Now I get it. This is embarrassing to admit, but until recently I actually believed that all the fund reductions of the post-bubble period were acts of magnanimity. What motivation, I wondered, could be behind the scores of venture capital GPs freeing their limited partners from billions of dollars in capital commitments, but a generous concession that the capital was not needed in light of a downsized investment opportunity? Would you believe a desire for profit?
This belated epiphany came to me while pondering this summer's otherwise unremarkable news that Silicon Valley veteran Sevin Rosen had raised a $300 million fund.
Good for them, I thought. Wait a minute, I thought again – a year ago Sevin Rosen informed LPs that they need not worry about a remaining $275 million in capital commitments to the previous fund, slicing its size down to $600 million from an original $875 million raised in early 2000.
So they “gave back” $270 million in 2003 but raised it all back again in 2004?
It's time now to pay tribute to David Bradley, the retired IBM engineer who invented a simple way to reboot the personal computer when it crashes – by simultaneously pressing Ctrl, Alt and Delete.
It's a matter of speculation about who first conceived of the venture capital equivalent of Ctrl Alt Delete, but all the top-tier VCs have used it: Accel Partners, Kleiner Perkins, Mohr Davidow all downsized funds between 2002 and 2003. “We came to the conclusion that [the fund] was just too big,” said an Accel partner at the time.
Picking up where this comment ends, it is safe to conclude that venture capital investments made in 1999, 2000 and 2001 are, on average, less likely to produce stellar returns. The current market offers a much better outlook. From a GP's point of view, why invest in the current good opportunities from an investment pool that is weighed down by a bunch of duds? Breaking even yields no carry. Better to call it quits on the old fund and reboot the IRR meter with a fresh partnership.
It is important to note that the firms that forgave capital commitments have had absolutely no difficulty raising new funds, such is the LP flight to quality.
Do these fund reboots represent an alignment of interests between GPs and LPs? No and yes.
The LPs in an elite firm's downsized fund who recommit to the new one (in other words, all of them) will end up paying their GPs more money, given the likely scenario that the next few vintage years will outperform the 1999, 2000 and 2001 vintage years. Had today's investments simply been made from capital left over from the giant funds of yesteryear, loyal LPs would have enjoyed cash distributions of the later investments but the bubble-era duds would have meant a low, or negative, overall fund IRR, meaning little or no carry to the GP.
On the other hand, it could be argued that a smart LP will not want to be committed to a longterm investment partnership where the fund managers have no hope of carry. If the GPs know they can be paid better on a new fund, that's the one you want to join as a limited.
This latter view of interest alignment brings to mind a broader problem in the private equity market – the specter of dud funds. An alarming number of partnerships currently under management have little hope of generating carry. This is an unhappy situation for the affected GPs, but it is making a number of LPs question whether the best course of action is to simply say “tough luck”. At least one major fund of funds manager is toying with the idea of essentially lowering the carry hurdle for poorly performing funds so that GPs will be reenergised towards squeezing maximum value out of remaining portfolio companies.
The VC reboot phenomenon is accepted with a shrug by most investors, because at the end of the day, they still really, really want to get into the next fund. But a certain cynicism accompanies the enthusiasm. A portfolio manager at a large endowment says he thinks his venture capital GPs are “gaming the reserves” to bring about a quick end to their current funds. In other words, the GPs claim remaining capital is earmarked for existing portfolio companies, not new investments. “This enables them to raise a new fund before LPs have any real clarity on the current one,” the endowment manager says.