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Investing in Venture Capital - Limited Partner or Fund of Funds? - Part 2

Igor Sill, Managing Director of Geneva Venture Management LLC


Huge problems still remain to be solved and massive opportunities loom as major corporations, mid to small businesses all seek competitive advantages via new technologies. The emergence of Software-as-a-Service and Cloud computing are major tectonic shifts occurring in the global software ecosystem. Technology's self-renewing cycle of new wave innovation continues, driven mostly by cost improvements, easier use and vastly greater efficiencies. With new regulatory issues requiring compliance, transparency, privacy, security to high computational performance via cloud computing efficiencies, there's a massive opportunity for a bunch of smart people to do some incredibly great things. There exist a huge community of seasoned serial entrepreneurs with a deep-rooted passion to build new companies. Venture capital enables and to a great extent, propels this entrepreneurial innovation. Understanding how investors gain access to the Venture Capital firms leading funding for these innovations, along with their higher returns, is keenly important.

Many of the brand name Venture Capital firms no longer benefit from their founder's experience, knowledge, network and impassioned mentoring of promising first time entrepreneurs--they have long since retired from active participation, though their names remain on the Fund's websites.

Though there are pockets of entrepreneurial ideas globally, the epicenter of breakthrough, disruptive technology innovations continues to emerge from Silicon Valley. This is a very unique place with a supportive ecosystem ready to back entrepreneurs' requirements for launching start-ups successfully. The weather is excellent, the lifestyle is wonderful, and the scenery exquisite. Stanford University, UC Berkeley, USF and University of Santa Clara provide an abundance of superb research and continually spin-off new patents, along with a steady flow of budding intellectual entrepreneurially-driven graduates. 80% of venture capital and Angel investors operate here, and, where else will patent attorneys, new business formation attorneys, equity attorneys give you their time without payment in advance of receiving venture capital funding? Although the capital markets have been sluggish of late, investment bankers eagerly swarm Silicon Valley in order to underwrite venture backed IPO candidates. In no other locale will you find the combination of all these factors.

In such a fast paced environment, with over 3,500 venture capital funds competing for the most promising start-ups, FoFs are a very efficient way to construct a balanced portfolio for investors seeking to participate in this market segment through the very best venture funds. Essentially, FoFs can offer an investor access to the very best performing Venture Capital fund Managers not otherwise accessible directly. Further complicating the process is the venture industry's notorious lack of transparency relative to their fund's actual value. A venture fund series financing in one invested company may report a value considerably different than the same series investment in that same company by another venture firm.

Generally, a FoFs has greater leverage in scrutinizing a venture firm's financial reporting, its partner expertise relative to market sector focus resulting in a better risk-return ratio than direct investments. They're also looking for more than the conventional venture model has traditionally delivered - multiples of cash back rather than straight Internal Rate of Return (IRR). They seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles, versus today's typical 10-12 years. The reasons for the impressive growth of FoFs is that they provide diversity among Venture Fund managers, reduce risk and hold out the promise of net returns higher than the average venture capital return rates. Investors are more willing to invest in FoFs for the benefits provided by this pooled investment structure, continual due diligence and on-going oversight compared to investing in a single strategy venture fund. The most common FoFs fee structure is a management fee of 1% and an incentive fee of 10% above that of the underlying Venture Capital fee structure. The additional fee layer is relatively small with returns generally more than offsetting the added expense. A balanced, properly allocated venture capital/private equity portfolio generally tends to provide higher returns with less inherent risk.

An industry focused FoFs is well experienced in assessing the most promising Venture Capitalists, both the Emerging Venture Fund Managers as well as the historical brand name Venture Capitalists. The brand name Venture firms provide a low-risk foundation for consistent top-quartile performance albeit with higher fees to their LPs. Emerging Fund Managers focused on rapidly growing market sectors offer outsized return potential for their portfolios. But, Emerging Venture Fund Managers who follow a more capital-efficient investment model can deliver industry-leading returns while reducing risk with shortened investment cycles at competitive fees to LPs.

The selection process of either brand name Venture firms or Emerging Fund Managers should entail research of their respective track record of investments, actual hands-on involvement of their investments, the firm or Emerging Fund Managers' lure and stature within the entrepreneurial community (deal flow source), and most importantly, the ethical reputation and transparency in reporting accurate market valuations. Do some serious research here, as the term "success has many fathers" applies in spades to promotional materials.

There are essentially three high potential appreciation types of technology investments which Venture Capitalist traditionally focuses on: seed & early, development stage and late-stage expansion. And, within these 3 categories, there are 3 sub classes: disruptive innovation, enabling technologies and special situations. Market trends and dynamics coupled with technical challenges are very often industry specific. Understanding these issues is critical to the successful mentoring and value creation guidance of start-ups.

Consistently successful returns are achieved from only a few select firms who diligently study, identify and invest in technologies and markets on the leading edge of disruption. They tend to focus on building companies at the forefront of market forces creating outstanding growth and exit opportunities. These particular Venture Capitalists are notorious for sourcing and developing fast-growing companies in large market growth sectors.

Look for a FoFs Manager with investments in venture capital funds possessing the demonstrated expertise, deep experience and qualifying techniques in specific areas of their investment focus. A top tier Venture Capital firm will utilize extensive analytical techniques to evaluate and compare each investment prospect. They will benefit from extensive industry contacts and global business leader connections. These relationships help provide the foundation for executive team recruitment in their portfolio companies, follow-on financings, facilitating strategic corporate alliances, new partnership opportunities and most importantly, exit strategies whether through leading Investment Banking underwriters for IPOs or M&A activity. Doing your homework upfront and placing your bets wisely can result in significant healthy returns whether through a FoFs or direct LP participation in a Venture Capital fund. Of course, past performance is no guarantee of future results.


Igor M. Sill, Managing Director, igor@genevavc.com

The author, Igor Sill, is a Silicon Valley venture capitalist and founder of Geneva Venture Partners. He is a Limited Partner in Goldman Sachs Investment Partners, Benchmark Capital, Norwest Ventures, Brentwood Associates, SV Angels, ICO Funds, The Endowment Fund and Granite Ventures. Sill was educated at the University of California, Berkeley, received his MBA from the Said Business School, University of Oxford and is a member of Merton College, Oxford University. He also attended Harvard Business School's Venture Capital Program, Stanford Graduate School of Business Advanced Management College and Stanford Law School Directors College. He is a Fund Advisor to 7Capital and Red Herring Limited and has managed venture investments on behalf of Societe Generale, AXA, Thales Group, Ace Management, Venture Capital Funds and numerous Family offices. Special thanks to David Swensen of Yale University, Cain Soltoff, Yale Investment Office, Legendary Venture Capitalist: Bill Draper, Paul Rydberg of Goldman Sachs Private Wealth Management Group, Emmanuel Roubinowitz of Fondinvest Capital and Dr. Mark Cannice, Professor of Entrepreneurship & Innovation at University of San Francisco Graduate School of Management for their sound advice and contributions to this article.