The Case For Lowercase

Recently, Chris Sacca, former Head of Special Initiatives at Google, announced that his new venture firm, Lowercase Capital, had raised $8.5 million. Sacca has raised $8.5 million for what is essentially an angel fund targeting web startups. While larger venture firms  often deploy more than $8.5 million in a single deal, Sacca’s fund provides start-ups with something much more valuable than just capital: “time, attention, and the empathy that catalyze winning outcomes for all involved,” as  he puts it. As I mentioned in my previous post, the cost of starting an internet company has fallen dramatically, so much so that angel investors (or “micro VCs”) may come to dominate early-stage investments in the internet sector. This is especially true since traditional firms find it difficult to deploy their funds at that level and often lack the personnel to do so in a truly meaningful way. Traditional VC isn’t dead; it just isn’t as competitive as it used to be at the earliest stages of internet investing.

Sacca does a good job of laying out some of the reasons why “venture capital is broken” when it comes to investing in internet startups:

“Today, web services can be conceived, architected, tested, and deployed to millions of users for little incremental cost beyond rent and Ramen noodles for the entrepreneurs. Yet, many traditional VC funds have been loath to admit this reality and downsize their five hundred million dollar hauls. Why? They are paid fees based upon their total amount of money managed, thus there is no incentive for them to be smaller. Yet, as they try to inject those piles of money into early stage companies, interests become misaligned and an inherent conflict between the investor and the founder often arises. Fund returns, the companies, the entrepreneurs, and the users all suffer as a result.”

It’s a rather harsh take but there is truth to his argument – there is now a huge disconnect between most venture capitalists and web entrepreneurs, and part of the solution is smaller pools of capital and dedicating more time to collaborating and working with entrepreneurs. It doesn’t necessarily have to be Lowercase’s approach (although it does address the problem directly), it can also be done through larger firms - they just need the discipline to invest smaller pools or simply set aside portions (and even staff) of larger funds for seed internet investments, otherwise they risk losing ground in the space.

Who are investors in Sacca’s fund? I’m not 100% sure but I know Kevin Rose is one. This brings about another aspect of the new angel/micro VC phenomenon – institutional investors could be left out. Instead, angels or micro VCs, are increasingly investing their own money or raising funds from other like-minded colleagues, entrepreneurs and investors. This works perfectly well because, again, the fund sizes are relatively small and when given the choice, you want like-minded, understanding, and potentially helpful limited partners.

Stepping back, as angles investment comes to dominate early stage internet investing, we may be seeing a bubble of sorts. The best are great at what they do, but those looking to mimic will probably suffer, just as “me too” venture firms have struggled. It seems as though angel funds are popping up all over the place these days. Are these angles and “micro VCs” restricting dealflow to the larger firms? In some cases yes, but you also often see them investing alongside the traditional venture firms that get this space. Plenty of traditional venture firms have recognized the shift occurring in seed internet investments and are active in this style of investing (and will probably be the most successful). Some examples are Spark Capital, Sequoia (though they kind of outsource their seed involvement through Y combinatory), and Charles River Ventures. There is undoubtedly a fascinating new venture ecosystem developing for early-stage internet companies and it will be very interesting to monitor its continued evolution – Lowercase capital is simply the latest reminder of where things are heading.

Falling Start-up Costs and Seed Investing

When you listen to and read about what is being said about the state of the venture industry you hear a lot of people throw out opinions, often misconstrued, about why venture capital is doomed. One argument that seems to be surfacing a lot recently is that venture capital is no longer needed (or not needed in the same capacity) because the costs associated with starting companies has fallen dramatically. While it’s true that the cost of starting an internet company has dropped dramatically (due to advances in areas such as development, storage and virtualization), it’s important to remember that internet-related startups only account for a fraction of venture capital investment.  It seems as though when people think of venture they immediately think of internet startups – a mindset probably resulting from the dot-com bubble era and the fact that startups in the internet sector are (and have to be) more publicized. As a result, venture investments sectors such as healthcare, media, mobile and cleantech don’t receive as much attention, even though they receive the most venture capital. To put things in context, according to PwC Moneytree data, companies fundamentally reliant on the internet for their business accounted for just 17% of all venture capital dollars invested in the first quarter of this year. So while dropping startup costs for internet companies definitely impacts venture investment, it’s hardly a development that is going to doom the venture industry.

But the role of venture investment in early stage internet startups is an interesting topic. It is absolutely true that as startup costs are in decline and because of this, the role venture capital plays is in flux. The value that a venture firm brings diminishes when capital isn’t the main concern. As a result, we’re starting to see increased angel investment activity at the seed investment level for internet startups, and it seems as though these angles either have access to, or are great at identifying, the best companies. Angles appeal to internet startups because they often have better networks and come with less bureaucracy. Plus, the smaller check sizes now required are a better fit for both parties. It’s also worth nothing that seed investments have much more flexible exit options. Interestingly, we’re seeing some angel investors, such as Ron Conway or Mike Maples (often dubbed “super angles”), building up large portfolios which essentially makes them a seed fund of sorts. This is how I think venture capital firms can still play in the early-stage internet startup space – through dedicated seed investment pools and staff.

Seed and early stage investments have historically performed very well while capturing the true essence of venture capital – early-stage risk taking. Because of this, a venture firm, even if it is raising huge funds, should consider dedicating a portion of their funds to seed investments or even raising separate side seed funds. A great example, even though it has a dual cleantech and IT focus, is Khosla Ventures. When they raised $1 billion last year, it was split between a $750 million main fund, Khosla Ventures III, which invests in early to mid-stage companies, and a $250 million seed fund, which seeks out smaller investments in very young companies. What would be even better is if such dedicated pools had a dedicated staff able to develop a good rapport with the technology community, much like angel investors. I know this essentially amounts to having an in-house angel investing platform, but if venture firms want to play in the most dynamic stage of internet investing, and capital requirements come down, it may be the only way to have access to such investments. I’m guessing we’ll see more of this as the venture model evolves.

As a side note, since I hit on the topic of leaner capital requirements for startups, I thought I would bring up a post Vivek Wadhwa made this weekend on TechCrunch. The post is titled “Startups: Poverty is Underrated. Be Glad That You’re Not Rich.” Wadhwa contends that when a company is running on a tight budget, it will usually perform far better than a company that is well capitalized because it won’t develop the bad habits that come with outside money. These “bad habits” include a shift of focus to revenue and keeping the board of directors happy instead of focusing on profitability, sustainability and keeping customers happy.

The lean vs. fat startup debate has been going on for some time, with the lean side arguing that lean is the only way to go, while the fat side believes capital is a requirement for success. I take caution picking sides on this debate because the argument should really be made on a situational, case by case basis. What is clear though is that more and more attention is being given to the idea of startups operating in a lean manner, which means we’ll probably continue to see more of them, and that the venture industry will have to adjust. 

Should Venture Funds Consider J-Curve Mitigation Strategies?

Most everyone involved with the venture industry is familiar with the J-curve. It is used to describe the nature of returns in a venture fund (based on the internal rate of return or IRR). Returns are typically negative in the early years and then turn positive in the range of three to five years after the fund starts investing. This happens as a result of a number of factors, including: management fees (which make up a larger portion of called capital early in a fund’s life), under-performing investments that are identified early and written down, and also the simple fact that investments take time to mature and grow. 

All in all, for investors with a long-term focus such as those investing in venture capital, the J-curve is is not a major concern since all good funds eventually emerge from it. Unfortunately though, in evaluating venture funds some investors irrationally eschew what are quality venture funds and firms based solely on IRR since it’s the most prominently used return measure and also the most commonly benchmarked. Funds with deeper J-curves or even funds whose early returns are viewed by investors without full understanding of the J-curve are often unfairly judged. This begs the question of whether or not venture funds would well served by taking actions that mitigate the J-curve. As the industry has come under scrutiny over returns and the competition over limited partner commitments intensifies, the idea of a venture funds using j-curve mitigation tactics isn’t so farfetched.

J-curve mitigation already happens at the portfolio level of institutional investors by mixing in funds with strategies that produce more immediate cash flows. Examples include secondary funds, direct secondary funds, venture debt funds and co-investments. Let’s say a venture firm wanted to mitigate the J-curve in a fund, what tactics could they use?

• Defer management fees to later years of the fund – management fees early in the life of a fund are a major drag on the IRR. Firms that can afford to defer them to later years of the fund could mitigate the J-curve and boost IRR.

• Be less conservative with valuations – by not writing companies off early or holding companies close to cost when they can be written up, a fund could boost NAV and IRR as a result.

• Alter the fund’s early investment strategy. Examples include:
  • PIPE deals – investing in publicly traded companies.  The liquidity associated with the public markets means an investment could be made and turned around in a short period of time.
  • Venture debt – providing debt financing to already venture-backed companies. Debt payments mean early cash flow while warrants can provide the option for future equity.
  • Early late-stage deals – If a fund has a balanced strategy in terms of investment stage, concentrating late state deals early in a fund’s life would provide early liquidity to mitigate the J-curve.
  • Direct secondaries – purchasing an investor’s (founders, employees or even venture funds) interest in a venture-backed company that is close to a liquidity event.

Below is an example of how early liquidity can not only help mitigate the J-curve but also impact a fund’s overall IRR. I’ve assumed that a fund is able to produce the same level of distributions regardless of strategy (the only difference being timing): 

As you can see, in addition to mitigating the J-curve, IRR can be boosted significantly by providing a moderate level of early distributions. Of course the difference in return is almost purely optical since the return multiple remains the same. Furthermore, by implementing these strategies, a venture fund is almost surely forcing a strategy that might not be optimal for the team, market and long-term benefit of the fund and limited partners.

Are investors concerned enough with the J-curve that they would accept lower risk-adjusted returns to mitigate it? The right answer to this question has always been no, since most sophisticated investors realize the long-term nature of the asset class (and use a broader measures of performance including return multiples). Still, the possibility of funds implementing such strategies is more real now than ever before, as managers try to keep ahead of peers and gain any edge they can in appearing better to less informed investors.

Don’t Sweat Year-End Venture Performance Figures

Last week year-end 2009 US venture capital performance figures were made available by Cambridge Associates (venture capital returns are reported on a quarter lag – even longer when it’s year-end).  Despite improving in the fourth quarter, returns over all major time periods were pretty lackluster save for the 15 and 20-year returns which still include the tech bubble. The 10-year return, the period given the most attention because it the same length as the life of most venture funds, dropped into negative territory. What’s more is that the net to LP returns for every vintage year since 1998, except for 2003, is negative. This to me stood out as the most discerning stat –it means that average investor lost money in venture pretty much every year since 1998. Yes, top quartile managers have done better, posting positive returns with IRRs in the 2-6% range – but single-digit IRRs for venture capital still cannot be justified, especially when when you factor in the illiquidity premium.

There’s no reason to be shocked by the return figures however, since they were somewhat predictable. Plus, the lag in returns makes the year-end numbers look worse than they really are because we’ve seen the public markets improve significantly since the start of the year.  You can expect the venture capital index to rise in the neighborhood of 3-5% when first quarter returns are made available– improving as a result of the public markets as well as heightened liquidity. Still, the forthcoming return increases will not go far in improving the overall picture of venture over the past decade. This means venture investments will be tough to sell to limited partners, which will invariably lead to an attrition of funds and firms and eventually lower levels of capital being deployed.

Lower levels of capital deployment, however, is almost exactly what the industry needs. Remember I mentioned 2003 being the only positive vintage year median? Well it also happened the year with one of the lowest fundraising and investment levels. Also, even though it does not make perfect sense, looking back at the returns over the last decade, imagine if only the top 50% of funds/firms were in existence – the median figures I mentioned would represent the low, and the top quartile the median. Real top quartile returns then would most likely have been in the double digits – more than acceptable. While we should always be forward-looking, we can’t ignore the fact that the past has shown a smaller group of better mangers results in a healthier industry and better returns.

And if we want to be forward looking, there are plenty of reasons for investors to keep faith in venture and continue making commitments:

• You have a contrarian play at hand;
• Innovation, the lifeblood of venture, continues unobstructed;
• There’s the diversification case -venture proved to be an extremely valuable diversifier for institutional portfolios during the recession;
• Lastly we’re finally seeing a thawing of the exit markets and the return of liquidity through IPOs and M&A activity, especially by tech giants who have huge sums of cash on hand.

These changes should result in successful vintage year 2009 and 2010 funds, but when coupled with sustained lower levels of investment, should also bode well for the future of the industry. Gaps in funding from institutional investors will be filled by novel ways for entrepreneurs to raise funding. Examples include crowdfunding site like Profounder, and more basic funding platforms such as Kickstarter. These sources of capital fill niches that traditional venture had for the large part had gotten too big for, but fewer dollars flowing into startups means VCs will (and have already started to) move back down to earlier stage deals, which also historically happen to deliver the best returns. Looking back at overall venture performance isn't pretty, but keep in mind that past performance is rarely an indication of what’s to come. The venture industry is undergoing a transformation and performance for the next few years is primed to transform as well.

Profounder: A Huge Step Forward For Crowdfunding

I've written about the compelling idea of crowdsourcing a venture capital fund a number of times (in fact these posts are consistently the most searched for and trafficked). The premise is that a web-based venture capital fund, with a large crowdfunded investor base and crowdsourced decision making led by knowledgeable investors can be a highly effective way to successfully indentify, invest in, and grow technology startups. By compiling a large base of tech-savvy investors who are involved in the decision making process you have a better chance of identifying the best new startups and once you do, you instantly have a large base of supporters and customers. This type of fund would have a set of leaders to guide the decision making process and also provide more hands-on support to portfolio companies, but all investors would participate through voting - a chance to invest in startups in a way like never before. All this sounds great, but the major issue preventing something like this from working is that normal people are prohibited to invest in such a fund due to SEC Regulation D which requires investors in private companies and funds to meet minimum income and net worth thresholds.

I’ve run into a few groups that have attempted workarounds (unsuccessful for the large part); however, recently launched Profounder has made impressive progress. The site, which allows entrepreneurs to raise funding for their ideas/companies from their community, was started by Dana Mauriello and Jessica Jackley, a co-foucner of Kiva.org. While not yet fully developed the site gives plenty of information on how the process will work: Entrepreneurs will first create a “Raise Page” which outlines their business plan and how much they are looking to raise. Profounder will then create a term sheet and combine it with the pitch on a custom password protected page which entrepreneurs share with friends, family and colleagues they have a substantial pre-existing relationship with. Once individuals are invited to view the business fundraising page, they will have 30 days to contribute funding. The funding must be repaid (automatically withdrawn by Profounder each month) along with a percentage of the business’ revenues each year. Profounder makes money by assessing a fee (not yet determined) on the total amount raised.

Here are potential keys to avoiding SEC issues I came away with:

• Password protected pitch page
• The need to have a “substantial pre-existing relationship” with potential investors
• Investors have 30 days to contribute funding
• Entrepreneurs can only raise up to $1 million
• Entrepreneurs must provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
• Limited to 35 investors, all other investors after the 35th cannot receive a percentage of revenue, instead you reward them for their contribution by giving that same percentage of revenues to a nonprofit in their honor.

Clearly there are limits to Profounder’s model but it’s the most progress I’ve seen in the crowdfunding movement for entrepreneurs. Profounder does a great job of highlighting the benefits of crowdfunding:

allows you to take advantage of your biggest existing resource: your community

can be a marketing tool in addition to a financing tool, as those invested in your business will become more loyal customers and avid supporters

shares risk among many, putting less financial pressure on just a few individuals

allows for your successes to be shared among many

cuts out banks, venture capitalists and professional investors to get better terms and a friendlier process

It will be extremely interesting to watch the progress of Profounder – its success would go a long way in not only proving the crowdfunding model but more specifically the impact it can have on entrepreneurship and innovation. Look for more updates from me on Profounder’s progress and how its success can potentially make a crowdfunded venture fund a possibility.

UPDATE (06/06/2010): Looks as though Profounder has gone stealth and will not be open to the public until the fall. The information used in this post has been pulled and is probably subject to change.

The Rise of Funds of Funds Another Sign of The Times

The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.

 

Source: Dow Jones Private Equity Analyst

We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds  managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.

In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).

Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.

A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments.  In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape. 

Fundamental Shifts in Venture Capital Becoming Clear

I was about to do an update on the Venture Capital Overhang I’ve been tracking, but instead of the typical chart this time around I thought it’d share something interesting that stood out - for the last three quarters we’ve now seen US venture capital investment outpace fundraising (and the quarter before it was almost even):

The only other time in recent history where we’ve seen investment activity even come close to surpassing fundraising was  in 2003 following the bursting of the tech bubble. What does this mean? We have numbers clearly indicating that a fundamental shift in the industry is underway. In previous posts, I’ve mentioned how fundraising could not forever outpace investment as dramatically as it had been doing so over the past decade (creating an ever increasing “overhang” of un-invested capital, or dry powder).  Fundraising has now slowed dramatically, while venture capitalists rightfully continue to invest in what is a good environment to be doing so in.

A drop in fundraising was expected, but we may now have a “new normal” for fundraising levels. There is clearly a new standard for raising capital now, especially with so many limited partners still skeptical of the asset class. At first a fundraising slowdown was blamed on the “denominator effect,” and later it was said that many limited partners were waiting to get a clearer picture of their allocation balance before beginning to commit again. But the truth is that most limited partners will not return to commitment levels of the past and therefore we will see a natural attrition of firms in the future.

Investment may outpace fundraising for a while - until fringe firms run out of capital and are unable to raise new funds. Just as I had said fundraising could not outpace investment forever, the converse holds true as well and we surely will not see investment outpace fundraising forever either.  Think of this period (of investment outpacing fundraising) as sort of a market correction. When we had huge overhangs of capital, venture capitalists knew there were others out there with capital to deploy as well which drove up valuations and reduced returns. What we should see after this correction is fewer firms - this means higher quality firms will remain, investing in better deals at better valuations and generating better returns.

The differential in fundraising and investing should be interesting to monitor. Too large of a crossover into fundraising outpacing investment again may signal another bubble, while a leveling out should indicate a healthier venture capital industry.

Note: Data from PwC, Thompson Reuters and the NVCA.  And for clarity, the VC overhang now stands at $88 billion – down from $89 billion at the end of 2009. 

A Vision For Venture Capital

I recently finished reading A Vision for Venture Capital: Realizing the Promise of Global Venture Capital and Private Equity. The book is an (assisted) autobiography chronicling the storied career of Peter  A. Brooke. As founder of TA Associates and Advent International, Mr. Brooke was crucial to the early development of the venture capital industry - he was truly a pioneer for the industry not only in the U.S. but in his work spreading the venture capital model internationally.

The book is split into two parts. The first half of the book takes you through his career – his development as a venture capitalist, building TA Associates, and then his shift in focus to international investments and the founding of Advent International. The second half of the book covers how to add value through venture investing and Mr. Brooke’s outlook for the future. If you don’t have time to read the whole book, I highly recommend the second part - there are some great takeaways and you still get many anecdotes from his storied career.

It was clear that Mr. Brooke is passionate about the true role of venture capital and it was a point he drove home throughout the book. Below is an excerpt that I felt exemplified Mr. Brooke’s ideology.

When discussing the industry’s early moves into international markets and the difficulty getting U.S. based investors to see potential Mr. Brooke said:

“It didn’t seem to have occurred to many venture capitalists and private equity managers that they could be a force for economic and social progress in the world. To me, however, this is the whole point of what we do. The frontier in the industry is wherever the skills of venture capital and private equity managers can be applied to address economic problems such as poverty, underdevelopment, and lack of opportunity, along with the many social ills associated with them. To put it another way, the pioneers today are those who apply their entrepreneurial spirit and problem-solving skills not only to make a profit for their investors and themselves but also to improve the lives of others.”

What’s often lost on many people in the private equity and venture capital industries is that there can be more to investing than just monetary gains.  Plenty of good can come from helping develop companies and markets, of course there is always room for rewards but that should not be the sole focus – Mr. Brooke really hammers this point home in his book.

Overall,  I think it’s a great read, especially for those starting out or considering a career in venture capital or private equity. You get a lot of history on the industry’s development and can really broaden your mindset on how to approach investing. The book is also great for those involved with venture capital and private equity investing in the emerging markets. Underdeveloped, frontier markets arguably stand to benefit the most from private equity and venture capital investment and it’s sure to be where much of the industry’s growth comes in the coming years. Approaching these markets with some of Mr. Brooke’s insights and lessons would surely be beneficial. 

Investing In Emerging Managers

Limited partner interest in “emerging managers” has grown impressively over the past decade. Many pension plans have programs targeting emerging managers or have made substantial efforts to increase their exposure to funds run by emerging managers in their venture capital/private equity portfolios. The definition of an emerging usually varies slightly for everyone, but in general, it usually refers to:

• Firms raising their first, second or third fund from a broad base of institutional investors.
• The firm may be a spin out of one or more members of an existing venture firm.
• It may also be the spin out of a group that was previously captive, i.e. they were the venture capital arm of a corporate parent.
• It could also be the coming together of investors from multiple venture firms or corporations.
• Many pension plans have mandates for emerging mangers which include a women/minority component, or a component targeting underserved markets.

In a time where funds are hard enough to raise for established venture firms with good track records, how can emerging managers compete? Why would anyone invest in them? First, here are some drawbacks associated with emerging managers:

• They often have no track record of investments or their track record is not substantial enough to qualify them. Basically, they’re unproven.
• Inexperience managing a venture firm. – an investor may have been great at working within an established firm with a developed structure, but when running their own firm, it’s a different dynamic and they are sure to run into situations not encountered within a larger organization.
• Team risk. Emerging managers often have difficulty in building out their team. An individual may be a great investor, but to have a successful venture firm it takes an entire team. There is risk around having emerging managers build not only a competent team, but a team that can work well together.

That said, emerging managers do feature characteristics which make them attractive, and in some cases even more attractive than established firms:

• They have comparable, or in some cases even deeper, domain expertise in the given sectors their strategy targets and often have relationship networks just as good as larger firms may, which means their access to deal flow is just as good too.
• They have the desire to build their firm’s brand and respect which lends to emerging managers being more hard-working.
• Being a smaller organization, they are more nimble when it comes to adapting to changes in the market.
• Without the influence of a larger organization, they can thoughtfully build a team that works best for the strategies they will be pursuing.
• Having a smaller LP base, emerging managers usually value their investors more and are able to give more attention to their needs.
• Investors are often able to get better economics in the form of a lower management fee and/or carry with emerging managers (although the argument can be made that emerging mangers need more fee income so they can build the proper infrastructure).

Manager selection is extremely important when investing in emerging managers. Understanding team dynamics, having a sense of their infrastructure, and the principals’ ability to run a firm are all factors that have heightened importance when evaluating emerging mangers. If the right group with the right backgrounds is coming together pursuing the right strategy the results could be impressive. Take for example Spark Capital, the firm was formed by Todd Dagres, formerly of Battery Ventures, and Santo Politi formerly of Charles River Ventures to pursue investments at the intersection of media and information technology. They’ve been early investors in great companies such as Twitter, Boxee, and Tumblr. A larger more established group may not have taken the risk to invest solely in such a narrow focus, but Spark’s nimbleness allowed it to identify and pursue companies in this exploding space. Investors would be foolish not to at least give emerging managers a fair shake when considering investments in venture funds, but they must be extremely prudent in their evaluation of managers because for every Spark, there is a firm that doesn’t make it.

The Venture Capital / Growth Equity Opportunity in Brazil

Apologies for the brief hiatus from posting – I was in Brazil for a good part of last month, which actually provided a great opportunity to examine first-hand the opportunity for private equity there. Why private equity and not venture capital? In almost all emerging markets, venture capitalism as it is practiced in the U.S. simply does not work for a number of reasons, including weak intellectual property laws, infrastructure and markets as well as limited innovative and entrepreneurial spirit. Private equity investment, particularly growth equity (growth capital for mature companies) is most appropriate in emerging markets. Growth equity, which involves making minority investments in mature but growing companies, trumps even buyouts in emerging markets because of issues gaining control and limited availability of leverage. I’m not close to being an expert on the Brazilian economy, but the following is some of my thoughts on the growth equity opportunity in Brazil based on a few observations.

In my travels I was able to explore second and third-tier cities and even some semi-rural areas of the country, which I think provided a better sense of the country’s potential than if I had just visited larger cities such as Rio or Sao Paulo. Compared to rural areas of fellow large emerging market (and BRIC) countries India and China, the more rural parts of Brazil seemed further developed, or more ready for development. Large infrastructure investment is not as necessary as a precursor for growth as it may be in India and China. But it is still needed, particularly in the northern part of the country which is growing faster than the south. I think the government and private investors realize this, and it was evident in the many roads and bridges under construction as I traveled through parts of the north. In many ways, investing in Brazil seemed like less risky of an endeavor than investing in India or China. There’s probably less of an upside to growth investments, but also that there’s less risk and more immediate potential, a tradeoff that is probably attractive to many investors.

Brazilian consumers seem ready for growth but I did notice that the aspiration factor was lacking, or it was at least not evident, especially when compared to Indian consumers. Examples include consumers shying away from higher quality goods even if they are priced the same, or diners shying away from nicer restaurants simply base on the aesthetics (assuming it would be too expensive). I made this observation much more in the north than in the south, which brings up another point – the country’s diverse culture. The population is not as homogenous as other emerging markets and investors will have to adjust for this, especially when it comes to investing in consumer goods and service companies.

Another thing I noticed was that there were few signs of recession or that there had even been a recession – Brazil was relatively insulated from trouble in the broader world economy. The country’s quick recovery had a lot to do with government policy (which has after many decades seems properly aligned for economic growth) but a lot of is also has to do with the fact that Brazil’s domestic growth is so resilient. It may not be as fast growing as India or China, but it’s strong and also somewhat sheltered because the country is not reliant on trade with the rest of the world, even though Brazil has been expanding international trade in recent years, particularly with the U.S., China and Europe (driven mostly by natural resource demand). Growth equity investment decoupled from the world economy provides true diversification for limited partners investing in a private equity fund - which gives Brazil a leg up on many other emerging markets.  

When it comes to private equity investment, Brazil consistently ranks behind China and India in terms of amount of capital deployed and number of deals. But in recent LP survey’s I’ve seen, interest in Brazil is growing and is often higher the level of interest in India or China. In Brazil, local pensions are a huge source of capital. They’re now allowed to invest up to 20% of assets in local private equity funds, but most only invest 1-2%, which still accounts for a little less than 20% of all commitments to brazil-focused private equity funds, according to the Emerging Markets Private Equity Association. Even though there’s currently plenty of dry private equity capital in Brazil, I’d expect to commitments to increase in the coming years. Expect investment to remain heavy in the energy/natural resources sector, but other sectors will see growth for sure.

Infrastructure investment in Brazil, both private and public, will probably see increase over the next few years, driven by the need for infrastructure improvement ahead of the 2014 World Cup and 2016 Olympic games. As I had mentioned though, the infrastructure need is not as great in Brazil as it is in other emerging countries. As such, other areas, particularly industrials, manufacturing and consumer goods and services will surpass infrastructure as a destination for private equity. What about technology and more venture-type investments? Despite what I mentioned at the onset about emerging markets not being ideal for venture investment, I actually think Brazil has promise - perhaps more near-term promise for venture capital than India and China. We’ve seen so many venture capital funds fail or pull out of India and the environment in China is too murky for venture to be attractive there. But in Brazil, the regulatory, legal (intellectual property), tax and corporate governance environment is advanced, stable and reliable enough to harbor venture investment. Furthermore, I get the sense that there is a growing entrepreneurial spirit, aided in part by government programs supporting innovation and developing technologies from universities.

There should be plenty of opportunity in the internet, and mobile sectors. Both have a lot of potential for expansion in Brazil, both from an adoption and evolution point of view. Increased broadband and mobile adoption will be a basic driver, which means me-too copies of successful internet and mobile technologies from the U.S. will do well, but also expect there to be innovation from within Brazil. Still, growth equity investment remains more attractive now (especially in the manufacturing and consumer goods/services sectors). Brazil is primed for it from many angles and it should be one of the least risky emerging markets. Investors will need to be careful they are in tune to cultural and operations nuances, which means experience is key to success, as it is in almost any emerging market. It should be interesting to monitor Brazil’s growth in the coming years and as the environment for venture capital improves, look for more innovative technologies coming out of Brazil.