From the March 2008 issue of Wealth Manager Web • Subscribe!

VC: An Insider's View

Venture capital may be but a small star in the pantheon of investment alternatives, but thanks to its role in a number of huge business successes, it is a highly visible and glamorous alternative. Among the household names that have been created from some of those compelling insurgent ideas since World War II, think for example, of Intel, Apple, Staples, Federal Express, Yahoo and Google--to cite just a few world beaters. Accordingly, no matter how settled and well-managed an investor's assets, the siren call of venture investing periodically beckons. For advisors, one question persists: Is there a rational way to participate?

VENTURE CAPITAL AND ASSET ALLOCATION

As a rule, the portfolios of most wealthy investors are dominated by allocations to quoted equities and bonds in a ratio of 70 percent to 30 percent respectively--with the allocation to bonds rising in direct relationship to the client's conservative bent. Many investors proceed no further, but more adventurous ones seek exposure to the world of alternative assets. This additional step provides an element of risk management based on enhanced diversity. Among the alternative assets usually under consideration are metals and other commodities, real estate, private equity, hedge funds and venture capital. In exchange for the heightened illiquidity of these frequently unlisted assets, they are expected to provide returns superior to the quoted index benchmarks--premiums of 200 to 500 basis points per annum--and generally, to perform in a pattern uncorrelated to those indices as well. My view is that an individual should have a portfolio with a value equal to, or greater than, $10 million before investing in alternative assets and, in turn, venture capital. And then, alternative assets would receive 10 percent to 15 percent of the total asset allocation and venture capital, from 2 percent to 5 percent of the entire portfolio.

WHAT IS VENTURE CAPITAL?

Essentially, venture capital investing involves providing equity capital to entrepreneurs which is deployed as seed capital to test their ideas or operating capital to support their fledging companies which often are pre-revenue and almost always not yet profitable. These investments are at the high risk/high reward end of the investment spectrum.

Although it is possible to make these investments in an ad hoc way--via personal introductions, through friends and relatives, this is an extremely high-risk and inadvisable route. Professional venture investing is the wiser alternative. This approach adds several critical risk-mitigating elements to the exercise. One is professional experienced investment management. Think of this as akin to calling a plumber or an electrician rather than tackling a household problem yourself. It may cost you somewhat more, but your chances of securing the desired results are greatly enhanced. The professional venture capitalist generally brings particular expertise to the exercise. For example, a retired retail executive may invest in retailing businesses or a bio-scientist in biomedical opportunities.

In addition, unlike the individual investor, the professional VC investor spends all his time working with the entrepreneur to help ensure his success. This "value-add" can take many forms--from providing additional financing to recruiting key personnel, to introducing the investee to prospective customers and to devising long-term operating strategies.

Finally, of major importance, the professional investor invests in 15 to 20 enterprises within the context of a venture investment partnership. This portfolio approach substantially reduces risk while it offers the prospect of a net return to the investor of 25 percent or better. The VC manager generally receives a management fee of 2 percent of the committed capital per annum and 20 percent of realized profits.

Furthermore, this is an activity only for patient investors. A capital commitment will be remitted to the partnership in small increments over a five- to six-year period, and the proceeds from profitable transactions will be distributed to investors periodically, with the bulk of distributions coming in years seven through 10--subsequent to the initial remitting of funds. The legal life of these partnerships is generally 10 years. The best analogy I've found for the VC investor is the vintner: He plants the grapes and tends them closely for several years. Only in year seven or eight can he taste the wine and determine the outcome. By the same token, interim assessments of venture performance are very difficult, if not impossible, to make.

THE VENTURE CAPITAL LANDSCAPE

Early stage venture firms generally raise money every four years or so for a series of discreet partnerships that they manage. Minimum commitments range from $250,000 to $5 million. Alternatively, there are a number of venture funds-of-funds which raise much larger sums and then select individual venture funds for investment. For their presumed expertise in making these selections, for their access, per se, to certain quality funds, and for their ability to meet the minimum investment thresholds some funds impose, they charge investors a management fee of 1 percent of their capital commitments per annum.

Depending on the resources an individual investor commands, he may elect to utilize the fund-of-funds route which usually involves a much larger capital commitment--$5 million or more. If the decision is to select one or more venture funds unilaterally, it is useful to remember that the VC community is highly diverse and increasingly so. There are funds that specialize in new medical drug compounds, medical devices, health care services, Internet marketing services, computer software, innovative retailing concepts and green or clean technology applications, for example. And there are still other ways to approach the market. One could choose to invest only in a VC fund which focuses exclusively on a geographical area or even on a stage of company development such as pre-revenue enterprises.

A Broadly Misunderstood Business

This is actually good news because venture activity remains inefficient and thereby pricing anomalies exist to the advantage of the astute investor. But the misunderstandings--due in large part to misperceptions created by the business press--also present false impressions that can mislead a newcomer.

For example, the December 31, 2007, issue of Business Week displayed a chart that purported to summarize the growth in VC investing since 2003--that is, the amount raised by venture capitalists who, in turn, invest the capital in promising companies. The chart showed that the asset class has been attracting more capital in the course of four of the past five years.

However the performance component of that chart showing 18 percent return in the past two years has little meaning in the context of venture investing. It simply reports on the movement of "value" of aggregate portfolios within each year taking into account cash inflows and outflows and the carrying values applied by general partners to portfolios at the beginning and end of each year. This latter element does not illuminate and is, at best, suspect because marking venture portfolios to market is a very uncertain and treacherous exercise. So much so, that, in the normal course, auditors decline to opine on valuations. The only meaningful measure is cash-on-cash return which generally includes meaningful data by year seven of a partnership's life and only dispositive data at the termination point of the fund--year 10. So interim measurements such as [Business Week's] are unhelpful and likely to be misleading.

As to the PVC Index, the only conclusion to be drawn here is that once public, listed companies originally backed by venture capitalists perform on a par with their peer listed companies. This is interesting but of little use to investors in venture capital funds whose principal challenge is to select managers who can find and nurture companies until such time as exits are possible either via trade sales or initial public offerings. There is some comfort from this data insofar as post-IPO performance is concerned. But post-IPO performance is a very small factor in overall VC success. Most of the value creation and multiple risk factors occur years in advance of IPOs.

This brings us to what I consider the best way to assess the performance of VC funds: the Vintage Year approach.

The optimal way to judge performance in a given year--let's say 2007--is to assess all those funds that commenced operations 10 years earlier--i.e. 1997--and to review cash-on-cash returns. If you insist on interim assessments, which I think are ill-advised, then, at the very least, consider funds of the same vintage together. Grouping funds that have comparable maturities provides a better apples-to-apples performance comparison. When you get information on funds younger than five years, treat it skeptically. As a rule, the more mature the fund, the more meaningful the performance data.

The optimal time to invest in a venture capital fund is during a period of moderate, steady growth in the economy which suggests a reasonable level of economic activity accompanied by modest entry-level pricing. In addition, this period should culminate five years in the future in a capital markets environment characterized by frothy IPO market activity and a comparably effervescent merger and acquisition market. These settings provide lucrative routes to liquidity for venture funds and their investors. That said, no one is sufficiently prescient or lucky enough to be able to engage in this kind of market timing. The answer to this dilemma is what is known in the venture community as "time-averaging." Under this approach, one would invest in a venture fund each year over a five-year period, thereby building a portfolio of five funds (and approximately 100 company stock positions) and mitigating the impact of hot and cool exit markets.

Getting Started

Having made the decision to participate in venture capital investing, there are a host of Internet sites which offer research opportunities. One essential stop is www.nvca.org, the website of the National Venture Capital Association. In addition, if you query all your contacts who work in and around money--asset managers, lawyers, stock brokers, accountants and investment bankers--recommendations will undoubtedly surface.

At the outset, keep in mind that the household names of the venture community--Kleiner Perkins, New Enterprise Associates, Sequoia and perhaps 30 additional top tier firms--may not be available to you. These franchises have investor demand which far exceeds supply and, in any case, generally impose very high minimum participation thresholds for investors. It is true that most of the industry returns are generated by the top performing quartile of funds--about 125 partnerships. Accordingly, some pundits have argued that investing in the balance of funds is a losing proposition. This is a seductive but, I believe, specious argument, because it is a static analysis. The venture landscape is always changing. Talented fund managers retire or their skills wane while new stars emerge. The key challenge is to uncover the emerging new wave.

Do your due diligence. See if fund managers' expertise and background align with their respective fund strategies. Talk with their current investors. Speak with entrepreneurs they have financed. Over time, you will find funds that suit your strategy and your clients' pocketbook.

With patience and persistence, you should be able to fashion a portfolio that will beat your listed securities' performance over 10 years by at least 500 basis points, provide you with much intellectual stimulation and inform your more conventional investment activities.

Edwin A. Goodman is Co-Founder and General Partner, Milestone Venture Partners (www.milestonevp.com). He has 30 years of venture capital experience with premier VC firms including Patricof & Co. (now Apax Partners) and Hambros Bank.

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