Yet another credit crunch casualty: venture capital firms, and potentially, their portfolio companies. The Wall Street Journal reports that VCs are seeing an increasing number of rebuffs, some borne of necessity, when they hit up their limited partners for dough (reader note: investors in private equity and venture capital funds do not remit the full amount committed at the closing of the fund, so these “capital calls” were contemplated in the partnership agreements).
The article mentions in passing that VCs suffered from missed capital calls in the dot-bomb era. Private equity funds did as well. I recall a partner in a PE fund of fund saying that nearly half the money committed to PE then was from wealthy individuals, many of them from Wall Street, and a large percentage of them was missing capital calls).
This then begs the question raised in an earlier post, on endowments selling their PE holdings, even though they are taking very big discounts to get out. Some readers suggested that they wanted to escape capital calls, particularly since the money was almost certain to be going to replace maturing debt (many of the recent deals had been done with a large component of short-term funding, and a fair bit is maturing now, just as interest rates for junk credits are super high). Given the high cost of exit, and the fact (as the article describes), some high profile investors, such as Calpers, are adopting the “just say no” approach to capital calls, why aren’t endowments doing the same? Are the endowments insufficiently tough-minded?
Indeed the Financial Times tells us the reverse side of this story, namely, that investors are ganging up on PE firms and telling them to forget about the idea of getting more money from them. This too parallels the VC experience in the dot-com bust, when funds were (effectively) told to shrink because the money crowd did not want to be putting more money into tech during a recession/post Y2K downturn.
From the Financial Times:
Some of the world’s biggest buy-out groups are coming under pressure from cash-strapped investors to reduce their commitments after Permira’s unprecedented offer to let its backers off the hook for €1.5bn.
Those most at risk are funds with poor records…
….private equity bosses have long boasted they have money locked up for a decade.
But now investors are turning the screw to discuss renegotiating the terms of these previously rock solid commitments…
But today many investors in private equity funds are considering something akin to a buyer’s strike. While most pension funds – the bulk of the money for private equity – say they have no trouble meeting calls for money, endowments and foundations have been hit by losses and some may no longer be able to afford to write cheques they promised.
From the Wall Street Journal:
From pension funds to rich individuals to once-deep-pocketed financial institutions now in desperate shape, this year’s plunging markets have made it much harder for some investors to come up with the money they promised to invest in venture-capital funds…The funds typically collect on investor commitments through periodic “capital calls.”
In October, Washington Mutual Inc. skipped a $700,000 capital call from a fund called Financial Technology Ventures Fund III…In late September, WaMu missed a $30,000 capital call to another fund, Arch Venture Fund V….
Defaults can cause venture capitalists to run out of money to keep start-ups alive.
Some venture capitalists are concerned that the fallout from defaults will be more prolonged this time because there are so few deep pockets around. During the tech bust, Storm Ventures, a venture-capital firm in Menlo Park, Calif., was able to sell the stakes of individual investors who couldn’t meet their commitments to institutions, which still had plenty of cash on hand.
Now, though, “there is distress” spread widely among all types of investors, says Sanjay Subhedar, a Storm managing director…
“In all likelihood, a number of institutional investors will not honor capital calls,” predicts Cynthia Steer, a consultant at Rogerscasey. While doing so could break legal agreements, there are few precedents for venture-capital and private-equity funds suing their investors, since they need to maintain long-term relationships with the investment community.
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In my biased opinion, good riddance. This should’ve happened anyway, even without the credit crunch finally becoming severe enough to curb the wealthiest investors and their magnificent egos.
VC is riddled with problems and unprofitable(which generally means unproductive for the economy as a whole) in its current incarnation. Myopia, favoritism, groupthink, and ill-informed investment, all with extremely deep pockets. It leads to some bad ideas that get pushed very far to the detriment of many good ones.
Maybe now we can stick to markets and more traditional cloak-and-dagger capitalism.
ndk,
One of my colleagues, former head of a mid-sized VC firm, said the industry business model didn’t work. When you parse the numbers, the entire industry returns are in a teeny subset of 50 to 100 to one returns, mainly dot com era.
He also contends the economics for the partners aren’t all that hot, believe it or not (I think that sort of reasoning will be exposed as dubious as financial services pay scales get reset).
There is a also an element of adverse selection. Why would you get outside money in if you could make it without the interference? I know people who have nine figure net worths via building businesses with no VC help. My lawyer steers her clients away from VC (this based on her own experience both working for Ron Perlman and later for a PE funded firm).
More bad news for the VC industry if Paul Graham is correct – he thinks that most startups don’t really need VC money any more.
http://paulgraham.com/divergence.html
He also contends the economics for the partners aren’t all that hot, believe it or not (I think that sort of reasoning will be exposed as dubious as financial services pay scales get reset).
I’m flabbergasted that this is even still in dispute, honestly. It’s a tribute to the ego involved. The hard numbers are already out there.
More bad news for the VC industry if Paul Graham is correct – he thinks that most startups don’t really need VC money any more.
I think he’s right. During bubble and bubble 2.0, VC’s were regularly foisting capital upon startups that they literally couldn’t spend effectively. Can’t grow that fast; don’t want to grow that fast; don’t want to get that deep in bed with the VC.
Like Yves, some of the better startups I know actively rejected these guys.
Yves, have you heard of Paul Graham, and if yes, what’s your opinion on his business model?
Very interesting. I actually just wrote a post on this, and it’s been getting a ton of attention:
“The Wiki Fund: People Powered Venture Capital”
http://scottdig.com/?p=84
The only kind of startup Paul Graham understands is the webby kind, and he’s right, that kind of startup doesn’t need capital any more. It just needs sweat equity. Software startups are in the same boat. Better to spend $10,000 and six months on an entirely new niche than try to tackle an established niche where the entry costs are millions and the weird economics of software make it harder to jump in the larger the market is…
If he’s going to generalize from that to any conceivable business venture, I think he’s blowing smoke. You can’t build railroads, jet aircraft, space tourism ventures, without seed capital.
Yves,
That WSJ article is pretty skimpy on the details of LPs defaulting on capital calls. Is WAMU really a good example? I don’t doubt that there will be more LPs not honoring capital calls since they are hurting but there isn’t much evidence out there.
As for the VC business in general, the model is just fine. The problem is that there’s way too much money in VC right now. If you look at the top quartile funds, they perform very well.
The reason why there is so much money is because various unsophisticated money managers across the country (eg. teacher pension funds) either read Swensen’s book or hired a consultant that read Swensen’s book and decided to allocated a certain percentage of their fund to VC.
That’s the wrong way to invest in VC. If you can’t get into the Sequoias and Kleiners, putting your money in some other fund won’t be the same.
As for the commenters getting excited about the Paul Graham model, what he’s got going seems to be working well for him but there is very little overlap between the scale of his investments and the scale of early stage VC investments. In my opinion, he doesn’t seem to be competing directly with VC as he is with angel funding and other forms of seed capital.
So VC-ists act in their own self-interest — who knew?
Are the endowments insufficiently tough-minded?
I read that as: Endowments are selling off the losers for whatever they can get (which they expect is more than letting it go to term even without delivering further capital calls.)
Let’s face it: Lots of VCs are dead men walking.
Only one side of this story is really told in the article. Presumably the banks, funds and individuals who are defaulting signed contracts that require them to meet their commitments.
In other words when they fail to cough up the money they have promised hey are breaking the contracts. It’s nice for authors to suggest that more funds need to “get hardnosed”, but breaking contracts has downside too.
I don’t have a lot of sympathy for, say CalPERS, over the VCs. CalPERS is one of the largest funds in the world. They go around acting holier than though. I still remember when some idiot CalPERS representative came to the annual meeting of the public company I worked for (revenue over $1 billion) and spent 10 minutes asking when we were going to get more minorities on the BOD.
Total freaking idiot who was only concerned with his politcally correct agenda and not with the business issues around the company that he had invested other people’s money in.
Hopefully the VCs and PEs sue and win big.
The endowments are in a tough spot. Private equity fund limited partners (the ones who fund capital calls) get crammed down on their prior investment if they refuse a call. This means that they need to be assured that the fund's current investments are actually underwater, and unlikely to recover, before refusing a call.
In most cases, it might make sense to suck it up and fund, just to get back to even in another 3 or 4 years. I'm not paid enough to make that call, though. Might as well ask the Magic 8 Ball.
While tech-related private equity & venture capital gets all the media attention, billions are invested into grassroots development opportunities by infrastructure, industrial, and resource funds. The buyout funds provide little value, but when you need $300 million to develop a steel plant based on a new technology, it's good to have the funds around.
The story will probably end like the rest of the financial sector: much smaller, but better funds that actually add value. That leaves little future for the big leveraged buyout operations, I hope.
Zeke,
VC funds had their commitments reduced by 50% in the dot com bust, There is precedent here.
As for PE, even thought the fund charters were no doubt drafted so broadly as to permit having the fund use a capital call to replace maturing debt, that most certainly is NOT what the investors were promised or ever thought would happen.
And that is a general problem in our society. There is often a big gap between the sales pitch and what the fine print says. People too often rely on verbal, non-binding assurances from supposedly reputable parties.
@Yves,
Could not agree with you more. Rather than living within the Law, players spend more time and money trying to bend or buy the keepers of the Law, to make a profit.
As a ex-sales executive here in Australia, I cannot count how many times I have had to fight those above me to work with in the law and not bend it. All because those above do not feel they had a win, with out being clever in the bending of the law or hoodwinking of a client.
Skippy
Queen probably sings it best; another one bites the dust, ok, to the power of 100 or so.
but honestly naren’t these deep pocketed individuals and organisations best able to ride out the storm?
Commenters so far don’t seem to know why institutions aren’t meeting commitments, so here goes: the big driver is what’s known as the “denominator effect”. Endowments have relatively fixed allocation percentages to different asset classes. Most have been crushed in the last couple years on public equities, real estate, and other investments, which throws their allocations out of whack. The progression of events is then: desist from making new private equity/VC commitments, do not meet capital calls on current commitments, and then even sell perfectly good positions in existing private equity and VC funds. If they can, they will sell poorly performing positions first – if there are takers out there. Since in this market there’s not much liquidity for such positions, they are being forced to do other things. Some major university endowments are way down for the year, with at least one of the biggies (wouldn’t be polite to say) at risk of insolvency. This is why a CalPERS might say “if you want our business in future, you will not make capital calls til things settle down”, and no, there is not a chance that the funds will sue. That would be stupid. CalPERS is not being malicious; they are freaking out like everyone else.