Posted by Mr. Smith on 2008-12-02
Investors in venture funds, called limited partners, are pulling out or selling their commitments to provide essential capital to the venture model, causing the "Limited Partner Shuffle." Some experts are quoted as saying as much as 10% of all private equity positions will change hands this year in hasty transactions to generate liquidity, including premium positions by top-tier institutions like Harvard. See below:
What does this mean and why is it relevant to entrepreneurs" A quick overview of venture capital will help to answer these questions.
Venture firms raise money to invest from limited partners (LPs), who are normally endowments, pension funds, insurance companies, and other institutions that manage large amounts of capital. An investment in venture capital is considered a high risk asset class with the potential for high returns. The professional consulting firms that publish guidelines for how limited partners should allocate money across asset classes generally recommend that a small portion go into venture capital, sometimes less than 1%. This small percentage still amounts to many billions of dollars per year being entrusted to venture firms by limited partners, who control trillions of dollars.
Generally speaking, a commitment to invest in a venture fund does not require the limited partner to transfer money until the venture firm makes an investment in a portfolio company. So, a $100 MM venture fund does not have $100 MM sitting in the bank. Instead, as venture firms make successive investments, they collect money from their limited partners and distribute that money to portfolio companies in rounds. To cover operating expenses, the venture firms separately collect approximately 2% of the invested capital as a management fee.
In order to ensure that each limited partner honors their obligation to provide money when needed, which is referred to as a capital call, venture funds implement onerous terms for forfeit or default. The most common default protection is to wipe out any returns from all previous invested capital. This encourages an active secondary market for limited partner positions, since it makes more sense to sell a commitment than to lose the value of the money invested to date.
Fast forward to Q4 2008, and you have the perfect storm of venture capital destruction. First, a relatively large number of limited partners, such as AIG and Lehman Brothers, are facing solvency issues, and they can no longer honor any capital calls to venture capital funds. The large scale dissolution of limited partners is something new.
Second, as the equity and debt markets have collapsed, the allocation of limited partners to venture capital has increased as a percentage. If an LP has $1 billion under management and 1%, or $10 MM, committed to venture capital and if that $1 billion suddenly becomes $500 MM, the allocation schedule of 1% stipulates that the LP now only invest $5 MM into venture capital. Many LPs have charters that strictly govern these percentages, forcing the LP to sell commitments in the secondary market to comply.
Third, many potential buyers in the secondary market have liquidity issues of their own. The purchase of a commitment requires resources to buy the asset, resources to pay for future capital calls, and resources to cover management fees at a time where the future is uncertain. The lack of liquidity and uncertainty has caused a collapse in the secondary market values, with many commitments selling for $.50 on the invested dollar or less. This in turn has encouraged limited partners that might otherwise commit to new positions in venture funds to consider purchasing discounted positions in existing funds.
Lastly, venture capital returns have been hard hit by the downturn, reducing or eliminating the ability of certain funds to get back any of the original invested capital. Portfolio company acquisitions are on hold, and the IPO market is frozen. For many limited partners, investing more money into certain venture firms is literally throwing good money after bad when cash is king.
Most venture firms worldwide are facing problems as a result of this "Limited Partner Shuffle." The best firms are distracted by helping limited partners transfer commitments. Other firms will cease making investments for some period of time, possibly forever. Still other firms will not be able to collect their management fees and go under in the next fews months. Nearly everyone will be fundraising and spending a lot less time with their portfolio companies.
Many entrepreneurs are now pitching firms without a future, wasting invaluable time. These "Walking Dead Funds" are going through the motions until the other shoe drops, forcing them out of business. Other entrepreneurs are counting on investments or participation from funds that have no ability to deliver any capital. Lastly, there are entrepreneurs with soon-to-be-insolvent firms that hold controlling preferred equity positions and Board seats, leaving a potentially deadly vacancy in governance and voting control. How do you sell when your primary shareholder is no longer around to grant approval"
As an entrepreneur in today's market, you need to understand the relative health of the investors that you deal with. Start by asking them directly about their financial resources and the state of their limited partners. Don't hesitate to ask other entrepreneurs and other funds as well. You future may depend on having good information about the solvency of investors that you deal with.
[Please reprint any or all of this post. Entrepreneurs need to know.]PRIVATE: Members Only
Posted by Anonymous on 2008-01-17
They say that VCs are "pattern matchers". Now after a couple of identical (bad) experiences during our current fund raising round, I think I see a pattern worth sharing.
Here's the story line:
-- Junior partner at mid-tier firm hears about deal, gets really excited, makes boastish claims about the speed at which they can get a deal done and makes strong enough claims about valuation that it's hard to say no to spending time
-- Junior partner researches the hell out of the deal, sucks down a lot of company time with questions, models, reference calls, etc.
-- Full partner meeting. Junior partner hasn't done his homework with the partnership to sell the deal. Senior partners start raising a series of questions and objections.
-- Junior partner, back on his heels, scrambles around to respond to all of the new objections, while assuring that the deal will still get done and a term sheet is just days away. Sucks down a bunch more company time. Objections are mostly silly and easy to overcome, and should have been handled before the full partner meeting.
-- As each objection is overcome, a new one appears from the big bag of silly objections. Objection overcome yet again.
-- Once this game has run its course, one final objection appears, this time, the objection that can not be overcome: "We just don't feel good about
As I reflect on these these two experiences, it is pretty clear what happened. The deal was dead by the time we walked out of the full partnership meeting. The junior partner had not properly sold the deal, and they didn't have the juice with their senior colleagues to get to the finish line.
But of course, the junior partner can't admit to any of this. It has to be the company's *fault* that the deal came off the tracks. So instead of a simple, "No, we're not going to be able to go forward," they reach into that good ol' big bag of silly objections. The management team is on their game, and so the objections are easily overcome.
After a few cycles of this, the junior partner realizes that he can't save face on the back of a factual objection, so he ultimately retreats into the vague ad hominem objection that can not be overcome.
So beware. Junior partner" Questioning his juice" All powerful senior partner stomping on the deal" Think twice before you spend any more time on a process to get to that elusive term sheet that is still coming. If they won't give you a simple "no", give THEM a simple "no".PRIVATE: Members Only
Posted by forrational on 2008-12-08
Bootstrapping is looking better and better.PRIVATE: Members Only (5345 Characters)
Posted by Anonymous on 2009-06-23
Posted by Anonymous on 2009-08-27
Posted by Anonymous on 2009-06-14
Posted by paloalto on 2009-01-19
Tags: Operations Partners
I just read the advice posting regarding vendors, which I agree with for the most part.
I offer the same warning for large partners. We spent several months developing specific features for our application in order to launch a major initiative (major for us) with a large national "partner". A year after the target launch date, the partner still has not delivered. We were to be a key part of their new website release, but they have not released their new website. Two of their website vendors have come and gone out of frustration. They are just dysfunctional internally, more than other large corporations I have worked with. They are also a quasi monopoly, making their employees experts at avoiding any changes, because changes = more work for them, while revenue continues to stream in, at least for now.
Most of our development can be used anyway, but there are specific pieces we spent money and time on that apply only to this partner. Ouch.
Now we are looking at other partners (one is a direct competitor), but we will make sure the partner has enough at stake to instill a sense of urgency in getting it launched.PRIVATE: Members Only