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The Not-So-Great Venture Capital Renaissance

Venture capital funds have been actively investing and generating high returns, but most institutional investors don’t seem to be impressed.

For the first time in more than a decade, venture capital is experiencing a resurgence.

During the second quarter of 2014, venture funds invested nearly $13 billion in more than 1,100 deals, according to PricewaterhouseCoopers — the highest level since the fourth quarter of 2000. But there has been a noticeable change in the industry’s investment behavior, notes Mark McCaffrey, a partner at PwC’s technology practice in San Jose, California. There are signs that the venture capital world is consolidating into a handful of very large funds focused mostly on late-stage investments, with an assortment of smaller funds that invest across the spectrum. The bigger funds are shifting their attention away from as yet unproven technologies and betting increasingly larger sums on more mature companies that are seeking to gain greater brand recognition and market share.

Yet despite venture capital’s increased momentum in recent months, the asset class is losing ground among a key group: large institutional investors such as pension funds and endowments.

As the venture industry consolidates and changes its investment behavior, it is looking more and more like its alternative counterparts. The California Public Employees’ Retirement System (CalPERS), which as of April 30 manages $290.5 billion in assets, since 2009 has made almost no significant commitments to venture capital funds. Instead, in an unprecedented situation, it is attempting to recover its capital from a $700 million health care fund in which it has been the sole investor.

Still, “institutional investors continue to support venture funds that have created a franchise and executed a consistent strategy over many decades,” says Robert Knox, founder and senior managing director of Cornerstone Equity Investors, a New York–based private equity firm. “As a result, there has emerged a category of late-stage funds in the billions of dollars,” says Knox.

Venture capital now is less than 15 percent of traditional alternative assets such as private equity and real estate. And when one includes hedge funds in the mix, reclassified as absolute return, venture capital’s slice of the total alternatives pie falls below 10 percent. Venture capital funds, which used to make up nearly 50 percent of major investors’ alternative asset allocation as recently as a decade or so ago, are in danger of being further marginalized.

Mark Suster, a partner at Los Angeles firm Upfront Ventures, estimates that nearly two thirds of limited partner capital is now concentrated in late-stage or full-cycle venture capital. Limited partners simply don’t want to invest in a portfolio of venture funds. They want to write a few large checks to a few funds. Just as important, they want a shorter time to return capital and the certainty of a win, even if it is at a lower multiple, Suster and others say.

It has been a remarkable time for venture capital. For the year ended March 31, venture funds posted one-year returns of 30.9 percent, compared with 4.5 percent for the year ended March 31, 2013, according to Cambridge Associates, a Boston-based advisory firm for institutional and private investors. Three-year returns were 15.3 percent, versus 12.5 percent the year earlier; five-year returns were 14.1 percent, up from 4.8 percent. The ten-year index had an annualized return of 10 percent in March, the first time that index has been in double-digit positive territory since 2009 and a nice recovery from its low point of –4.6 percent in the third quarter of 2010.

Venture capital raised $16.4 billion this year through June, slightly less than the $17.1 billion raised in all of 2013. The largest of the funds during this period was Tiger Global Private Investment Partners, part of Chase Coleman’s New York hedge fund firm Tiger Global Management, which raised $1.5 billion. Palo Alto, California–based Norwest Venture Partners raised $1.2 billion for its NVP XII fund; Boston’s Bain Capital Ventures raised $650 million for its sixth fund; and Lightstone Ventures of Palo Alto raised $172 million for its first fund. The money raised by the five largest funds during the second quarter of 2014 accounted for 43 percent of new commitments. In the first quarter the top five venture capital funds accounted for 60 percent of the total raised.

The success enjoyed by large funds is really a function of performance, says Jeff Crowe, managing partner of Norwest Partners. He says that his firm’s latest fund has benefited from having one major investor: Wells Fargo. The San Francisco–based bank took over Minneapolis–headquartered Norwest Bank in 1998, to which the venture fund traces its roots, when Norwest provided seed funding to Midwestern computing companies starting in the early 1960s.

But large institutional investors also say they are more comfortable going with older funds with a proven team and strategy — no more than one or two large commitments — however unlike venture capital that might seem. Ironically, the traditional attributes of venture capital funds — to provide superior returns and transform the economy through innovation and problem solving — have gotten lost in the debate. Institutional investors seem unwilling to look closely and manage the risk of truly innovative venture funds. And venture capital funds have done a poor job of explaining risk and their role in an imaginative institutional asset portfolio.

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