Why LPs may be changing their tune on venture

Limited partners have been slowly opening up to new VC relationships now that the industry has shrunk and top managers are back to courting investors

Limited partners have for several years seen venture capital as almost anathema – an asset class that has consistently underperformed over the past decade. The problem, according to one LP, is that there has not been a big explosion of innovation in the US on which VC firms could profit, like during the dot-com era.

While that’s certainly debatable, the fund performance numbers are indeed stark: over 10 years, US venture capital funds in aggregate were returning negative 4.6 percent on Cambridge Associate’s venture capital index as of 30 September 2010. VC managers are often quick to point out the cumulative numbers are dismal because of the nature of venture capital – the top firms’ exceptional returns are diluted by the scores of not-so-successful VCs that have made up a large portion of the industry.

But that may be changing.  Some LPs have been quietly looking into venture again, arguing the environment is ripe to profit from VC investing as the industry has shrunk with many of the subpar managers (finally) disappearing. A look at shorter-term Cambridge statistics, which presumably include fewer of the dud funds raised years ago, shows that over the most recent one-year period, venture capital funds were returning 8.2 percent.

The evidence of this resurgent interest in venture can be seen in some of the outsized fundraisings that have taken place in the past two years. Most recently, Bessemer Venture Partners closed its largest-ever fund on $1.6 billion to invest in early stage companies. The fund was heavily oversubscribed, according to a New York Times report.

Another key thing that has changed, according to LPs, is the attitude of some venture capitalists towards investors. In the past, certain VCs took an elitist stance and shunned public institutions because of the mandated transparency that came along with receiving their commitments. But with venture fundraising at its lowest levels ever – the industry raised about $11 billion in 2010 compared to $85 billion at its peak in 2000 – that stance has weakened.

Investor enthusiasm also stems from some of the huge valuations placed on former Internet start-ups-turned-superstars like Facebook and Groupon, that, once public, will pay fortunes to the venture firms that took early stakes in the companies, as well as the GPs that took direct secondary stakes by purchasing shares from founders, employees and other investors.

 One large institutional investor, New Jersey’s $72 billion state pension system, has begun exploring its options with venture capital this year. In the past, it has gained exposure to VC via separate accounts with various managers like BlackRock, but the pension is now interested in making targeted commitments to individual managers and has been meeting with California-based firms.

“Venture capital in the past 10 years hasn’t performed as well … now we’re seeing a rationalisation of the venture capital market,” the system’s head of private equity, Christine Pastore, said during an investment council meeting in March. “It’s an opportune time to come into the venture capital market when those top quartile managers are going to outperform. The amount of money going to those managers is less and they’ll be able to attract top-tier entrepreneurs.”

And public pensions are not the only US-based investors excited about upcoming venture capital opportunities. Kirk Dizon, co-head of private equity at Hall Capital Partners, an advisor to families, endowments and foundations that manages around $20 billion, says venture is one of the more interesting opportunities among the 1,500-plus funds expected to come to market this year. “Our 50 to 60 active relationships are global and range all the way from mega-buyouts to early stage venture with growth and distressed in between,” he recently told PEI. “ In the next three to four months, our highest priority pipeline consists of a US seed stage venture fund, an Indian VC/growth fund, a China VC fund, a Brazil buyout fund, a US buyout fund and a European distressed fund.”

If more institutions are increasingly able to gain access to top-tier managers, their outlook on venture capital is likely to change and have a knock-on effect on other LPs. But it isn’t expected to happen overnight. So-called “zombie funds”, those funds that are well past their lives and living on extensions granted by LPs to try and manage out remaining investments in the portfolio, still haunt many LPs’ portfolios and serve as a warning to building further exposure. VC fund managers, therefore, still have a way to go before LPs are singing from the same song sheet.

Disrupting the LP base

A global shift from guaranteed to employee-contributed public pensions raises questions about the future of private equity funding

When private equity managers assess future risks to their business model, their thoughts will generally centre on their ability to deliver great IRRs to investors thereby allowing them to raise new investment vehicles in the years ahead. Few will be thinking about whether their investors will even be around in 20 or 30 years’ time.

As pensions face mounting liabilities from their ever-aging retirees, debate is raging over whether public and private pensions should structure themselves as defined benefit schemes, where employers guarantee beneficiaries a stream of income until their death, or defined contribution plans, where employees take charge of their own investments. Rather than pooled capital being managed by professional pension fund investment officials, DC plans give individual employees much greater control over how and where to invest their retirement pot. Such delegation leaves DC plans with a penchant for equities, fixed income and cash and little, if any, money flowing to private equity, real estate and other alternatives.

Of course, that’s not to say that corporate and public pensions globally are set to disappear from the private equity investment scene – far from it. However, the long-term fall-out of global pensions’ shift from DB schemes to DC plans could have a fundamental impact on the ability of all alternative asset classes to raise future funding. And rather than being a distant unspecified risk on the investment horizon, the future viability of DB schemes is front and centre of many pension investment officials’ minds today.

In recent weeks, Rick Scott, Florida’s governor and trustee of the $157 billion Florida State Board of Administration public pension, backed new efforts to replace the state’s DB scheme with a DC plan. In supporting the “Floridians for Sustainable Pensions” coalition, which is calling for public pensions to be replaced with personal retirement savings plans, Scott said government pension reform was a “priority issue”.

Scott is certainly not alone in his thinking. Since 2000, the proportion of DC schemes in the US has risen from 49 percent to 57 percent as of the end of 2010, according to a Towers Watson global pension asset study. And with the US representing 58 percent of all pension fund assets globally, what happens in America has far-reaching implications for GPs everywhere.

For some, the answer to the DB/DC debate is some form of hybrid model that offers the professional management of defined benefit with the portability of defined contribution. It is an answer, though, that will take years – if not decades – to make itself known. In the meantime, private equity managers need to understand that the risks to their investment model don’t just relate to interest rates and return rates but also where the next generation of LPs is set to come from.  

LPs love LatAm

Private equity limited partners have strong appetites for emerging markets and have been turning their focus towards Latin America. Lisa Lacy reports

LPs looking to boost their exposure to emerging markets have poured their capital into Latin America. The region is viewed by LPs as being less crowded than other emerging economies like those in Asia and also more resilient than other places as it survived the credit crisis relatively unscathed.

The region had a record fundraising year in 2010 and the growth is expected to continue. In fact, 52 percent of respondents to a 2010 survey of global institutional investors from the Latin American Venture Capital Association (LAVCA) said they plan to increase commitments in the region in the next 12 months. That’s up from just 15 percent in 2009.

According to Cate Ambrose, president and executive director of LAVCA, Latin American funds raised an estimated $7.3 billion last year. That dwarfs the previous record of $6.4 billion in 2008.

And even though local capital is increasingly available to GPs from domestic pensions in Brazil, Colombia, Peru and Mexico, funds in the region remain dependent on international sources of capital, according to the Emerging Markets Private Equity Association (EMPEA). This has created a window of opportunity for international LPs.

Mega-funds find traction

The $7.3 billion figure includes two mega-funds: Advent International’s Latin American Private Equity Fund V, which closed on $1.65 billion in March; and the Southern Cross Group’s Latin America Private Equity Fund IV, which closed on $1.68 billion in September.

Advent’s LAPEF V is 25 percent bigger than its previous fund, which closed in 2007 with $1.3 billion. Alfredo Alfaro, managing partner for Latin America with Advent, says the firm was targeting $1.5 billion and was fundraising for just over one year. The fund will be invested in control buyouts and expansion financings of companies mainly located in Brazil, Mexico and Argentina, because they are the three largest economies in Latin America and they are also where Advent has local offices. Alfaro is based in Mexico City.

LAPEF V’s LPs come from all over the world: 56 percent are North American; 25 percent are European; and 19 percent are from institutions in the Middle East, Asia, Latin America and Africa, Advent says.

Southern Cross did not respond to a request for comment. However, according to a press release, the fund exceeded its original target of $1.25 billion due to “strong support from existing investors and significant demand from new investors”. Investors were based in Latin America, North America, Europe, Asia, and the Middle East.
As with these two marquee funds, Ambrose says the majority of the $8 billion raised for Latin American funds last year also came from outside the region, although LAVCA did not have a specific breakdown.

Firms investing, fundraising and opening offices in Latin America during 2010 included some of the biggest names in private equity: The Carlyle Group, The Blackstone Group, TPG Capital, Apax Partners, Warburg Pincus and Silver Lake.

Ambrose expects the fundraising momentum to continue, in part because the region is still considered to be underpenetrated. “India and China have been a major priority for global private equity investors in recent years,” Ambrose says. “There’s been a lot of fund formation, and they are perceived to be more crowded and competitive, with higher valuations than in Latin America.”

Ambrose doesn’t expect to see additional mega-funds in 2011, but she thinks there will likely be an increase in the number of smaller funds raised. Meanwhile, many global private equity firms are also making new investments in Latin America, but not through dedicated Latin American funds.

In the past, many investors have shunned Latin America over concerns about political instability or market volatility, but this has changed dramatically in major markets over the last decade, Ambrose notes.

“There are many new global investors seeking to commit capital to the region,” she says. “Ask any fund manager in Brazil – they’ll say, ‘Three years ago, I met one institutional investor a month and now every day or every week, there are meetings going on with international LPs.’”

Brazil leads the pack

According to EMPEA, Brazil was the most popular fundraising destination in 2010, thanks to “a growing and increasingly diversified pool of capital from LPs looking to expand their emerging markets exposure.” For its part, EMPEA tallies fundraising for Latin America and the Caribbean at $5.6 billion in 2010. It also notes that nine of the ten largest deals in Latin America last year – and five of the largest investments in Brazil – were made by global funds as opposed to vehicles dedicated to investment in the region.

According to Advent’s Alfaro, Brazil has strong export capacity and strong internal demand.
“Investors have been attracted to the improved economic outlook for the region and the opportunities it represents for private equity. Brazil and Mexico have emerged from the global downturn in relatively good condition,” Alfaro says. “They each have stable currencies, sustained GDP growth, strong international reserves and an emerging consumer class.”

Ambrose also notes that Brazil is rich in natural resources, credit is expanding and it will host the Summer Olympics in 2016, which is driving infrastructure development. The country also has a good tax structure for private equity, she says.

 However, as a result of its feverish growth, Brazil is also considered to be the most overheated and expensive market in Latin America, Ambrose says. She expects some of the more sophisticated investors to shift their focus to Argentina and Mexico.