Growth at all costs

Explosive growth in venture-backed companies can come at the cost of good governance – a risk some LPs seem willing to take.

There are plenty of column inches devoted to venture capital in speciality publications, tech magazines and start-up blogs. But over the last year the asset class has taken up more and more space in the pages of mainstream news publications – for good and bad reasons.

You can’t have escaped talk of Facebook’s data privacy problems, Uber’s governance challenges or the troubles at Theranos. Nor would you have missed the high-flying IPOs of Spotify, Dropbox and cloud software company Pivotal.

The hyper-fast growth venture capital funds look for from their portfolio companies can result in jaw-dropping follow-on funding rounds and IPOs; it can also result in poor corporate hygiene, leading to the types of headlines we’ve seen over the last year or so.

A drive among funds to be considered ‘founder-friendly’ in an extremely competitive, high-priced environment can lead to a lack of proper culture-building and implementation of governance protocols. After all, the last thing a VC fund wants to do is to stifle the creativity of an entrepreneur with the same cumbersome policies and procedures that drove many of them from corporate life to begin with.

This is exacerbated by companies staying in private hands for longer. If the venture investors which backed the company during the first and second rounds, and didn’t put any constraints around it, go on to make third- and fourth-round investments, without any other institutions coming in, the start-up can turn into a substantial business without having to come into line with established norms and practices.

Limited partners are both aware of and concerned about these reputational risks, addressing them in due diligence questionnaires and, in some cases, requesting withdrawal rights or deal-by-deal opt-outs. But thus far they have not been put off the asset class altogether. In fact, quite the opposite.

Last year North American and European VC fund managers raised more than $40 billion for the fourth year running. This year is likely to be another good one if Sequoia’s latest offering is anything to go by; the venture giant is seeking a whopping $8 billion for its latest global growth fund which would be quadruple the size of its predecessor, which closed last year.

LPs are, of course, performance-driven, and performance has been solid. After plummeting from 91.8 percent for US 1997-vintage funds to -0.88 percent for 1999-vintage vehicles, pooled internal rates of return have steadily risen. IRRs for 2010-vintage funds were 28.1 percent as of 30 September, according to Cambridge Associates. The latest available figures, for 2015-vintage funds, show them delivering a respectable 11.75 percent as of the same date.

Recent data from eFront show European venture capital funds have also performed better than it first appears once sampling biases are stripped out.

LPs are also keen to boost their exposure to growth technology in their private equity portfolios, plugging into the fundamental positive drivers of fast-paced innovation and the way technology is disrupting all industries.

Recent reputational challenges may well push LPs – and VC firms– to take a harder look at governance issues and take steps to mitigate them. But as long as these portfolio companies keep growing and delivering returns for investors, worries about reputational issues are likely to take a back seat.

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