Why LP defaults isn't an issue for good VC firms

Amazing. In the blink of an eye we've come from Web 2.0 mania to Limited Partner commitment defaults in VC funds. Wow... who turned on the lights in the club? Party's over, I guess.

"You don't have to go home, but ya can't stay here."

Anyway, Doomsday aside, the way venture capital works is that high net worth individuals and institutions (pension funds, endowments, insurance companies) make commitments to VC funds. Unlike hedge funds, however, they don't hand the money over day one--it gets drawn down as VCs find and fund deals. Some funds, like Accel, draw down chunks of their fund 5% at a time, just in case a deal needs some quick cash. Otherwise, Limited Partners generally have 10 business days from the day VCs request their money to pay up. If they don't, they can be in default, and lose their stake in the fund. If you really don't have the money, though, I guess that's not such a bad scenario.

From '00-'03, many dot com entrepreneurs and even some institutions (like banks) realized that, as a % of their shrinking wealth, they had overcommited to VC funds and either couldn't keep up with the capital calls or just didn't want half their savings tied up in VC funds.

Some of them had pieces of VC funds that had already been fully invested, others had relatively new commitments. Eiither way, they wanted out and that's where the VC secondaries market came into play.

How do I know this? When I was on the VC investment team at the GM Pension Fund (now PEQM), we were a major investor in secondaries. Not only did we back secondary funds, like Lexington Parters, who bought these commitments from others, but we did a number of transactions on our own, buying direct. One of our major purchases was a portfolio of VC funds sold after the crash, when VC funds seemed to b devaluing their portfolio and shutting down companies every quarter. It was a bloodbath and those who were newbie investors went running--right into the arms of long term institutional investors like ourselves that had been doing venture since 1979.

The most interesting portfolios we saw were the mostly unfunded ones, where investors had made big commitments to newly raised VC funds only to realize that they'd never be able to follow through.

So what's the going rate for an empty VC fund that has yet to draw down any capital? More than you think!

Some funds, like Kleiner, Sequioa, August, Accel, were seen as so attractive to investors and so difficult to get into, that people were paying money for completely unfunded commitments--just to get into the fund. The idea is that if you target a 15% return and you think a given fun will return 25%, then risks being equal, you'd actually pay up to put your money into it if you were limited in your access to other similar funds.

That was the exception, though. Most funds were sold at heavy discounts for the existing assets. The point is, there was never a shortage of investors looking for access to these funds. The idea was that if you bought in, made nice with the VC firm, and proved to be a stable source of capital, you could hopefully get into their next fund as well, plus make some money with your "value" bet on the existing assets.

Therefore, good firms with good LPs will always have someone waiting in the wings to take over their commitment. Also, some existing LPs have "ROFRs", which stands for right of first refusal. That means that before you think you're going to pick up a few pieces of the next Sequoia fund on the cheap, the existing investors will get a shot at it before you do.

If you do have a commitment to a top tier fund and you're looking to get out, drop me a line and I'll put you in touch with some folks who would be willing to take it off your hands. Just remember, when I say top tier, I don't mean Joe's Auto Body Shop and VC Fund.

Totebags

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