Capital flows into venture capital funds from limited partners (LPs) such as pension funds, university endowments, foundations, finance companies, and high-net-worth individuals. In this post, I'll attempt to describe each LP and how they look at VC. If you are raising a fund, this can help you to understand LP profiles, their constraints and identify which LP may be best suited for your fund.
While pension funds are the largest contributor, these are also conservative with respect to VC allocations. Endowments and foundations are comparatively more aggressive and allocate larger portions to VC asset classes. Finance companies function as specialized intermediaries and follow the guidelines established by their sponsors. A fund-of-funds (FoF) is established as an intermediary to allow larger institutional investors to research, access, and manage VC investments. Within all these players, some have a stronger penchant for PE and VC and will often deviate from the aggregate.
As a VC, you should be able to answer:
- Which LP is best suited for my fund ? Larger well established venture funds attract pension funds as LPs while upcoming emerging managers are often successful in attracting family offices and foundations.
- Do I understand the LPs constraints? Every LP operates with a certain set of constraints. Some need a steady stream of cash flows (annuities in pension funds) and other are risk-averse (insurance companies). Some are bold and can bet the farm and some make decisions quickly (family offices - if you talk to a family member). To put it in LP jargon, the four criteria LPs care about are:
- Capital Preservation - How do LPs minimize their risk and ensure their principal amounts stay safe?
- Capital Appreciation - How do LPs expect their capital to grow? At what rate per annum?
- Current Income - What cash flows do LPs expect from their entire portfolio? Does the need / pressure for cash flow trump long term capital gains?
- Total Return - How is the total portfolio value increased and surplus generated?
- Can I meet their expectations? Well. everyone expects high IRR but some expect VCs to address socio-economic or environmental goals.
In this post, I will lay out each LPs underlying "business model" and cash flows, as well as their appetite for venture capital. Note that venture capital is often a subset of "Private Equity", which in turn falls under "Alternative Investments". Let's start with the pension funds:
By far, the largest source of capital for the VC universe are pension funds. A public entity or a private corporation establishes a pension fund to manage employees' investments. Employees set aside a certain amount of their paycheck in a separate account, with the goal of savings for and enjoying their years of retirement. Employers, with an objective of attracting the talented employees and incentivizing savings, match the employee contribution into the pension plan. Thus, the two sources of cash inflows into pension funds are a sum of contributions made by individuals and employers. With a larger pool of employees, the steady trickle of contributions grows to a significant amount over time. The goal of any pension fund is to provide financial security to the employees and their beneficiaries. The pension fund is typically a separate entity and is governed by a board of trustees. The typical asset allocation strategy for this pool of capital depends on the cash needs of the pension plan. Pension fund cash outflows are a factor of the benefits paid to retirees. Consider California Pension Retirement System (CalPERS), the largest public pension fund in the United States, which had over $299 billion in assets in management. CalPERS has allocated ~10% or $28 billion to Private Equity asset class.
It's worthwhile to take a deeper dive in this treasure trove and read their annual reports - all publicly posted online. In many cases, the government mandates investment activities and prescribes language requiring that pension funds "maximize returns without undue risk of loss." Pension funds are also subject to political pressures, and political interference can severely affect a pension fund's viability. All these factors impact the pension fund’s ability to make investments in venture capital funds.
Endowments and Foundations
University endowments invest heavily in Private Equity and Venture Capital. Like every financial institution, they have to manage inflows, outflows and returns on their capital. A university's cash inflows are a sum of student fees, grants, and contributions. On average, student fees and grants constitute 48 percent of a university's revenues; as these sources are uncertain, universities seek to insulate their position by creating endowments. Less than ten percent of revenues at Yale University have resulted from tuition but over forty percent of the university's operating income comes from its endowment. An endowment generates investment income and provides a cushion against any potential uncertainties. With it, a university can focus on its primary goals of providing education and conducting research (or building a football stadium, depending on priorities)—activities that further social causes and knowledge. The grants and contributions are fickle and insufficient—neither of these are tantamount to predictable revenue streams. More than 90 percent of endowments typically spend around five percent of their assets each year. They use these cash outflows for university operations or capital expenditures. The rest is often set aside for investments. Due to limited demands on their cash outlays, endowments are better suited for investments in alternative strategies. At Yale University Investments Office, as much as 33% of the assets are set aside for Private Equity. Recall that with CalPERS, it was less than 10%.
In comparison with pension funds, endowments have invested as much as four times the percentage of their assets in alternative assets. In a perfect world, endowment funds can potentially last forever, while pension funds can run out of money due to demands of current liabilities.
Like endowments, foundations are a significant force in the world of private equity. Foundations exist to support charitable and nonprofit causes. Governed by federal laws and regulated by the United States Internal Revenue Service (IRS), foundations are managed by their trustees. Foundations support programs that are likely not supported by federal or state grants, such as childcare, arts and education, health care, climate and environment, and religious and social causes. The emphasis placed on health care by the Bill and Melinda Gates Foundation is one such example. Foundations offer grants to various nonprofit organizations to conduct these programs. Over 75,000 foundations in the United States manage over $500 billion in assets. Private foundations are established and endowed by corporations (e.g., Ford Foundation, W. K. Kellogg Foundation) or families or individuals (e.g., Bill & Melinda Gates Foundation) and fund programs that are important to the donors. To meet IRS eligibility, private foundations must grant as much as 5 percent of their assets each year. The balance, 95 percent, is invested using asset allocation strategies. Foundations have to report their financial information publicly, as IRS guidelines mandate this disclosure. Besides private foundations, other types of foundations include community foundations, which attract a large number of individual donors from a geographic region, and corporate foundations. Corporate foundations exist to further the cause established by the donor corporation and are funded from the corporation's profits. Over 2,000 corporate foundations in the United States hold over $10 billion in assets. As seen from NACUBO research, larger endowments are more aggressive with private equity investments with as much as 57% of capital invested in Alternative Strategies for endowments over $1billion. The number falls to 10% with smaller endowments below $25 million.
Other forms of foundations include operating foundations, which conduct research or provide services, as opposed to grant-making activities. Compared to an endowment, the short-term cash needs of a foundation are not as significant. Hence the allocations toward long-term assets, such as alternative assets (which includes VC), tend to be higher in comparison to those of a pension fund.
Within the LP universe, finance and insurance companies provide as much as 25 percent of the capital for venture capital and private equity. Finance companies are treated as a catch-all category to ensure clarity of presentation in this book. These include banks, nonbank financial companies, fund-of-funds, and other entities like TIAA-CREF funds, investment trusts in which assets are pooled for investment purposes. Each finance company defines its own internal criteria such as target returns, volatility, holding period / time horizon which helps develop their asset allocation plan. Consider GE Capital, Equity—the financial arm of General Electric that positions itself as an entity that "maximizes the return on GE's investment capital by combining deep equity investing experience with GE's industry expertise, operating experience and global reach." GE Capital, Equity has invested in over 500 LP funds and currently has over $5 billion of assets under management.
Like pension funds, insurance companies manage a large amount of cash inflows and outflows. Any insurance company is in the business of managing risk. An insured party pays a premium at a fixed time interval—say, monthly, quarterly, or annually. Insurance companies invest the premiums, but the underlying driver is to meet a potential obligation that may occur in the future. If an accident occurs, the insured receives compensation. The business model of any insurance company can be reduced to inflows via premium payments and investment income. Underwriting expenses and incurred losses are primary outflows. The scope of the insurer's business and required guarantees drives the target rate of return. These factors determine an asset allocation strategy for any insurance company. As the demand for liquidity is high, the insurance companies do not wish to lock up their capital in VC funds for 10 years. The appetite for VC / PE is often low.
Insurance companies have a unique advantage as a business model: The customer pays up front and eventually, at some point in the future, may receive benefits. In some cases, all a customer may ever get is the proverbial peace of mind. The primary mechanism to generate investment income for insurance companies is management of "float"—the amount of money that "floats" with the insurance company as premiums arrive and sits around, waiting to be paid out in the event of any claims. Insurance companies need to maintain certain levels of capital; if they fail, regulators can swoop in. Solvency requirements are an important factor; hence the need to maintain a certain level of cash is important. Thus, insurance companies have to model their cash needs based on an actuarial assessment of risk and liabilities. In any insurance company, the accounting and actuarial teams develop the overall plan that determines cash inflows and outflows. Inflows are predictable, but outflows are not entirely predictable. Actuaries invest an enormous amount of time in modeling demographic patterns of fire, floods, accidents, and other acts of God to derive a co-relationship between premiums and claims—or risks and rewards. Hence, insurance companies attempt to manage their cash positions and liquidity effectively, as unanticipated events could occur and affect their solvency. Thus, asset allocation for insurance companies is heavily weighted in low-risk investments such as bonds. Venture capital investments are lower on the totem pole and fall in the "Other" category for most insurance companies.
Family Offices and High-Net-Worth Individuals
As much as 10 percent of PE and VC assets come from family offices and HNWIs. A family office is a private company owned and run by a single wealthy family. The family office manages the investments and trusts of the family. A single-family office (SFO) or a multi family office (MFO), as their names suggest, are professionally managed investment services companies that serve wealthy families. One of the primary functions of a traditional family office is to consolidate financial management with a view to preserving wealth, generating returns, and minimizing the tax impact for any family's fortune. Small teams of confidants, including professional investment managers, are responsible for managing the family's assets and the family office.
Among the other major tasks handled by the family office are the management of taxes, property management, accounting, payroll processing, and other concierge-type services such as travel arrangements. Family offices are classified as Class A, B, or C depending on their administrative structure. Class A family offices are operated by an independent company with direct supervision from a family trustee or an appointed administrator. Class B family offices are operated by an accounting firm, bank, or a law firm, and Class C family offices are directly operated by the family with a small support staff. MFOs consolidate activities for several wealthy families with the objective of minimizing operational costs. The Family Wealth Alliance estimates there are approximately 3,000 U.S.-based SFOs and 150 MFOs. SFOs manage assets ranging from $42 million to $1.5 billion. Total assets under advisement by MFOs are upward of $350 billion, with an average client relationship size of $50 million. Median asset size at any MFO is close to $1 billion. According to a study conducted at the Wharton School, the most important objective for the SFO is trans-generational wealth management. Having an SFO also allows the family members to pursue their own careers, while enjoying the benefits of cost-effective money management. As the wealth comes from family business, 58 percent choose to focus on their strengths and remain involved in operating the businesses, and 77 percent are majority stakeholders in their holding companies. This has implications from an investment decision-making perspective. Cap Gemini World Wealth Report reports typical asset allocation for HNWIs and family offices. In comparison to endowment and foundation allocations, this category is conservatively slanted, with around 8 percent in alternatives. However, some family offices have a strong propensity to invest heavily in venture capital asset class.
The Hillman family office of Pittsburg, PA, played a significant role in the launch of Kleiner Perkins Caufield Byers (KPCB) Fund I in the early seventies by investing as much as half of the entire fund. KPCB Fund I invested $8 million in seventeen companies (including Applied Materials, Genentech, Tandem Computers and one called "Snow-Job") and returned $345 million to its investors. The estimated 43X Cash-on-Cash return made the Hillmans very happy, thank you very much.
In Europe, 63 percent of SFOs perform asset allocation in-house versus 47 percent of SFOs in the Americas. Thus, investment decisions and process timelines may differ if professionals manage the office. Due to the size of assets, and the conservative undertones, the decision-making cycle for investment in PE and VC is comparatively longer. Family offices and HNWIs are a significant source of capital for venture funds. According to World Wealth Report, worldwide, wealthy families and individuals control about $42.2 trillion. More than 100,000 individuals in the United States are estimated to have assets in excess of $10 million.
North America remains the single largest home to HNWIs, with its 4.3 million HNWIs (2014) up from 4.0 million in 2013, accounting for 31 percent of the global HNWI population. In terms of the total global HNWI population, it remains highly concentrated, with the United States, Japan, and Germany accounting for 60.3% percent of the world's HNWI population. The fastest growths of HNWIs are in Asia or "Ch-India."
Corporate Operating Funds
Corporate investments in venture funds make up a bare whisper of 2 percent of all capital flowing into venture funds. A number of corporations such as SAP, Dow Chemical Company and IBM invest as LPs in externally managed venture funds. Others establish internally managed "corporate VC funds," (CVC) such as Intel Capital or Google Ventures which invest directly in companies. CVCs invest ~6% of annual VC investments in companies.
Sapphire Ventures (fka SAP Ventures) spun out of the corporate venture arm of SAP AG, the German software giant with $16 billion in revenues. The venture arm manages over $1 billion. The fund has invested in companies as well as ten early stage venture capital funds. Its fund-of-funds portfolio consists of funds like SV Angel, a seed fund, August Capital, a Sand Hill Road-based fund, known for big data investments and Data Collective, a seed fund. Internationally, Point Nine, a Berlin-based seed fund with a focus on SaaS, marketplaces and mobile investments and Magma, a Tel Aviv-based Israeli seed and early stage fund have received commitments from SAP Ventures. Elizabeth ‘Beezer’ Clarkson, Managing Director of SAP Ventures says, “SAP’s global software ecosystem and 50,000 customers bring a strong advantage to any fund or startup relationship. We know enterprise software can impact a startups go-to-market strategy effectively.”
Wrapping it all up
The universe of LPs is vast, with each LP seeking different risk / return goals. A seed stage fund may be better suited in targeting HNWIs whereas a national / global fund with an established track record can attract pension funds and endowments. As in any sales process, understanding LPs will help you to manage your "somewhat hellish" fund raising process. Fund-of-Funds is a separate "mini-LP-universe"- I will write about it in my next post.