Fund-of-funds investors get shut out by Sequoia

MENLO PARK, Calif. — Sequoia Capital Partners is shutting the door on funds of funds that want to invest in its new $450 million fund.

Sequoia and some other top-tier venture capital firms barred public pension funds two years ago for fear proprietary data would be released to the public. Now, Sequoia is telling funds of funds to take their money elsewhere, choosing to work with investors directly.

Other venture capital firms — such as ITU Ventures, Los Angeles, and Investcorp S.A., New York — have always shied away from accepting commitments from funds of funds. OVP Venture Partners, Kirkland, Wash., accepts commitments from managers of pooled capital only if there is a single investor.

One reason for the move is that top-flight venture firms are raising smaller funds and, therefore, need fewer investors. These funds are particularly sought after by investors because there is a tremendous difference in returns generated by the top 10% of all venture capital managers and the rest. So, top-tier managers have the luxury of picking their investors.

Another reason is that executives at venture capital firms don't want the funds of funds to have access to information about the fund and firm that could be used as a selling tool.

Menlo Park-based Sequoia is rejecting fund-of-funds investors because the firm does not want them to use its name in marketing and then invest in competitors' funds, according to informed industry sources. What's more, fund-of-funds' management fees are not aligned with Sequoia's profit-based incentives, sources said. Calls and e-mails to Donald Valentine, founder, and Mark Dempster, spokesman, were not returned by press time.

Industry sources said Sequoia began weeding out some funds of funds a few years ago. Even so, funds of funds never accounted for more than 20% of Sequoia's partnerships, sources said.

"In an era of tight allocations, most funds of funds are also not perceived to be ‘value-added' investors, and it is much easier for Sequoia to throw them overboard in order to maintain tighter relationships with wealthy individuals with strategic insights into the tech economy, as well as endowments and foundations not subject to FOIA (Freedom of Information Act) requests," said Kelly K. DePonte, partner at Probitas Partners, a San Francisco-based private equity placement agent.

While Sequoia is the first to shut out all funds of funds, others are winnowing down their list of fund-of-funds investors, he said.

"I can't imagine over time any of the top-tier venture funds will have a fund of funds (as an investor). It will be like having a scarlet letter," one knowledgeable source said. "Sequoia just now cut off its addiction."

Monte Brem, president of PCG Asset Management, La Jolla, Calif, said funds of funds that have been longtime venture capital investors "have small legacy positions in the top five venture capital firms."

"It's typically a small allocation that can't materially affect the overall performance of their portfolio, but they use it as a marketing pitch," he said.

Venture capital firms that just now are turning away funds of funds probably are doing so because of "concerns related to access to information," Mr. Brem said.

Those "concerns" first surfaced in 2002, when some universities and public funds released performance data on their private equity investments in response to FOIA requests. That prompted Sequoia — later followed by Charles River Ventures, Waltham, Mass., and U.S. Venture Partners, Menlo Park, Calif. — to stop accepting public pension fund and other public limited partners because they did not want fund return information released.

Sequoia Capital later asked the $3.5 billion University of Michigan endowment, Ann Arbor, and the $62 billion University of California pension and endowment funds, Oakland, to leave its venture capital fund. (Pensions & Investments, April 5, 2004).

Most of the venture capital managers banning fund-of-funds commitments are concentrating on endowment and foundation dollars, consultants said. Some are developing an endowment-only investor base, said Gary Robertson, senior vice president at Callan Associates Inc., San Francisco.

"Endowments will support any new products that venture capital firms want to launch," he said. "Funds of funds are more circumspect in what they put their money into in that they are registered investment advisers, and I could see some funds of funds kicked out."

However, Mr. Robertson added: "I'm not really sure what's in the hearts of the Sequoia folks."

Gerry Langeler, general partner with OVP Venture Partners, said venture capital managers are looking for a rationale for cutting out some investors. "Some of the funds are so widely oversubscribed, they are looking for a real simple model to explain who they threw out and who they kept in," Mr. Langeler said. OVP's 2006 fund was oversubscribed.

Mr. Langeler said OVP executives prefer to work directly with investors, rather than go through an intermediary. Two of its fund-of-fund investors are Grove Street Advisors LLC, Wellesley, Mass., and Gerard Klauer Mattison & Co., New York. Grove Street is investing in OVP through a vehicle managed for the Sacramento-based California Public Employees' Retirement System; GKM, through a vehicle managed for the GKM Generation Funds for the New York State Common Retirement Fund, Albany, he said.

"They are dedicated pools managed by a third party … but we know who the client is."

Executives at ITU Ventures also prefer to do business directly with investors, said Chad Brownstein, managing partner. It is important to have relationships with investors that know you and will continue to invest over the long haul, he added.

These moves by venture capital firms will not necessarily signal the end of fund of funds' investments in venture capital, said Mark Heesen, president of the National Venture Capital Association, Washington.

"Funds of funds are becoming, and will become, more important and used more as the years progress," Mr. Heesen said. "There are so many smaller (venture capital) funds and interest in the industry that limited partners have a hard time investigating the funds, and need funds of funds to put all the smaller funds together and present it to them in a package."

Venture capital executives are looking for investors that are easy to work with, responsive and understand the industry, Mr. Heesen said.

"The vast majority of venture capital firms will work with funds of funds," he said.

New Venture Partners LLC — which started in 2001 —— has fund-of-funds investors in its new $275 million fund. Executives at Venture Partners included funds of funds in their investor mix partly because the broad exposure from buyout to venture in the same fund meant fund-of-funds managers would understand the firm's strategy of helping corporations develop and spin off technology discoveries into separate companies, said Stephen Socolof, managing partner of New Venture Partners, Murray Hill, N.J.

What's more, the size of the firm's fourth fund made it impossible for large public fund investors to invest in the fund without going through a pooled vehicle.

"When you have a 10% to 15% limit (when a pension fund investor can't account for more than 10% to 15% of the fund), that would make the maximum size $20 (million) to $25 million per investment, which would have been too small for public pension funds," explained Andrew Garman, managing partner at New Venture Partners.