The recent capital markets have reinvigorated investor confidence in venture-backed companies to the levels of 2004, when Google and Salesforce’s initial public offerings (IPO) debuted. The pent up current IPO pipeline represents a significant liquidity window fueled with strong returns for the venture capital investment class.

 

Of foremost interest to investors is venture capital’s emergence as an exemplary financial engine in the alternative asset class. The reasons for venture capital’s success are many.  The venture structure encourages innovation and gives entrepreneurs the tools they need to create, develop and launch their innovative ideas globally.  These inherent incentives facilitate the creation of breakthrough, industry disruptive businesses. The very best venture capital funds have consistently out-performed the industry and, of course, it’s everyone’s ambition to invest in the best performing of these funds. 

 

After all, some of the most successful public corporations such as Apple, Amazon, AOL, Autonomy (HP), Baidu, BusinessObjects (SAP), Cisco, Compaq (HP), eBay, Facebook, Genentech, Google, Hewlett-Packard, HomeDepot, Informix (IBM), Intel, Linkedin, Microsoft, Netscape, NetSuite, Oracle, Salesforce.com, Skype (Microsoft), Starbucks, Sun Microsystems (Oracle), PayPal (eBay), Yahoo, YouTube (Google) and, soon to be public traded Twitter, were all financed by Silicon Valley venture capital funds.  The venture investors in these funds realized significant returns, well above capital market rates.

 

Over this past decade, the rate of technology innovation has rapidly accelerated, challenging traditional corporations’ ability to maintain a competitive edge.  The more established corporations are increasingly dependent on innovative new technologies in order to remain competitive, thus it would only seem natural that these corporations value venture backed companies with considerable above market premiums. The technology innovations and investment returns are obvious– venture-backed technology companies have consistently exceeded every corporate R&D outcome. 

 

It’s no wonder that corporations acquire start-ups at excessively high valuations, long before they can even launch their public debut. I’ve noted a marked trend in the number of multinational corporations opening up business development offices to capture access to the explosion of start-ups at a breath taking pace.  Corporate venture arms invested nearly US$3.26 billion in Silicon Valley companies last year.

 

Keeping close tabs on venture portfolios has proven successful for acquisitive companies such as HP, Salesforce.com, Facebook, Oracle, Dell, Apple, EMC, Google, Cisco, SAP, AOL, as well as other tech companies. This strategic M&A approach exploits venture capital’s efficiency in developing technology, its access to new advancements, its capacity to respond quickly to changing technology, its ability to leverage additional resources throughout the development cycle all while returning favorable financial returns and creating significant value for those investors in the venture capital asset class.

 

David Swensen, the chief investment officer at Yale University, has also realized great investment success in the alternative asset classes. When he arrived at Yale in 1985, its endowment was worth approximately US$1 billion, and today the endowment is worth greater than US$17 billion. Swensen increased investments in private equity funds, venture capital, real estate and hedge funds.  In numerous speeches, Swensen has championed such alternative investments. He argues that while beating the stock market is almost impossible due to the overwhelming available information about public companies and the subsequent valuations, astute managers can exploit inefficiencies in the value pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk. He argues that keeping funds in investments that are more liquid is a tactic of short-term players versus that of endowments, which tend to hold until private equities are sold or go public.  Swensen says “investors should pursue success, not liquidity. Portfolio managers should fear failure, not illiquidity. Accepting illiquidity pays outsized dividends to the patient long-term investor.” Over the past 20 years, no educational institution has achieved a better performance record than Yale.

 

 

The decision of whether to invest as a limited partner in an available venture capital firm or participate in a “basket” of venture funds (venture fund of funds-VFoFs) is a critical one.  Deciding between direct venture capital participation, or the more conservative venture fund of funds path should entail research on each manager’s respective track record of investments, investment access, actual hands-on value creation involvement within their investments, the fund managers’ lure and stature within the venture capital entrepreneurial community (deal flow access) the ethical reputation and transparency in reporting performance returns, and, most importantly, alignment with your long term strategy.

 

In such a fast-paced environment, with over 3,500 venture capital funds competing for the most promising start-ups, VFoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through the very best performing venture funds.  Essentially, good VFoFs can offer an investor access to top tier performing venture capital fund managers not otherwise accessible directly.  Do some serious research here, as the term “success has many fathers” applies in spades to self-published venture performance stats.

 

After two decades of direct venture investing and more recent 14 years as an investor in many top venture funds, it has become incredibly obvious to me that a venture fund of funds invested in the very top performing venture capital partnerships historically out-performs the overall venture capital index.

 

Realistically, single strategy venture funds are notoriously a “hit or miss” gamblers bet despite the exceptional track record of a very few funds.  One should focus on investing with leading, top performing venture funds as well as a very few early successes emerging manager funds, and second on those funds deployed within the technology growth segments on high value creation growth potential and delivery of superior returns.

A focussed fund of funds is a more efficient and risk adjusted means to construct a balanced portfolio for investors seeking to participate in this market segment. The rationale behind the FoFs approach is simple; there are only 14-16 venture funds which have historically delivered consistent out sized returns.  Brand names do not necessarily make for top decile returns. A few of the leading firms, consistently topping Red Herring’s top VCs, preqin and venture economics performance lists are Accel Partners, Andreessen Horowitz, Benchmark Capital, Foundation Capital, Founders Fund, Goldman Sachs Investment Partners, Greylock, NEA, Sequoia, Union Square Ventures, Index Ventures (non-US) and, in the seed investment class, Ron Conway’s Silicon Angels.

 

As is the case in many industries, the “out with the old and in with the new” phenomena applies to the top venture funds as emerging, sharper-minded general partners have excelled past one time leaders. Such is the case with Kleiner, Perkins, Caufield & Byers (KPCB) who lost their lead and effective edge back in the early 2000s.  Essentially, KPCB passed on the opportunity to invest in numerous next generation  internet winners, Groupon, Facebook, Twitter, Zygna, Linkedin, etc., opting instead to invest vast amounts in the cleantech sector.  Realizing its mistake, KPCB raised a US$1 billion very late stage fund in an attempt to participate in Facebook, Zygna and others by buying shares from early investors rather than the companies at premium prices. They overpaid considerably as Facebook’s public market valuation has demonstrated. As Henry Blodgett says: “they (KPCB) are now looking like spectacular athletes who stayed in the game too long and retired long past their primes."

 

VFoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through these top venture funds.  Essentially, VFoFs can offer an investor access to the very best performing venture capital fund managers not otherwise accessible directly.  Generally, a VFoFs have greater leverage in scrutinizing a venture firm’s financial reporting, actual money-on-money returns multiple and negotiating terms, resulting in a better risk-return ratio than individual direct investments. They’re also looking for more than the conventional venture model has traditionally delivered – multiples of cash back rather than straight IRR. They seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles.

 

The reasons for the impressive growth of VFoFs is that they provide diversity among venture fund managers, reduce risk and hold out the promise of net returns higher than the average venture capital return rates by accessing the top performing venture firms.  Investors are more willing to invest in VFoFs for the benefits provided by this pooled investment structure, continual due diligence and on-going oversight compared to investing in a single strategy venture fund.  A balanced, properly allocated venture capital/private equity portfolio generally tends to provide higher returns with less inherent risk.

 

There exists a massive market with a strong rising tide for quantifying this new venture capital paradigm, one with increased efficiencies, better probabilities and lowered risk.  Playing the venture capital investment game can be incredibly rewarding, if played cautiously and astutely.  Seems that success tends to create more success- it’s not merely just a coincidence.