VENTURE CAPITAL-U.S. firms struggling to raise funds

Aug 26 - A confluence of factors, including poor returns and limited partner investors still smarting from the financial crisis, has made it increasingly difficult for venture capital firms to raise new funds.

Joanna Glasner of Venture Capital Journal reports:

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* Majority of VCs say next 5 years more difficult -survey

* Veteran VC needed 18 months to raise a new fund

* Ten-year VC returns turned negative in Q1 -report

SAN FRANCISCO - It has become increasingly difficult for venture capital firms to raise new funds. And even those that are successful are often unable to meet their fund-raising goals.

Money flowing into venture funds slowed to a seven-year low in the second quarter, as just 38 U.S. venture capital funds raised $1.9 billion, according to the National Venture Capital Association and Thomson Reuters (Reuters' parent company).

The so-called limited partners (LPs) that provide the capital for VC funds to invest in start-up companies used to be able to rattle off plenty of good reasons for investing in venture.

For one, VC offered above-par returns for limited partners, which are typically pension funds, endowments and wealthy families. For another, investing in venture allowed LPs to get an early stake in the next generation of leading companies. And, given the volatility of public market holdings, private, venture-type assets provided diversification to a well-balanced portfolio.

But with overall returns for the decade now in negative territory, those reasons no longer sound so compelling. In the 10 years preceding the first quarter of this year, returns for venture capital (after fees, expenses, and carried interest) were -3.7 percent overall, according to Cambridge Associates' U.S. Venture Capital Index. That compares to 15-year returns of 38.2 percent and 20-year returns of 24 percent.

"The decision to invest in VC has become difficult as long as other asset classes offer a lower risk investment with good returns," said Richard Henkel, private equity portfolio manager for the Arizona State Retirement System, which manages assets of $24.9 billion.

The problem, he said, is that venture fortunes have historically stemmed from a handful of home runs, such as wildly successful IPOs, and there haven't been many home runs in recent years. That's why Henkel agrees with the consensus view that more venture firms will fold and fund sizes will shrink.

HAVE YET TO RECOVER LOSSES

Many pension funds and endowments are also hesitant to invest in VC funds because they have yet to fully recover losses recorded during the financial crisis -- let alone swing back to posting the annual returns upon which many had predicated future allocations to VC and private equity funds.

Pension funds and other large institutional investors "were relying on these distributions (from VC funds) to cycle back into venture and private equity," said Paul Denning, CEO of Denning & Co, a provider of private equity fund-raising services. "And now they're out of gas."

During the dot-com boom, venture capitalists could raise a fund in just a few months, but now the process often drags on for 18 months or more.

Alan Patricof, co-founder of Greycroft Partners, knows all too well how difficult it is to raise a fund these days. Despite being an industry pioneer who founded the predecessor firm to Apax Partners -- a VC and private equity investor with $35 billion under management -- Patricof said it took him and his partners 18 months to raise their second fund.

In a July blog post about the experience, Patricof said Greycroft reached out to 515 LPs. Only after 154 visits, 97 due diligence requests, 33 follow-up visits, and 12 reference requests was Greycroft able to convince nine institutional investors to commit $130.7 million to the firm's second fund, Patricof wrote.

Most of Patricof's peers expect tough times for the next five years, according to the "2010 Global Venture Capital Survey" conducted by the National Venture Capital Association and Deloitte.

More than 500 VCs worldwide participated in the survey, which was published in July. Over half of the U.S. VCs (56 percent) said they expect LPs will be "less inclined" to invest in U.S. funds over the next five years. In contrast, a large majority of venture capitalists in Brazil (92 percent), China (91 percent) and India (76 percent) predicted limited partners would be "more inclined" to invest in their countries during that time.

The survey also found that most U.S. venture capitalists (68 percent) expect the number of VC firms to decrease "slightly/moderately" (by 1 percent to 30 percent), while 24 percent said they expect the number to shrink "significantly" (by more than 30 percent).

Despite the difficult environment, many venture capitalists are putting up with stacks of rejection letters in the hope that their tenacity will result in successfully raising a new fund.

"Just don't give up," Patricof said. "You have to keep persevering, no matter how long it takes."

-- Additional reporting by Constance Loizos

(Venture Capital Journal is a Thomson Reuters publication. Contact editor in chief Lawrence Aragon at lawrence.aragon@thomsonreuters.com)