“Venture capital has been the best performing asset class going forward, so those who have invested in it before may put in less now, but are inclined to stick with it,” predicts Bill Dietrich, an entrepreneur and investor who also is the principal at the Dietrich Charitable Trust in Pittsburg.

Long-Term Performer
When a private equity venture pans out, the long-term returns easily beat those of other asset classes, according to Clint Harris, a managing partner at Grove Street Advisors of Wellesley, Mass., which manages several billion dollars in private equity investments for the California Public Employees Retirement System (CalPERS).

Hedge funds attracted more capital during the bear-market years than private equity did, but historically, private equity has been the more popular asset class. Last year venture capital, buyout and mezzanine funds raised $37.5 billion, a long way from their peak of $182 billion in 2000, but a respectable 8 percent increase over 2002. Meanwhile, about $60 billion flowed into hedge funds in 2003, according to Tass Research, a firm that tracks the hedge fund industry.

In the 10-year period ending December 2003, investments in the top quartile (by performance) of all private equity funds—which includes about 25 or 30 of the most successful and sought-after funds—have yielded over 25 percent, Harris says. The larger universe of all venture capital funds, numbering around 1,000, has yielded 14 percent or so, according to Peter Lawrence, a managing director of FLAG Capital Management of Stamford, Conn., a private equity fund of funds that manages 11 limited partnerships with combined commitments of over $2 billion. Over the same decade, the S&P has yielded around 11 percent and the Lehman Brothers aggregate bond index has yielded approximately 7 percent.

Andreev is quick to reassure investors that venture fund managers are not the daredevil investors they were in the last great start-up wave. “During the bubble years,” he says, “there were probably 20 start-ups pursuing the same business and embarrassing themselves in front of potential clients trying to close deals; now there are far fewer companies competing in the same space.”

Private equity firms are also promising to be more circumspect in their fund-raising. “In the previous cycle, what created problems was that as the IPO market rose, venture capital started to come from the public, which created an excess of funding,” explains Donald B. Marron, the chairman and CEO of Lightyear Capital of New York, which manages $2 billion in assets, including its $750 million Lightyear Fund targeting private equity.

“By and large, as venture capital funds are coming out for new financing again,” says John Taylor, the vice president of research at the National Venture Capital Association (NVCA) in Washington, “the amount they are seeking is half of their previous fund-raising, or less.”

Buyout and mezzanine fund commitments are also rising, though volumes are nowhere near the $76 billion high recorded in 2000. Last year saw $26.7 billion in new buyout and mezzanine fund commitments, with $13.1 billion of that activity occurring during the fourth quarter, according to the NVCA. Buyouts and mezzanine funds can finance new companies anywhere in the growth cycle from the early stage to an IPO. Buyout funds typically involve large amounts of capital and are supported by institutions like university endowment funds.

Venture capitalists invested $18.2 billion in entrepreneurial companies last year (down about 15 percent from the 2002 total) with $4.9 billion of that in the fourth quarter. “Now the industry is on pace for investing $4 billion a quarter and holding steady,” says Taylor. The fresh venture capital is flowing into a variety of sectors or subsegments, including both traditional and new areas of the economy.

The New Darlings
Biotechnology is beginning to edge out software as the venture capital funds’ favorite sector. Private equity funds invested over $1 billion in biotech in the fourth quarter of 2003. Last year, these firms invested $3.6 billion in software, $3.4 billion in biotech, and $2 billion in telecom, according to the latest statistics from the MoneyTree Survey, a joint venture between PricewaterhouseCoopers, Thomson Venture Economics and the NVCA. Telecommunications, medical devices and networking companies also figured among the top targets for funding last year.

Venture capitalists also favor business outsourcing technology—whether it be software- or hardware-related. Applications of this technology, which boosts the efficiency of the financial sector, particularly for banks, is very hot, Lightyear Capital’s Marron points out.

PARKING FEES Managing our capital between the time we commit it and the day our private equity fund calls it—a period of several years in some cases—can be vexing. Indeed, if the portfolio companies do not grow enough to require all the anticipated rounds of follow-on financing, we can be trapped in financial limbo for some time. What to do with earmarked funds is “never an easy question to answer,” according to Grove Street Advisors’ Clint Harris. Some financial advisors will provide alternative fund-parking strategies for a fee. Alternatively, we can put our committed, but uncalled, capital in liquid money market mutual funds, principal protected investments or low-volatility ETFs.

Life sciences also attracted a significant amount of capital in 2003, with $4.9 billion invested overall, representing 27 percent of all the monies put to work last year. This figure is the highest proportion for life sciences in the last 12 years, NVCA reports.

Within telecommunications, wireless solutions are the biggest draw for venture capitalists. “Some very interesting wireless companies have been built up to be consistent cash flow generators,” notes James McElwee, a general partner at Weston Presidio in San Francisco, which has $2.3 billion under management.

Energy and alternative energy companies are also in the crosshairs: $263 million, or 7.7 percent of all venture capital money went into these sectors last year. “We’ve been recommending energy and real estate investments in private equity to our clients,” notes Stephen Smith, the chief investment strategist for Whittier Trust of South Pasadena, Calif., which has 160 family relationships and $4 billion under management.

Eyeing the Exits
Quite a few venture-backed companies from these top sectors have recently gone public, and investor demand for their shares suggests the funds’ investment instincts were well-honed. Software producer Patni Computer Systems of Bombay, for example, found its February IPO was oversubscribed by a factor of 22 and yielded a capitalization level of some $634 million; among venture partners were General Atlantic Partners and General Electric. GTx, a men’s health products company based in Memphis, launched a successful IPO in February; Oracle Partners and MB Venture Partners had backed it.

While the IPO market has performed admirably thus far in 2004, it is notoriously finicky, and private equity specialists do not plan to rely solely on its fortunes. Indeed, fund managers say that, going forward, they expect to gain liquidity via private sales more often than in the past. The regulatory burden of greater disclosure under the Sarbanes-Oxley Act of 2002 may also put a damper on small companies’ desire to go public. Selling their portfolio companies to others may prove a less costly and faster method for private equity firms to exit investments. “M&A will replace IPOs to a certain extent, because it is the most direct way for both management and venture capital holders to get liquid,” says Weston Presidio’s McElwee.

Interests in top-tier funds are selling in the secondary market at around 70 percent of net asset value, but if the seller’s hand is forced because he or she is delinquent on his capital calls, these interests might go for as low as 5 percent of NAV. In a healthy market, we might pay a premium to NAV in the secondary market, because we really want the fund and will still make money.

The value of venture-backed M&A activity in the third quarter of 2003 was up several hundred million dollars to $2.1 billion, involving 74 deals, the NVCA reports; full year 2003 data had not been compiled when Worth went to press. (A total of $68 billion in venture-backed M&A activity took place in 2000, when the market was at its peak.)

Secondary Thoughts
While these funds may struggle to find the most advantageous exit, we must consider our personal liquidity needs. Indeed, some regard the inherent difficulty in getting out of a private equity investment, should the need arise for cash, as a major drawback. “Most of our family clients were not very interested in getting into venture capital during the bubble years and still are not,” because of the liquidity risk, says Whittier Trust’s Stephen Smith.

Those of us who are unwilling to invest in a private equity fund without an exit strategy may take some comfort in the development of a secondary market where we can sell our interests if, for example, we are unable to make a capital call, notes Edward M. Esber Jr., an individual investor and a member of the Angel Forum in Palo Alto, Calif. “The problem is that, in the secondary market, the percentage paid for your invested capital tends to be at a huge discount. But,” he notes, “if you need the money out, you need it.”

The secondary market in private equity is growing rapidly, thanks to the massive volume of investment still tied up in stalled or failed ventures. In 2003, some $4 billion in private equity ownership interests were traded on the secondary market, compared with $2.5 billion in 2002, according to Laurence G. Allen, the managing member of the New York Private Placement Network (better known as NYPPE) of Greenwich, Conn. While most of these were trades by institutional investors, exits by individuals also are on the rise. NYPPE estimates that roughly 15 percent of individual investors sold private equity interests in 2003; it expects that rate to rise to 20 percent this year.

Running with the Big Dogs
As private equity funds ramp up their fund-raising this year, we may find ourselves in competition with institutional investors for the best funds’ attention. Institutions are increasing their allocations to private equity, or are looking to meet previously set allocation targets; since they invest larger amounts—and are often better able to tolerate liquidity risk—many private equity funds prefer institutional money. “In this environment, the best venture funds are still being heavily oversubscribed, and they will not throw out a past supporter, which makes it very difficult for new money to get in,” says Harris.

Global institutional allocations to alternative investments—including private equity—increased by about 1 percent last year. Institutions in Australia and Canada led the way, allocating 14 percent and 10 percent of their portfolios, respectively, according to Chris McNickle, an analyst at Greenwich Associates, the Greenwich, Conn.-based financial markets research firm. “Endowments and foundations in the United States represent the only category of funds in the world that have surpassed this threshold, with average allocations of 20 percent in 2002, up from 16.3 percent the year before,” he says. Individual investors and family offices are more likely to allocate around 5 percent; anything much lower than that is probably not worth the bother.

Angels Rush In
There are alternatives, however. Angel investors typically band together to form virtual funds of funds. The Angel Forum in Palo Alto has a membership of about 25 entrepreneurs who meet weekly to consider new investment opportunities. Often only a few of the angels choose to invest in a given start-up, but in cases in which enough forum members choose to invest, the group commits its own funds.

“Angel funds like our Halo Fund are a great place for individuals or institutions to put money, depending on where in the company’s development process they want to invest,” says Esber. But those of us seeking access to angel or venture funds will often need to have “entrepreneurial capital” to contribute along with money, or we may find it difficult to get access. “When venture capital funds accept individual investors, it often has more to do with their strategic value to the partnership than their money,” says McElwee.

If we have no entrepreneurial skills to offer, or we simply cannot spare the time, the funds of funds that specialize in private equity may be an attractive route into the asset class. Some of these funds are willing to take investments as low as $1 million. Since these entities typically invest in a dozen or two different venture funds, their risk is usually diversified over several economic sectors and geographic regions. The endemic problem for funds of funds is the cost: They often charge 1 percent to 3 percent, in addition to the venture capital funds’ own fees.

Some funds of funds, among them FLAG, accept only individual investors and their trusts or foundations as limited partners. “The best funds of funds are wonderful vehicles for individuals,” Dietrich says. But liquidity risk remains an issue—exit provisions differ markedly among even the best funds of funds. 

Additional Information
Virtual Overhang