Entrepreneurs aren't the only ones in startup land feeling pressure from the economic slump. Venture capitalists themselves are feeling heat from some of their biggest and most powerful constituents: the university endowments that have plowed million of dollars into VC coffers.
Harvard, Yale, Princeton, Columbia, and Duke are looking to sell stakes in venture firms, according to a half-dozen venture capitalists, some of whose firms could be affected by the sales. VCs won't discuss the potential sales on the record, and representatives of each of the endowments either declined to comment or didn't respond to requests.
Sales by some of venture capital's big limited partners (LPs) could weaken the standing of some firms just as the global financial crisis erodes returns and threatens to force some VCs to shut their doors (BusinessWeek.com, 10/9/08). The exit of steadfast endowments could see the emergence of LPs that are less familiar and—worse—less likely to meet commitments, compromising the ability of a venture capital firm to continue funding startups.
Valuations Are Tricky
Valuing and selling a stake in a venture capital firm is no mean feat. For buyers that need to borrow, there's not a lot of lending going on amid the credit squeeze. Most venture firms can reject any new buyers of their securities they don't like. Making sales more complex is how to decode exactly what these portfolios might be worth.
Since they're full of early-stage, privately held startups, venture capital portfolios are completely illiquid. Valuations of many of those assets are dated as far back as June 30, and in this macroeconomic climate nothing is worth what it was back then. And valuations are expected to fall further as the economy gets worse. Some transactions may not happen until some time in 2009, by which point funds would be revalued to reflect a dismal fourth quarter and the stakes sold for less than they were worth even a few months ago.
Why the urgency to sell then? In large part, the venture capital investments got too big for their own good. Early warning bells that LPs were pouring too much money into VCs came at a 2003 private equity conference in San Francisco, from Fred Guiffrida, managing director for Horsley Bridge Partners, a so-called fund of funds that invests in other investment funds. During a presentation, Guiffrida showed a slide depicting a huge elephant trying to fit in a tiny box. His point was that far too many limited partners were shoving an unsustainable amount of money into venture capital.
Asset Models Force Sales
That elephant got so big in part because of strict allocation models that dictate how much of an investment portfolio goes to what asset class, including venture capital. As endowments, pension funds, and other investment pools surged, so did the amounts poured into VCs. Back in 2003, this elephant represented $1 trillion wedging its way into an asset class that had only returned $88 billion from 1990-1997. And while some investors, such as funds of funds, adhere loosely to allocation models, university endowments tend to rely on them more rigidly. "More staid and respectable LPs are the ones that have the issues," says one venture capitalist who asked not to be identified.
Meantime, university endowments, like other big investors such as pension funds, are underwater in almost every investment category—from stocks and commodities to real estate and emerging markets. As those asset classes shrink, the endowments now find themselves having to reallocate funds out of venture capital to keep their models balanced. Hence the potential sales.
Other investors are making sales of certain asset classes, too. The pension fund California Public Employees Retirement System, or CalPERS, for example, lost more than 20% of its value in the wake of October's sell-off, and it's selling shares in publicly traded companies to help it meet pension obligations. But unlike university endowments, many big pension funds don't hold stakes in the top venture funds. Some VCs cut pension funds out of the mix after a movement in the early part of the decade spearheaded by the San Jose Mercury News that forced public pension funds to release previously confidential information about the value of their investments in venture capital firms and their underlying portfolio companies.
The Makings of Disaster
Whatever the LP's makeup, VCs don't want to see a trusted partner jump ship, to be replaced by an unknown quantity that may not make good on commitments. When VCs raise funds, they don't get all the money up front. They ask for it on an as-needed basis, in what's known as a capital call. One source who requested anonymity says that at least a few LPs are talking to lawyers about how they can outright default on capital calls. In those cases, an LP wouldn't even worry about selling a stake in the secondary market; they simply wouldn't meet their commitments. So if the firm has only drawn down 5% or so of the capital committed and the LP has the option to lose just 5¢ on the dollar, that might be as good of a return as it is likely to get in this market.
Combine shaky LPs with the collapse of 10-year returns I outlined in my last column, and you've got the makings of a looming disaster in venture capital. Mediocre firms will close their doors. Superstar partners will likely spin out and form new partnerships or go out on their own. And there will be even more uncertainty for entrepreneurs looking to close funding.