The Hidden Gems of Venture Capital

LP Considerations in the Current Investment Climate

The venture capital industry is under assault from defaulting investors, declining public image, poor returns, and portfolio failures. Within this turmoil, the venture capital model provides some compelling investment opportunities by supporting nimble companies that will mature in the future, after the downturn passes.

Start-ups today show more promise than many banks and car companies, so venture capital may prove to be one of the best performing asset classes in the current downturn and recovery. But, the greatest opportunities to invest in venture funds are neither obvious nor traditional. Many venture funds are raising money today, and as much as one trillion dollars of private equity positions may be for sale, including billions of venture capital. What should a savvy investor in the venture capital model, a limited partner, be looking for in these uncertain times?

Here are six tips for limited partners from the inside.

Tread carefully with discounted opportunities in the secondary market. A growing number of limited partners are unable to honor current capital calls demanded by venture capitalists, selling their commitments for $0.50 on the invested $1.00 through banks and accounting firms. NYPPEX Private Markets reports a 9.1% drop for top quartile funds since the end of last year in secondary transactions. All secondary opportunities need to be heavily scrutinized with a careful review of the portfolio and the other limited partners. The first risk is to have a series of undercapitalized portfolio companies pursuing models that are no longer relevant in the current economic climate. Then, if the other limited partners do not honor their commitments to the fund, the best business in the portfolio will find it difficult to raise further growth capital, collapsing the entire fund returns.

Pursue direct private equity investments in promising start-ups. Investors with more free time should consider buying one or more equity positions in today’s most successful businesses, like Facebook, Twitter, Tesla, etc. Larger investors can contact significant shareholders of target companies to either invest in an upcoming round or purchase a current holding. Smaller investors can contact founders and managers that need liquidity to purchase a portion of their common equity positions. The likelihood of failure in some of the more established start-ups is low, and direct investment avoids expensive management fees and participation in other poor portfolio decisions.

Invest in the new breed of incubators. A series of capital efficient incubators has emerged over the last few years, producing a higher proportion of successful business than either early stage venture or angel investing. These “Incubator 2.0″ companies replace poor performing and cumbersome early stage options with a streamlined process that trains, supports, houses, and funds new companies, leveraging the newest trends in building a business. Firms such as Y Combinator, Seedcamp, TechStars, LaunchBox, and BrightHouse all present an attractive alternative for investing in the early stage market.

Back top funds in smaller venture markets. The availability of venture capital has consolidated significantly over the last ten years to the Bay Area in North America, Israel in the Middle East, or London in Europe. The best entrepreneurs will often migrate to these locations, creating higher costs, more competition, and false positives for the venture model within these hotspots. Markets with a weak venture industry, strong pools of talent, and entrenched industries present a unique opportunity for venture funds to generate greater returns by backing the best local businesses. Top funds in undeserved markets include Clearstone Ventures in Los Angeles, First Round Capital in Philadelphia, and Union Square Ventures in New York.

Take extra caution when backing industry-specific funds. Healthcare has been the least hard hit by the current economic climate, and there are still many opportunities in forward thinking sectors of cleantech. Yet, real estate, banking, insurance, advertising, manufacturing, and media industries are all experiencing transformational downturns. With an uncertain economic and regulatory future, it is difficult for any industry specific fund to create a forward looking investment thesis. So, scrutinize the investment thesis and delay participating as long as possible, since time will provide more data on where the industries are heading.

Back the best of the best, if you can. There are very few funds that have consistently performed, that are well regarded by entrepreneurs, and that have survived multiple downturns keeping a top position. The most prominent fund in this elite class is Sequoia Capital. If you have the chance to invest in one these funds, do it. They know the business of start-up investing inside and out. The problem is that these funds don’t really need or want more money, so getting a seat at the table is next to impossible.