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Investment Practice Changes By LPs Could Help Startups

By Brian Orelli
BioWorld Insight Contributing Writer

The Ewing Marion Kauffman Foundation issued a report this month blaming the lackluster returns from venture capital on a lack of oversight from limited partners (LPs) that invest in the funds.

Based on a strategic look at the Kauffman Foundation's experience investing its endowment in venture capital funds, the authors concluded that LPs are to blame because they haven't demanded higher returns for the riskier investment. "Institutional investors are investing too much capital in under-performing VC funds with opaque economics and on misaligned terms," Diane Mulcahy, director of private equity at the Kauffman Foundation and an author of the report, told BioWorld Insight.

Bob More, general partner with Frazier Healthcare Ventures, doesn't disagree with the need for higher returns: "If you're providing an illiquid investment, you need to produce an illiquid premium."

Lately venture capital hasn't met that benchmark. While 71 percent of funds the Kauffman Foundation invested in prior to 1995 beat a public index by 3 percent, since then a dismal 18 percent of funds reached that level.

Much of the problem, the report concludes, stems from the lack of alignment between the interests of LPs and general partners (GPs) at VC funds.

Most funds have a 2 percent management fee and 20 percent profit-sharing structure, but that encourages GPs to raise larger funds to increase the guaranteed income.

More said if management fees were reduced and profit sharing was increased so GPs had more skin in the game, it might "sharpen the edges on the decisions," especially in cases where GPs had to make a decision about whether to continue investing. "Sometimes it's easier to just go along with another round, but if a GP had to write a big check alongside the investors, it might change the thought process."

From a biotech prospective, that might take away investments from some companies, but it would put the funds in the hands of the most-deserving companies. "It's VCs' job to create alignment between investors and great management teams," More said, and aligning everyone's interests financially could help accomplish that.

One of the other problems the Kauffman report highlights as a cause of the diminishing returns is the constant need to raise additional funds, which creates a pressure to have high internal rate of return (IRR) to attract investors for future funds. Because early exits increase IRRs, there's pressure to exit investments before the company has reached maximum value.

Mulcahy suggests that the pressure for early returns could be avoided with evergreen funds. "The way that the fund is structured removes the pressure for the GPs to have serial fundraises every three to five years," Mucahy said.

Sutter Hill Ventures has such a fund with eight institutional LPs that reinvest every four years, which has been stable for many decades. "Because it has a persistency, there is less of a temptation to look at the IRR over short periods of time or by generation of funds because it's all kept in one fund," Jeff Bird, managing director at Sutter Hill Ventures, told BioWorld Insight.

The longer development time for biotechs and the need for multiple rounds of funding fit well with an evergreen fund. Holding investments in a single fund eliminates the problem of allocating a certain amount of money per company and the requirement to exit before reaching a critical value-inflection point. "We don't ever say, 'we've run out of money in this fund for you as an investment.' We view every funding opportunity on its own merit and try to decide whether it's a good investment to be making or not," Bird said.

While the evergreen fund might be an attractive model for venture capital, it requires a small number of well committed LPs to make it work. "The majority of the industry is not going to go this direction," Bird said.