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LPs warm up to venture

These are good times for venture. Fund performance is up, distributions are at near record levels and GPs remain intensely excited by the innovation at their portfolio companies.

LPs, too, are showing signs of a new warming to the asset class. First half fundraising reached an eight-year high, with $17.3 billion coming into the business, according to data from Thomson Reuters.

The inflows show few signs of slowing. In the first seven weeks of the third quarter, through Aug. 17, another $4.3 billion was raised. That brings this year’s total to $21.6 billion, by itself more than any year since 2008.

So when is too much of a good thing a bad thing?

The debate about an asset bubble in venture continues with most GPs shrugging aside comparisons to the bubble years of 1999 and 2000. The industry’s investing and fundraising totals are, in truth, not close to what they were then. But that doesn’t mean there aren’t signs of excess.

Late-stage valuations can be exorbitant. Big-round, big-deal checks startle even seasoned veterans. Now, capital flows are beginning to bear watching.

The issue, of course, is whether fundraising continues at the same pace through the remainder of the year and into next year. Many LPs expect a tapering, especially since a big reason the money faucet opened earlier this year was to fill five billion-dollar and larger funds from Andreessen Horowitz, Technology Crossover Ventures, Norwest Venture Partners, Founders Fund and Accel Partners.

Few similar mega funds appear to be in market now or lining up for next year. New Enterprise Associates apparently has feelers out for a multi-billion-dollar initiative that seems more like a 2015 event rather than a 2014 one. But few others are on the horizon.

Sure, lots of smaller funds are in the market. But it’s unclear if their collective mass is enough to tip the total fundraising scales toward, say, $30 billion this year and next. Most LPs interviewed for this story don’t think so.

They anticipate fundraising this year in the vicinity of $25 billion, with next year’s falling from that level.

“People are looking for portfolio octane and traditionally the place you get it is venture capital,” said Chris Douvos, a managing director at Venture Investment Associates. But “the increase in fundraising is a result of the supply of funds in the market this year. I think we’ll see a slowdown to more typical levels in 2015.”

Douvos and others who hold this opinion could be right. The stirring of new LP interest in the industry is hardly a great up-swelling at this point. After 10 years of venture as the forgotten asset class, fundraising phone calls are being returned, and once reluctant investors and consultants are spending time smartening up on GPs.

But there is no stampede to write checks.

“There is a gentle breeze, a whisper of something changing here,” explained Roland Reynolds, a managing director at Industry Ventures. Perceptions take a long time to change.

“People are more open minded,” added Mac Hofeditz, a managing director and head of the private funds group at GCA Savvian Advisors. But lots have been sitting on the sidelines since the 2008 downturn.

However, there are reasons to think the new shoots of interest from LPs could blossom into something more.

One is the rise of distributions and the prospect that more bundles of capital could flow to LPs in the years to come. In 2012, venture firms distributed $22.3 billion to their LPs and another $21.5 billion in 2013, the third and fourth largest totals ever, following only 1999 and 2000, according to Cambridge Associates.

Some LPs for the first time in many years could point to venture as their top distributing private equity asset class. With money coming back came the need to redeploy it.

Additional years of elevated distributions could follow if the public-market demand for young high-growth companies remains high, in turn sparking more fundraising in the years ahead.

Another incentive is the improved performance of the asset class. One-year venture performance rose to 27.2 percent in the fourth quarter, the best year-end annual performance in 15 years, Cambridge reported. Performance topped that mark in the first quarter, climbing to 30.5 percent and besting even the Nasdaq Composite. The key 10-year return nudged up to 10 percent in the first quarter.

It is not hard to imagine strong performance for several more years. Gains are being driven by portfolio mark ups of Internet and information technology companies, and plenty of well performing companies remain in venture portfolios.

New GP strategies have been paying off, as well. Firms have been able to turn late-stage and pre-IPO investments into quick profits as companies exit promptly into the public markets. Seed and early-stage investors make money from acqui-hires and other quick-turn acquisitions for their young companies.

“The venture industry has gone through a massive restructuring over the past decade,” Hofeditz said. “It’s definitely got smaller. It’s definitely got smarter. It’s starting to pay dividends.”

These trends are unlikely to reverse themselves as long as the IPO window remains open.

Add to that the sustainability of technology cycles for cloud, mobile and Internet companies. The easy money might have been made already, but “I’m convinced we’re still early in the technology cycle,” said one LP who asked not to be named. “You’ll have ebbs and flows, but the fundamental move to the cloud, and to technology trends such as mobile computing, is just getting started.”

All this is making LPs panicky about not being involved. With money managers who lived through the liquidity crisis of 2008 and 2009 moving off investment committees, risk is becoming more acceptable. Newer managers appear more willing to chase portfolio performance.

“Institutional memory is really important and really underrated as a factor in the decision making process,” noted Douvos.

Another reason to think the pace of fundraising will continue is the rapid pace of fund creation. Capitalizing on what they see as abundant opportunities, GPs are returning to LPs faster than in the past.

Three quarters of Fisher Lynch Capital’s fund managers are in the market this year, when in a more perfect world a quarter or a third would be, said Managing Director Georganne Perkins. They are returning in two years rather than three or four years, said Perkins, who is keeping a watchful eye on the trend.

Examples of firms returning on the heels of a previous fund include Kleiner Perkins Caufield & Byers and Canaan Partners, according to Thomson Reuters and other sources.

Already, this year’s new surge of capital is signally restraint among some LPs.

“I’m a tiny bit less positive on venture capital than I would have been in the recent past,” said Texas Children’s Hospital CIO Robert Durden, who has made venture commitments since joining the hospital in 2013 and expects to make more. “If future venture returns are at least partly influenced by capital flows into the strategy, company valuations, and the pace and level of innovation, it’s fair to say that the first two factors have become less appealing since 2009 and 2010.”

Perkins also advises LPs to be deliberate. On the surface, the amount of money being committed to venture funds “raises eyebrows,” she said. A lot of it seems to be going to later-stage and pre IPO rounds and therefore sparks less concern. It is not creating a large volume of companies.

Nevertheless, the challenge for LPs is where to get involved and at what valuations. They need to have a long-term approach, she said, and work to get to know managers over three to five years.

Distributions also need to be examined thoughtfully.

Last year’s distributions of $21.5 billion represent slightly less than one-seventh of the $161.1 billion of value created by the 1,493 U.S. venture funds that Cambridge monitors. This suggests that about 13 percent of fund assets passed to LPs. Whether this is enough to justify the current level of fundraising is an open question.

At first blush, it may seen acceptable. After all, GPs distributed $43.8 billion to LPs in past two years. But the total is only 81 cents on the dollar of the $54.4 billion raised during the average two-year period between 2005 and 2009, when the distributing funds were created. Distributions may need to climb higher to justify a pile of new capital.

Despite all this, improving fortunes in venture industry are leading to the “first signs of an LP perception change,” noted David York, CEO of Top Tier Capital Partners. “But it hasn’t turned to action yet.”

Whether it does will \bear watching over the next couple years, as will industry capital flows.