Busy signal

Ps to VCs: Don’t call us, we’ll call you.

Like it or not, that’s the message that many venture firms poking around for capital this year are likely to hear, thanks to lackluster returns and institutional investors who remain smitten with leveraged buyout funds despite the credit crisis, which has dampened their ability to shop since summer.

“It’s illogical, but [to LPs] venture capital is the forgotten stepchild of private equity right now,” says placement agent Mac Hofeditz of San Francisco-based Probitas Partners, which has raised nine VC funds since 2002, including, in 2007, Scale Venture Partners in Foster City, Calif., and Toronto-based Summerhill Venture Partners (formerly BCE Ventures).

“We glibly say that interesting funds continue to raise money, but the bar for ‘interesting’ in venture capital is as high as it’s ever been,” Hofeditz says.

Lisa Edgar, a managing director with fund of funds shop Paul Capital in San Francisco, is hearing much the same from her firm’s investors, which include Ohio Public Employees Retirement System, Generali Global Private Equity and BP Trustees Pension Ltd. “The LPs who’ve been in the market the longest—such as university endowments and family offices with broad, deep portfolios—appear to be using the secondary market to scale back venture relationships,” she says.

It’s illogical, but [to LPs] venture capital is the forgotten stepchild of private equity right now.”

Mac Hofeditz

Edgar attributes the shift in part to a lack of liquidity for venture-backed companies over the last few years. Even though more than 75 venture-backed companies managed to go public last year—the biggest number since 2004—it’s not much to crow about when you consider that venture returns seriously lag behind private equity returns over the past several years.

The chill toward VC is more than anecdotal. The National Association of College and University Business Officers—which each year surveys roughly 750 colleges and universities, representing hundreds of billions of dollars in endowment dollars—says class allocation to venture capital has remained steady since 2002 at about 3.5%, while the average allocation for private equity jumped from 4.3% to 5.9% over the same period.

Although the take on VC isn’t particularly good these days, plenty of venture firms are having no problem raising funds, according to data from Thomson Financial, publisher of VCJ. As of Dec. 5, 224 venture funds totaling about $33 billion had been raised, compared to 230 VC funds totaling about $32 billion for all of 2006, according to Thomson.

National Venture Capital Association President Mark Heesen assigns the discrepancy between the data and perception to foreign investment. “There are many more sophisticated investors around the world these days who want to be in the [venture] asset class. A lot of that interest is coming from Asia, but there are also a growing number of Europeans who were investing in European VC and who’ve since realized that [Europe] isn’t the best place to invest—that the U.S. is.”

Good thing. While both Edgar and Hofeditz believe that abandoning VC is a mistake, both say their case to institutional LPs in the U.S. is largely falling on deaf ears right now.

We are seeing many investors from around the world who are trying to get into venture.”

Lisa Edgar

“We think VC returns should and will produce results above the public market over the long term given the inherent inefficiencies in private markets, and historically the number was close to 20% over long periods of time,” says Edgar. “But in the absence of an IPO market, you can’t have those returns. It’s impossible.”

Adds Hofeditz: “VC isn’t dead, and when the market recovers, the cruel irony is that many investors won’t have a chance to participate in the upside because they didn’t commit in the downturn. We will likely be looking back 10 years from now saying mid-2000 VC funds performed better than expected.”

If it’s any consolation, buyout firms are also likely to feel the pain of complacent investors in 2008. “Next year, we’ll probably see a slowdown in buyout fund-raising,” says Hofeditz. “A lot of LPs are already over-allocated to buyouts, particularly mega-buyout funds. What we will see is that big buyouts are cyclical, and pretty correlated to the public markets,” which continue to be roiled by soaring fuel prices and credit problems.

That could mean some good news for the most persuasive VCs, particularly those veering away from traditional software and semiconductor investments and more toward digital media and clean tech. “People are concerned about valuations in certain of these new sectors and the sustainability of so many companies,” says Edgar. At the same time, clean tech “continues to be one new area of interest, though LPs are still trying to figure out if it’s a standalone industry or a component of the broader economy, and where it fits in venture capital because it’s so capital intensive.”

Investment from abroad is continuing, too. “We are seeing many investors from around the world who are trying to get into venture,” notes Edgar, who predicts the LP base in VC will shift rather than shrink.

Our interest level is actually growing in VC.”

Erik Hirschbr />Chief Investment Officer

And certainly, not all U.S.-based LPs are down on the industry, especially as the ongoing credit crisis causes buyout firms to cut back on mega deals, prompting investors to look elsewhere. “Our interest level is actually growing in VC,” says Erik Hirsch, chief investment officer of Hamilton Lane, a massive fund of funds manager headquartered in Bala Cynwyd, Pa.

“Clearly there are times when we think venture is more in favor than others, but we see the public market looking for growth,” says Hirsch. “And we think it will reward growth, and venture provides that. So we think the liquidity possibilities will increase for those guys.”

Still, there will likely be plenty of people crying in their PPMs in 2008. Hofeditz says the gap between emerging and established funds is as wide as it has ever been. “Newer fund managers are being especially hard hit,” he says. “Notwithstanding teams that have worked together before, it’s harder than ever to be a first-time fund [because] many LPs don’t have the time to evaluate these teams, especially when they’re focused on their existing portfolios.”

Meanwhile, Heesen thinks that individuals without track records are the ones being hardest hit. “A Shasta Ventures can still get funded,” he says, referring to the firm started by three VCs with solid track records but little history of working together previously. “It’s the people newly coming to VC and hoping to raise a fund who are out of luck.”

Based on the number of first-time funds raised in 2007, either lots of experienced VCs are raising new funds or the lack of interest in such funds by longtime U.S. LPs is being made up for by foreign investors. A total of 49 first-time funds raised nearly $3.3 billion last year (as of Dec. 4), compared to 46 such funds that raised $2.1 billion in 2006, according to Thomson.

First-time funds may be gaining traction with LPs by targeting regions that aren’t already crowded with VCs. Of the 10 largest first-time funds raised last year, only three are based in Silicon Valley. The two largest—Intellectual Ventures and Tech Stars—are both based in Bellevue, Wash.