Fund Cycle Shrinkage

Like many of you, I often am asked by friends and family to explain the VC/PE basics. So I tell them that “limited partners” (and I do the finger quotes here) like endowments and foundations contribute to a fund pool run by the “general partner,” which then takes that money to invest either in growing companies (“venture capital”) or to buy up established companies (“private equity” or “buyouts”). Then I tell them that limited partners pay an annual management fee to the general partners on their committed capital, that GPs get a percentage of the returns (“carried interest”) and that funds typically invest for five years with an overall life cycle of ten years.

Fairly simple, right? Well yes. The only problem is that the last part is no longer accurate.

We all remember how fund investment cycles shrunk during the bubble, but almost everyone chalked that up to irrational exuberance. The post-bubble economy wouldn’t burn through cash nearly so quickly due to both revitalized due diligence and lowered valuations. More importantly, every VC/PE pro insists that fund-raising is a laborious pursuit that takes time away from their primary investment responsibilities (even firms with professional fund-raisers usually need to drag along senior GPs for at least one roadshow).

But the return to five and ten didn’t happen. Instead, more and more firms are now settling into a two-year investment cycle. Take the hallowed example of Kleiner Perkins Caufield & Byers, which closed its most recent fund in the spring of 2004. This week, firm bigs like John Doerr have been camped out at the Peninsula Hotel in New York, meeting with potential LPs for a new fund (KP also is coming out with some major announcement today, but the details currently evade me). NEA is finishing up a new fund even though its last one held a final close in early 2004, while Sequoia Capital seems like a slowpoke by waiting three years. And this isn’t limited to VCs firms, as recent buyout examples like Bain Capital and ArcLight Capital prove.

So does any of this investment cycle shrinkage matter? For LPs looking at individual funds, the answer is no. KPCB will get its money, as will NEA, Sequoia, Bain, ArcLight and many others because they have generated adequate – and in some cases beyond adequate – returns.

From an industry-wide perspective, however, this phenomenon is further evidence that VC and PE pros are full of it when they prognosticate five years out. In fact, they don’t even have much insight into 2007 or 2008. If KPCB knew in 2004 that it would be back fund-raising in early 2006, it would likely have just raised a larger fund. Ditto for almost any firm raising a new fund three years or less from their last drive (exceptions here are emerging managers without much access to LP capital). This may seem like heresy to some and common sense to others. Either way, it’s worth keeping in mind the next time someone discusses future multi-billion dollar market opportunities or how a fund is appropriately sized.