The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.
Source: Dow Jones Private Equity Analyst
We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.
In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).
Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.
A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments. In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape.