermore, a stark difference exists between top quartile vs. bottom quartile managers in terms of fund performance – measured in net IRR. The chart below shows that the net IRR range over a 10-year horizon is between 16-17%. The median is about 6-8%. However, when you look at the bottom quartile performance, difference is more distinct.


Thus, the challenge for institutional investors is to find top quartile fund managers. There is no guarantee that one can generally invest in this asset class and get the type of the returns they target.

 

Q&A

In our discussion, the first topic we are going to discuss is the best practices our panelists and their clients have used to go about manager selection successfully.

 

  1. Matt, from a CFM perspective, what are the top two to three criteria that you have used successfully to select high performing managers?
  2. We tend to look at three criteria to evaluate and identify top quartile fund managers. These include: a) Top quality leadership – GP’s at the firm; b) A differentiated approach to investing in the markets they focus on; c) Early stage focus – to enable us to take advantage of the equity valuation increase that comes from investing in innovative companies at this stage.

 

  1. Freeman, what do you recommend to your clients around due diligence best practices to evaluate fund managers?
  2. We tend to advise our clients to diligence the fund’s governance and infrastructure to identify and make investments and also on how they manage the investments over time. Our emphasis is on ensuring there are sound, robust and repeatable processes to manage investments over time and not just identify investments.  We also tend to look for transparency in the processes.

 

  1. Matt, you see a high number of pitches from fund managers, how do you diligence the quality of the team?
  2. We tend to look for specific characteristics in the individual GP’s including: a) Strong operating and investment backgrounds; b) Their ability to relate well to an entrepreneur – the journey that an entrepreneur takes from startup to exit is a unique and difficult one to navigate.; b) A track record of consistent success and their ability add value beyond the capital be it as a coach, a trusted advisor and/or a productive board member. At the team level, we look for teams that have worked together successfully before – this ensures that they have worked out how they make decisions and work as a team.  

 

  1. Freeman, could you give us a few examples of robust repeatable processes that you look for when evaluating fund managers?
  2. We look for teams with demonstrated expertise in the areas of investment and operational focus. For example, we like to see a clear segregation of responsibilities and processes in areas such as making investments (i.e. investment committee etc.), finance/back office operations, management of portfolio companies and portfolio exit/dissolution.  We like to see that processes are well documented and have been implemented consistently over time.

 

In our next blog, we will summarize the best practices around sustaining returns over time once LPs have made the manager selection for investment in the VC asset class. 

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