Are VCs Strong-Arming LPs? Struggling firms look for additional funds to prop up investments

Tom Stein

What’s a venture capital firm to do when all its investments start to turn sour? The honorable thing, of course, is to call it quits and return whatever money it has left to its limited partners. But most struggling venture firms are not about to give money back to the pension funds, endowments, and wealthy individuals that act as their limited partners.
Instead, quite the opposite is true. These VC firms are more likely to ask their LPs for even more money. Some LPs are forking it over, while others are asking whether the VCs ought to consider putting themselves on the block instead.

At the end of June, the well-respected venture firms New Enterprise Associates and Accel Partners announced they were seeking so-called annex funds of $150 million and $75 million, respectively, to prop up their waning portfolios. Unlike a traditional venture fund, which looks to invest in new companies, annex funds are often seen as a desperate ploy to feed money to existing portfolio companies that should have already gone public or received follow-on financing from other venture firms.

Nancy Dorman, a general partner at New Enterprise Associates, confirmed that the firm was raising the $150 million annex fund. “We are raising the annex fund to add to (the $565.7 million) NEA VIII,” she said. “We needed additional money to continue to support the portfolio companies in the fund. We expected many of these companies to be liquid by now, but the shutdown of the IPO market increased the need for follow-on financing.” Accel could not be reached for comment.

Last year, Crosspoint Venture Partners set the VC world reeling when it became the first firm to abandon fund-raising efforts, although it had already secured $1 billion in LP commitments. (IDD, 12/04/00). Since then, at least two beleaguered late-stage venture capital firms have given money back to their limited partners. First, Octane Capital Management shut down and returned about half of the $265 million fund it raised a year ago. Then, Bowman Capital scrapped its $2 billion Bowman Technology Fund (one of several funds it operates) and returned about $1 billion to investors. In both cases, these venture firms paid a premium for late-stage investments in privately held startups such as Loudcloud Inc. and Support.com Inc. and then watched their money quickly evaporate as the companies got trounced in the public markets.

Those firms are no doubt reaping some good will, if nothing else. “Most limited partners wish they could relinquish their commitments to venture capital and get back their money,” said Paul Kedrosky, a professor of business at the University of British Columbia who specializes in private equity. “Instead, most are being [strong-armed] into handing over more money.”

At the same time, a handful of wily limited partners are attempting to change the rules of the game, said Kedrosky. In a quid pro quo of sorts, some LPs are politely requesting that they not be forced to follow through on committed capital. In return, the LP promises to give even more money the next time the VC firm raises a new fund. For instance, an LP that promised to put $10 million into a venture fund, but has so far handed over only $5 million, is asking to be relieved of its responsibility to ante up the remaining $5 million. Though declining to name names, Kedrosky said he has seen this arrangement on at least three separate occasions. “I think it will happen more and more,” he said. “LPs are very reluctant to throw good money after bad.”

Clint Harris, a partner at Grove Street Advisors, a fund-of-funds that spreads hundreds of millions of dollars among scores of venture capital firms, admitted that “many LPs are tapped out and may be tempted to pull out of their commitments.” But he said that is not likely to happen on a grand scale because there are severe penalties for bailing out of commitments. He added that no self-respecting venture firm would ever invite an LP that weaseled out of its commitment back into subsequent funds.

Still, some LPs are thinking up other creative ways to get their money back without ruining their good name or running afoul of the law. Lucy Marcus of Marcus Venture Consulting, a strategy group that works exclusively with venture capital firms and limited partners, says more and more LPs are encouraging struggling VC firms to sell themselves and their portfolios to bigger and better-positioned rivals.

“LPs have no choice but to take a more proactive approach because their reputation and their money is at stake,” said Marcus. “They put a lot of money into venture funds that looked good at the time but were clearly big mistakes.” At the request of several limited partners, Marcus has sat down with VC firms to determine whether they are worth saving or whether their portfolio should be sold to competitors. “In two cases, we have made the decision to sell the fund and are now going through the process of pricing the portfolio and figuring out who would be most interested in acquiring the fund.”

Marcus is confident that the venture world will soon see many more mergers and acquisitions. But not everyone agrees. To begin with, there is almost no history of venture firms being snapped up by stronger rivals. “We’ve never even thought about acquiring the assets of a weaker firm,” said Jennifer Fonstad, a managing director at VC firm Draper Fisher Jurvetson. “It’s not like acquiring the stock of a public company. The very idea is fraught with challenges that no one has ever dealt with. How will board seats be transferred and who will manage the new relationships?” And perhaps more importantly, why would anyone want to buy a crummy fund with a crummy portfolio?

These are all questions that LPs hope will get answered very soon. After all, as the moneymen behind venture capital, they have the most to lose. “I think it’s clear that the next couple of years will see a tremendous shakeout among venture capital firms,” said a limited partner who works for a large pension fund. “Some firms will merge, some will commit suicide, and some may even give us back our money.”

Reprinted from Investment Dealers’ Digest http://www.iddmagazine.com