What do LPs want?
If you’ve been paying attention to PE land, last week marked the annual Canadian Venture Capital and Private Equity Association conference. If you are a VC or PE fund manager, the Montreal meeting served as a good opportunity to chat with some of the pension funds and institutional limited partners (LPs) that make up the key funders of Canada’s VC and PE industry.
Think of CPP Investment Board, CDP, OTPPB, OMERS, AIM, EDC, TD Private Equity Partners, FTQ, NBIM and so forth.
At each of these conferences there’s the requisite panel of large institutional funds, and the panel is always held during the final slot on the final day to ensure that all of the attendees stay for the entire conference. The moderator does his best (Kensington Capital’s Graeme Johnson had the tiller this year), and the conversation will quickly revert to a traditional theme: what does it take for a VC (or PE firm) to raise money? what are LPs looking for from VCs? do LPs have a nationalistic flavour when it comes to allocating capital?
Whatever the city, and whoever the conference organizer might be, the answers and the conversations that flow from the Canadian LPs are generally the same:
– “We want returns, returns, returns.”
– “VC returns have been poor, which makes us wonder about adding new fund managers or even putting any more capital into the asset class.”
– “Of our $1.4 billion private equity program, we have 8 core Canadian GP relationships and we aren’t adding any more.”
– “Venture Capital investing is hard, and if there are only 20 or 30 funds in the world who are good at it, then perhaps we should just invest in them.”
– “Every fund manager thinks they are top quartile.” (LOL)
– “Canadian VC fund sizes are too small to be effective.”
– “Canadian VCs need to do larger Series A and B financings for their portfolio companies to succeed.”
– “Canadian VCs need to change management out far more quickly than then is the norm.”
– “Canadian VCs need to cut off their loser investments faster; to be more like American VCs when things aren’t going well at a company.”
– “For us to put money into your fund, we need to commit at least $500 million to the relationship for it to move the needle at our institution; that’s why we can only fund international GPs.”
– “We’ll need you to open up an office in our Province if you want an allocation on your new fund.”
– In general, “Canadian VCs may be too nice to be effective.”
Much of that might be fair, and it is obviously a series of generalized statements. But for every entrepreneur out there who thinks the VCs are the Kings and Queens of the Hill; I must inform you that it’s not true. We are servants of the limited partnership universe, and without their capital we couldn’t fund your companies.
The message of last week was bleak to many, and the mood was grim according to more than a few attendees. I didn’t see the glass being three quarters empty myself, but others in the industry certainly left Montreal with anything but a spring in their step.
The trouble is, even the most successful Canadian VCs don’t actually know what the LPs want. Now don’t get me wrong, we are lucky. Our LPs are a wonderful collection of experienced, considerate, fair-minded and knowledgable folks. They know what they want from GPs and they have a strategy in place to achieve certain ends for their institutions. But in a conference of 570 people, many GPs don’t seem to be as fortunate as we are.
The LP panelists say “returns, returns, returns”, but what does that mean in practice? Many in these audiences are still scratching their heads on that front by the time the panels wrap up.
– Do LPs risk adjust their returns or not? Is a VC return of a higher risk than a private equity return, an infrastructure return or a debt return? If so, does that mean a PE fund needs to earn 17% net to be a success, where a VC fund needs more than that to keep pace as their asset class is seen to be more risky?
– If an LP is risk-adjusting returns across different asset classes, how are they actually doing that? What beta is being observed? What risk factor is being applied?
– Do LPs differentiate between levered returns and unlevered returns? And if so, how do they do the math? Is a 10% unlevered net return better than a 12% levered one?
– Do LPs want relative outperformance or is it all just about absolute performance? Or both?
– Which benchmarks do LPs use? Thomson Financial’s U.S. data? CVCA return data as compiled by Thomson? Capital IQ? Is it appropriate to compare Canadian returns to U.S. returns since U.S. returns include funds such as Seqoia, Kleiner Perkins and so forth — none of whom are accepting new limited partners. Why not G-7 or OECD VC returns?
– Isn’t the appropriate benchmark the one that an investor CAN actually invest in, versus what others are making?
– If the annual S&P 500 three year return is 6.4%, and the current 10 year Canadian bond provides a yield of ~3.50%, is the private equity, debt and VC world not doing well so long as they beat those two numbers handsomely and consistently?
– Over the long term, VC returns exceed those of Private Equity (see prior post “Buyout vs. Venture returns” February 20-08). Why then, do short term VC returns get in the way of long term asset allocation decisions? Aren’t the institutional investors making long term investment decisions to match up against their long term liabilities?
– If the average pension fund’s liabilities are more than met if a fund manager consistently generates returns that represent a 180 basis point premium to the pension fund’s own hurdle rates, is that not adding sufficient economic value to the pension fund to warrant a pat on the back for the GP? What about 280 bps?
– If the Thomson Financial 5 year benchmarks for VC returns are 8.5%, PE is 14.3% and the mezzanine return is 5.4% for the same time period, would fund managers be shooting the lights out if they beat those returns by, say 500 basis points? Those returns would be well above the equity markets, for example. But we don’t even know if equity market returns are a viable benchmark to compare ourselves to.
– Since personal relationships are often part of the puzzle, how important are pre-exisitng relationships between the GP and the LP prospect when it comes to landing that initial allocation? Also, do the returns of a “known quantity” need to be the same as an “unknown quantity” to earn that hard-to-come-by allocation?
– Why do some LPs believe they have a constructive role to play in their local economy and others feel that they should invest where the returns are likely to be the most attractive?
– When investing in foreign funds, do LPs hedge their CDN$ position, assuming that all of their planholders are Canadian-based and earn CDN$ denominated pensions? If LPs don’t hedge their foreign currency exposure, does a US$ denominated fund get penalized if they shoot the lights out in their home currency, but underperform on a CDN$ basis? If not, why not?
– Why do PE and VC managers need to guarantee their upside payouts (which makes sense btw), but hedge fund managers such as the defunct Amaranth don’t? (see prior post “No one is surprised, but whose to blame?” September 21-07)
– Why is it when a pension fund’s public equities external manager beats the benchmark by 100 bps they’re a star, and the one who beats by 150 bps is a superstar, but a PE/VC/Debt Fund manager who beats the benchmark by “only” 200 bps or 400 bps can’t get an allocation from that same institution?
The questions go on and on and on. For VCs and PE funds to do a better job, they need more information. Last week’s CVCA meeting was a good start.
For every entrepreneur that leaves a meeting with a PE/VC investor saying: what do they want? Take heart. It may not be much solace, but you’re not alone.
Great post! Lots of questions raised. I dug into this topic myself a bit last week (http://startupcfo.ca/2008/05/canadian-vc-performance-in-2007.html)
As someone who is dependent on local VCs for funding, I have to say I’m very concerned about the returns. Both short and long term IRRs are not enough to keep $ in this asset class.
I enjoyed your commentary. To help advance your cause, I would like to share some additional institutional perspective:
I think that VC’s might examine their own business model, and offer up some further innovation. The limited partnership fund is not the only way to make investments, and even within this structure, there is room for some changes to approach, e.g more concentrated portfolios, smaller fund sizes, different economics or timing of such economics are some things I have discussed with the community, and in a couple of instances my institution have supported such unique arrangements (in Canada, and in the States/Europe, both in venture capital and other private equity variants). Or, as another example, the daisy chain of funding rounds, and wide variety of partners in a typical VC deal are peculiar to VC investing – but maybe this club context conspires against good outcomes for all kinds of investment selection and behavioural reasons?
Maybe rethinking all this just ends up reinventing the wheel, but I would like to see some form of introspection by VC’s which suggests that risks going forward are calculated and thought through – that is all us “capital allocators” can really ask for.
In any event, you are on a difficult track to take guesses on how institutions work, or should work, and how they chose to allocate their capital. Better to simply make the realistic case for what you are doing, or plan to do, rather than trying to fulfill some notion of what you think institutions might want. Isn’t this the way you hope the entrepreneurs you back think of you and how to deal with you?