By Georges van Hoegaerden

I have the utmost respect for groundbreaking entrepreneurs, or better yet all the people who produce great products (or unique services). I love technology and believe we have not even scratched the surface of its macro-economic impact.

And it is those entrepreneurs, with the simple power of their dreams and perseverance, who collectively and unwaveringly hold up the massive weight of an outdated and incompatible financial system eleven times the size of production that keeps this country afloat.

It is for them that I fight to make our financial system more modern and nimble to withstand the test of time.

The writing is on the wall

Unless you have been living under a rock, you should by now be aware that the performance in Venture for the last twenty years has been deplorable. After a fantastic start by people like Bill Draper, and point successes from next generation icons like Vinod Khosla in the nineties, Venture quickly became the stomping ground for anybody with money, not necessarily combined with merit.

Growing numbers of Venture Capital (VC) firms arguably over-invested in their interpretation of innovation that had the majority of even the 90s funds (with vintages in the 2000s) generating no more than 10% IRR on average. Just the last 10 years VCs have generated no more than 3% public value out of all investments made, or specifically lost about $1.7 Trillion in, mostly public, money from their Limited Partners (LPs). And the performance of the current funds does not look much brighter as witnessed by incoming reports from early 2000 funds and the discontent of many LPs I speak with.

And on the mirror

But even if you are not a fan of numbers, which often become the subject of endless debate and can be excused away since they are lagging, not leading indicators, Venture has produced only a handful of viable companies that ultimately created some sustainable value public markets have faith in. Seven-hundred-and-ninety (790) VC firms in the U.S. chomping at the bit producing no more than a handful successes is the billowing smoke that indicates a raging fire. More specifically it indicates "the system" or "the compass" by which Venture is deployed does not work, its systemic approach is broken and only a few outliers in Venture produce the returns that make the headlines for all.

When doing your best just isn't good enough

VCs now hold on for dear life, blaming their lack of performance on esoteric macro "windows" of opportunity (irrelevant to startups), and they feverishly add up portfolio revenues to claim they are still producing value and are doing "their best", all while big corporations frequently beat them to the punch with real innovation that outpaces the market.

VCs attempt to hang on to comparing Venture to 100-year old asset-classes, sectors or segment indices, patting themselves on the back with a relativity theory that is as flawed as comparing apples and oranges. Unlike these old indices that have become somewhat stale because of their age, Venture continues to ride on the information technology platform that continues to grow aggressively (despite the economy) and still leaves a massive greenfield (5/6 of the world's population) underserved. VCs have not succeeded in tapping into that upswing and their best is clearly not good enough to make us proud.

Venture Capital morphed into Micro-PE

Venture Capital, after the irrational exuberance of the early 90s, has quickly and predominantly turned subprime - or - into micro-Private Equity, with most risks deflated and/or deferred to the entrepreneurs. LPs who thought they invested in Venture Capital, by virtue of how they deployed money, instead invested in a more risk averse Private Equity segment, a different thesis with different risk/rewards associated with it. But we ended up getting what we invested in; micro-PE returns. Nothing Ventured, nothing gained.

Looking good spending money

Now, I see some LPs "blindly" renewing their commitment to Venture, which for LPs that have access to prime VC firms that have still produced healthy returns in the last two decenniums makes only nominal sense. If an LP does not have the wherewithal to understand the dysfunction in Venture, it may as well bet on the best horse in the race, even if the race ends up being a Private Equity race instead. Those LPs may make a buck (with a minor part, 10-15% of their total allocation), maybe even outpace other asset classes and care less.

But the wide-open greenfield in technology and the culmination of a fantastic real-time distribution mechanism (the Internet) of technology should have made technology Venture the best performing asset-class, bar none. That is of-course, if one understand the requirements of the sector and deploys the appropriate risk, discipline and market model.

Social Economic Value

Most of the money invested in Venture is (indirectly) public money, such as the endowments and pension funds (CalPERS, ~$17B) which beyond a sheer money making objective also has a strong social economic value attached to it. CalPERS needs the money, but also needs Silicon Valley to be at the top of its game to produce healthy economic spin-out (driving other asset classes as well). The new funds just deployed by the North Carolina and Florida (coming) treasurers also promise to carry the good karma spawned to aid the most important driver of the economy; innovation.

Yet most meaningful innovation, that has the potential to scale big fast, does not start with or in Private Equity, it starts with the unique risks deployed by Venture Capital. And so the importance of what you as an LP are betting on, with the specific knowledge of what is Venture and what is not, is crucial in establishing a healthy conversion from technology to large social economic value, and subsequently public support and trust.

The Insanity in Venture

The systemic failure in Venture to produce returns in line with the wide-open opportunities in technology is the result of the composition of its incompatible financial system. Venture today is an artificially restricted marketplace to which not the outliers of innovation are attracted, but those who are attracted to the commoditized investment thesis of the predominantly subprime VCs.

But even if one knows nothing about Venture, insanity is the descriptor that belongs to the person who believes in a marketplace where the following attributes can consistently produce outlier returns:

• A marketplace that marries the assets of supply and demand, with the arbiter not having - or earning - verifiable merit
• A marketplace that marries the assets of supply and demand, using a single commoditized investment thesis
• A marketplace that hides behind the performance of hybrid asset classes, sectors, segments and stages
• A marketplace that hides behind ten levels of diversification of risk
• A marketplace in which the arbiters do not compete (but syndicate)
• A marketplace which openly engages in price-setting and operates as an innovation demi-cartel
• An in-transparent marketplace that functions like a black-box to most marketplace participants
• A marketplace that appears extremely sensitive to economic aberrations
• A marketplace that has not produced healthy returns in twenty years

No tinkering with micro-economics in the marketplace such as management fees, carries or other micro-incentives can turn a subprime VC, prime. Just like entrepreneurs are born, not created, so are venture investors with their unique intuition for taking risk born, not created.

The marketplace needs to be rebuilt from scratch and embed free-market principles that allows for healthy competition between all participants in the marketplace. Any LP with $1 Billion committed to Venture can do so independently today, and reap the rewards that lies at the untapped and phenomenal foundation of the growth in technology.

We owe change in Venture to those that produce

We owe it to the producers of groundbreaking products and value, to support them with a financial system that is lean and mean, nimble and modern, competitive and transparent, that dynamically establishes, monitors and corrects the merit associated with all marketplace participants. We will dramatically flatten and simplify the marketplace, remove excessive diversification and fragmentation of risk. We, the marketplace, will establish and expose the authentic merit of every participant.

Venture investors with merit and foresight will thrive by ignoring subprime propositions that cannot re-establish their individual supremacy, and instead focus on those innovations that match their authentic competency and skills. Groundbreaking entrepreneurs will come out of the woodworks again once they see the development of a better custodian than their corporate overlords flourish. Limited Partners will be happy because they reap rewards that outperforms their ancient asset classes by a long shot.

Groundbreaking entrepreneurs are the life-blood of this country and we better start treating them with the care and attention they deserve. We need to lift the weight of this incompatible financial system off their shoulders if we want to remain on the leading edge of innovation.

We still can.

Tags: Subprime, Limited Partners, VC, Venture, CalPERS, Macro-economics, Marketplace, Meritocracy, Transparency

By Georges van Hoegaerden

Last week, through a long string of conversations with a CalPERS board member and some trusted peers, I ended up speaking with Joe Dear (Chief Investment Officer) and other members of his Venture team at CalPERS in Sacramento, the largest pension fund in the United States with $200 Billion in total Assets Under Management and single largest investor in the Venture sector (as a Limited Partner, or LP), with an allocation of around $20 Billion in direct and indirect (fund-of-funds) alternative investments (which includes venture).

Joe expressed specific concern about the ailing Venture sector, a message we as participants in the Venture ecosystem should all take very seriously. I do, because I hear it all the time, and it worries me how devastating a withdrawal of CalPERS (10% or so of all U.S. Venture and the consequent ripple) from Venture would be to Silicon Valley and to our country.

Such withdrawal would be devastating to our entrepreneurial capacity and drive to which we owe our statue in the world. We still have many parasites (some quite well known, and not too anxious to be found out) who are too busy deploying ingenious methods to suck this ecosystem dry while it lasts, unable and unwilling to see the dark clouds forming above their heads.

Yet, we all need to pay attention to the discomfort of LPs, and resolve those - not with a new set of lies and promises - but with a breakthrough systemic solution to improve the performance of Venture Capital.

Late to the table in 1988 as portfolio manager Jesús Argüelles explains, CalPERS made up for it in the 90s followed by disappointing performance today. Joe questioned the sector's viability as a whole, by rhetorically asking me (amongst other topics):

Does Venture Scale?

Before I answer that question it is important to note how ignorant the many players in Venture are to the impending threat this question poses.

1. At this public event, I recognized only two Venture Capital (VC) firms that where present. If as a VC I really wanted to make money for my LP in these turbulent times, I would show up to offer whatever support I can muster. I did: to represent the unwavering value of disruptive innovation.
2. No-one of note from the National Venture Capital Association (NVCA) was present according to the attendee listing handed out at the event. Rather than to focus on helping CalPERS generate upside, I guess it prefers to spend its time protecting its members' downside to lawmakers. The VC lobbyist needs to rethink its leadership focus.
3. The dismay of LPs in the Venture sector is in sharp contrast to the incessant, blind, self-serving and false optimism of many Venture participants, journalists and investors who continue to suck entrepreneurs dry and leave a subprime Venture pool behind that clouds the opportunity for serious investors and serious entrepreneurs.
4. No-one (except we) in the Venture community is truly acknowledging, with a plan of change, how the performance in Venture can systemically be improved. Better times, with more of the same is what many wait for, but hope is not a plan.
5. If we do not take the subtle message from CalPERS serious, more than 10% of Venture investments in the United States could suddenly disappear, with many other LPs quickly following suit. And that means that (once again) the deployment of an incompatible financial system destroys the innovative capacity of those that deserve better.

My answer

So, my short answer to Joe's loaded question was:

"Sub-prime Venture does not scale, but Prime Venture does".

The currently deployed economic model of Venture will never scale, and here is why:

1. Ten levels of diversification with multiple (hybrid) relationships from LP to startup investment makes it impossible to identify the real merit and performance of VCs and the validity of their investment thesis.
2. A (loosely coupled) commoditized investment thesis can never outgrow its peers, and thus is incapable of generate meaningful alpha.
3. Sub-prime VC systemically destroys the trust of Public Markets by pushing so-called innovations through the funnel, soiling the opportunity for more discretionary value.

The necessity to produce public value

It is a bad idea to ignore the public's perception of Venture Capital. With a large sum of Venture money (roughly $1.9 Trillion) over the last 10 years producing no substantial public value by way of IPO, sub-prime VC has lost the confidence of the public that does not only supply the money to VC (indirectly through the public pension funds, endowments etc.) but is also expected to buy post-IPO stock on the public stock market.

So, rather than to continue with "the models for success that have worked for our industry in past decades" as many of the NVCA cohorts continue to preach, we need to rely on a new economic model that fundamentally changes Venture Capital to its core.

Our proposal in the presentation "2010: The State of Venture Capital" will do so and it scales because:

1. Our Venture model removes the diversification at the bottom of the Venture equation, exposing VC matchmaker merit and accountability.
2. Our Venture model employes dynamic marketplace merit, not static institutional merit.
3. Our Venture model attracts unique investment theses that have the ability to find the outliers of innovation.

Incompatible financial systems

The problem with Venture is that traditional financial systems (stemming from more conservative asset classes and times) are incompatible with the risk and returns that early stage Venture has to offer. Over time the old financial system has steadily suffocated, and worse alienated disruptive innovation, by forcing sub-prime innovation through an exit funnel that as a result left a trail of eroded trust.

Venture has lost trust with public markets, but even more so with the outlier entrepreneur. Truly disruptive ideas do not even show up at the doorsteps of many VCs any more, because certain corporations have become better custodians of innovation than venture capital (remember those ludicrous buyers/sellers-market arguments of VCs).

Change the dating service

But just because VC is broken does not mean innovation is. We need to re-establish the merit and definition of disruptive innovation and stimulate the creative and intelligent minds that can spawn it. The Internet provides a massive opportunity to tap into the buying power of 5/6th of the world population that is still technologically disenfranchised.

But if we leave the Venture Marketplace functioning the way it does today, less money-in will not change the alpha (portfolio returns) for Limited Partners. Survival of the fittest in a dysfunctional market is a worthless asset.

Superior Economics

Smart Limited Partners stay committed and realize that Technology Venture has superior economics, that with the right economic construct has the ability to outperform any other asset class.

Technology feeds the brain in the same way water feeds the body. Technology can be served up in many ways to produce, share and monetize knowledge, just like water can be used to produce soup, coffee, tea or anything else you can think of. We have all the ingredients in this country to make lovely dishes, all we need is a better economic system to attract the right chefs with scrumptious recipes.

The new size of Venture Capital

So, stop making statements about whether Venture Capital should be smaller or larger. It's a futile discussion. The size of an inefficient marketplace is irrelevant and thus by definition wrong. First we need to deploy an efficient marketplace (that is designed to find the real merit of innovation), before we can make educated guesses about how to best support it with a proper financial system and size. Lowering the commitment to Venture Capital does not create more efficiency, changing the marketplace does.

So, LPs need to deploy a new economic system that systemically roots out sub-prime. The solution that scales to its authentic potential is here today.

Tags: Limited Partners, VC, Subprime, Meritocracy, NVCA, Marketplace, CalPERS

By Georges van Hoegaerden

Last week I was invited to attend (thank you Brenda Chia, president AAAIM) the panel discussion "Market Changeup: Fund Management as a Business", with Priya Mathur (Board director of CalPERS, California Public Employees' Retirement System; one of the biggest investor in LPs and VC funds), David Fann (President & Chief Executive Officer, PCG Asset Management), Jan Le Chang (Vice President, Centinela Capital Partners), Phil Phleger (Morgan Lewis) and Bob Grady (Managing Director, Carlyle Ventures).

Compared to last year (written up here) the opinion of the people at the top of the innovation food chain was remarkably introspective:

Venture Capital is broken in some fundamental way.

So much so that PCG predicts a revolution and a complete redesign of the Venture Capital model, with CalPERS nodding in agreement. CalPERS has gone from a yearly review of their asset allocation to quarterly and is currently debating new hybrid asset allocation models. That means less dependency on VC, and more on other vehicles. At the same time it is looking to reduce its relationships to only the top quartile VCs and getting out of the mid and bottom tier ones altogether. Annex funds, created to fill the void of fleeing late stage investors, are not found to be interesting as the majority of the funds currently in the pipeline will not produce positive returns anyway.

The sentiment from the fund managers was that they are literally "fed up with the rock star parties from VCs that don't produce returns". A conclusion clearly not received by all funds as we hear (from a trusted source) that general partners at a downtown Palo Alto walking-dead VC firm are still fetching $1M yearly salaries each, this year.

Everything is going to change.

VC is not dead, but everything is under review. Fund managers are now for the first time talking to each other to fundamentally change the outcome of the game, regardless of the state of the economy. They all admitted that none of the widely used mathematical risk models prevented the precarious situation that now forces even CalPERS to pay close attention to its balance sheet and carefully manage available investment cash.

Limited Partners are looking for full transparency of the VC funds, going as far as wanting to see their balance sheets and who is holding their securities. Under the magnifying glass are VC management fees (no more 25%), splits, as well as exorbitant fees gained through stacked funds. Co-investment with endowment funds are debated as they are too over-allocated in the equity vehicle to provide sustainability. We may see more monolithic investments in VC as a result.

All fund managers think clean-tech and health-tech are interesting asset classes, but think the fleeing from technology is somewhat worrisome, they have become weary to over-allocate anywhere. Globally, no economy has proven to show any disparate advantage, the asian and china plays fell equally as hard as the US and elsewhere.

Moving forward, but not so fast.

New VC funds will need to come up with a better story. The creators of the new VC funds will likely be experienced operators (just like at the start of technology evolution), removing the pure money managers who failed to add substantial value. They are expected to, as a team, have demonstrated an ability to warehouse deals before, deliver a unique value proposition to the investment climate and provide substantial value to the disruptive proposition of their portfolio companies.

CalPERS is eagerly looking to invest in emerging money managers who in due time (2-3 years expectancy to close a new fund) can expect their renewed support. So far, in the first quarter of 2009, 3 new funds have been invested in (compared to 47 all of last year) and no significant uptick is expected until this summer.

Clearly fund managers are licking their wounds, in a holding pattern for some positive news on the economy and perhaps some much needed regulation with regard to transparency. Rest assured, no fund manager seems to debate the value of venture capital as an investment vehicle, it is here to stay.

Help is on the way.

The great outcome for entrepreneurs is that fund managers (as we predicted) from now on will pay close attention to the type, behavior and performance of VCs that allows entrepreneurs to build new companies more effectively.

Good times are coming.

Tags: VC, Funds, Fundraising, CalPERS

By Georges van Hoegaerden

As an entrepreneur, getting to know your Venture Capitalist is important, especially because their life is not as cushy as you may think.

Just imagine the onslaught of business plans they get, and how much time it takes to find that rewarding investment. Eliminating the false positives and false negatives takes time, lots of it. We personally reviewed about 40 companies over the last 7 months, yielding 3 companies that have huge potential for our investors but they need work. Hard, fun work. But life of the VC doesn't end there. Knowing the goals of your VC (in terms of fund composition and exit requirements) will make you better understand why a VC firm behaves the way it does. Its fund needs to end up in the top quartile, with or without you.

Operating on both sides of the isle and getting to know the investors I work with better, I attended the AAMA-AAAIM session in San Francisco called "Fund Management As A Business" (presentation in pdf used with permission from AAMA), moderated by the skilled and jovial Robert Grady, Managing Director of The Carlyle Group with a fantastic group of fund managers (Hamilton Lane, SFERS) and a surprisingly honest VC (Altos Ventures). I wish everyone in the investment community was as transparent as this group so we can remove some of the stigma around VC.

Here are three reasons why VCs don't have it that easy:

1/ Many more VCs need to compete aggressively on a relative steady amount of fundable deals, hovering around 4,000 equity investments in venture backed companies per year. The number of VC firms has grown from 399 in 1990 with $31B under management, to 798 firms in 2006 driving $236B into the US venture marketplace.

2/ Joe Schoendorf (Partner at Accel Partners and board-member of World Economic Forum) confirms that less than 5% of the VCs deliver the goods that sustains technology as an investible asset class. That means 95% of the investors are probably stressed out. So don't take a lack of response or a no from a VC too personal. VCs deal with complicated and sometimes long drawn investment strategies (it took Altos Ventures 3 years to land their last fund). Investment allocations may be another reason why you don't always get a quick response for your technology venture.

3/ VCs are working hard. The exits of about 400 M&A plus IPO transactions per year account for less than 10% of total venture investments made. And in order to get a successful exit, VCs review more than 20 times (and that's a conservative assessment) the amount of business plans before they invest in one. So, south of 0.5% is where their - and your - statistical probability of producing a successful exit lies.

The same criteria that apply to the return of the collective technology investments made by a VC with a fund, applies to their Limited Partners (LPs) trying to find great collective VC returns for their Investors (Pension Funds, Insurance Companies, Endowments/Foundations etc). The VC is sandwiched smack in the middle between the entrepreneur and LPs breathing down their neck. Their only "luxury" is time: 5 years of investing and 5 years of harvesting.

As an entrepreneur you can't worry too much about the statistics, if you did you wouldn't be an entrepreneur. But that the amount of deals is slightly on the rise again, perhaps indirectly spurred by massive influx from sovereign funds, means access to money - to live out your dream is improving slightly.

But be prepared to talk to more VCs and saddle up for an extensive roadshow. Fact remains: the cost of doing business to entrepreneurs and investors has increased dramatically.

Tags: Investment, Innovation, VC, Funds, Limited Partners, CalPERS