CalPERS' VC Talent Search (Updated)
Imagine you had one year to invest between $2 billion and $4 billion in private equity. Where would you put it all, and how would you avoid losing it? Those are the questions Johncarlo Mark faces every day. As portfolio manager for the alternative investment management program at the California Public Employees Retirement System, he helps oversee a $22 billion pool of investments in venture capital, buyout, and distressed debt funds. That's the largest alternative investment portfolio of any public pension fund in the U.S. I recently spoke with Mark about CalPERS' latest VC investment, Clearstone Fund III, and the state of VC from a limited partner's perspective.
For the uninitiated, limited partners (LPs) like CalPERS invest money in venture capital funds, which are managed by general partners (GPs), whom we generally think of as VCs. The GPs invest the money in startup companies. If those companies appreciate in value, the GPs distribute the returns from the investments back to the LPs in the form of cash or stock. The LPs pay the GPs for their services with fees and a percentage of a fund's returns.
Finding good GPs is the tough part of Mark's job. It has gotten even tougher as VC fund sizes have shrunk. During the Internet bubble, lots of VC firms raised funds from $500 million to $1 billion only to discover after the bubble burst that they had more money than they could invest. Now, many firms are raising funds under $500 million. That was the case with Clearstone Venture Partners, which just closed its third fund at $200 million, about 45% smaller than its previous fund.
As a result, LPs often must settle for a smaller chunk of a fund than before. In the case of the most popular funds (so-called fortress funds), it's hard to get a chunk at all. When today's blue-chip VC firms were first starting out in the '70s and '80s, they raised much of their money from foundations and endowments rather than public pension funds. Twenty or thirty years later, those firms allocate the lion's share of their new funds to those same investors. "Clearly, they’re trying to reward people who've been there since the beginning," Mark says. That means LPs like CalPERS have to identify the blue-chip firms of tomorrow.
Not that CalPERS isn't already in some top VC funds. Austin Ventures, New Enterprise Associates, Sevin Rosen Funds, and U.S. Venture Partners are just a few of its investments. CalPERS aims to establish long-term relationships with GPs. For example, it has invested in all three of Clearstone's funds. The first fund, raised in 1998, produced hits like Overture and United Online, while the second fund, raised in 1999, is still in the red. Though Clearstone is still proving its mettle, the firm has enough of a track record for CalPERS to feel comfortable re-upping. Says Bill Elkus, a GP at Clearstone, "[LPs] need to take an early look at new venture funds that are likely to be great rather than pile on ones everyone knows are great."
Despite small fund sizes, lots of new funds are being raised as VCs return to investing after a slow-down from 2001 to 2003. "In a market where we have 50 fund managers coming back to us for re-ups, there is adequate supply, but you want to invest only in the top-quartile players," Mark says.
A selling point CalPERS uses to attract those players is its vast network of contacts. Because the pension fund has so many GPs managing its money, it can make valuable introductions among money managers. One of the fund's VC managers had a portfolio company that wanted to sell technology to the fast-food industry. CalPERS introduced the VC to a buyout manager whose firm owned a fast-food chain, and a sale resulted.
Disclosure has also made it harder for public pension funds to get into some VC funds. Because they manage taxpayer money, public funds are subject to freedom-of-information laws, which allow anyone to request information about the performance of public funds' investments. When VC investments started deteriorating after the Internet bubble burst, pensioners sued CalPERS and other public pension funds to gain access to performance information. Some GPs have expressed alarm at having their internal rates of return exposed. Others say people may try to obtain financial statements of private companies in VC portfolios.
Mark says a few GPs have had problems with CalPERS' public status. But some may be using it as an excuse to cut fund sizes. "It's a reason the GP community can use to carve back dollars," Mark says. To solve the problem, CalPERS is supporting proposed legislation in California that would clarify what state pension funds must disclose. The legislation would require CalPERS to report the amount and performance of its investments but not financial statements of portfolio companies or other sensitive information.
Historically, CalPERS has expected its VC investments to produce about a 30% internal rate of return. Some VCs consider that high today since so much money has flooded into their industry and so few companies go public at high valuations. Nevertheless, Mark is upbeat. "We think it's an attractive time to be investing in VC," he says. "I.T. spending is up, and it appears to be up for the next few years. Pricing [of startups] is more in check versus the late '90s. And you're seeing better entrepreneurs putting together more viable business plans." Let's hope so.
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