VCs Should Be Careful While Riding Unicorns, Says Funds Manager FLAG

Venture capitalists who are busy chasing unicorns, or companies with valuations of $1 billion or more, shouldn’t lose sight of the need to manage their overall portfolios, says fund-of-funds manager FLAG Capital Management.

While this advice might seem obvious on the surface, managers of venture funds face immense pressure to keep betting on potentially huge winners rather than cashing in some chips to boost fund performance in the short run.

FLAG examined its portfolio of funds and found that slightly more than a quarter of funds with unicorns have at least recovered the cost of  investments they made in highly valued deals.

Believing that the best venture capitalists make great investments and excel at portfolio management, FLAG assembled a presentation reminding general partners of the importance of the latter.

It did so against the backdrop of marked improvement in venture returns since 2009, driven by plenty of initial public offerings

lucrative acquisitions, especially last year. This has delighted limited partners by producing positive net cash flows during the past three years, which means that capital returned to investors exceeded the amount of money called down by general partners to make new investments.

For the 11 years prior to 2012, net cash flows were negative, forcing LPs to tap other sources to meet capital calls.

While the venture industry tends to focus on fund IRR, or internal rate of return, which is based on realized and unrealized investments, LPs keep close watch on fund distributions.

The most recent vintage year where top-quartile funds have returned all capital committed by investors was 2003, FLAG said, based on an analysis of Cambridge Associates data. Part of the reason for this, FLAG said, is that companies are staying private longer.

Nonetheless, the time it takes for venture funds to return LPs’ entire capital commitment seems to be shortening, FLAG said. The top quartile of funds raised in 2007, for instance, is already close to the mark, with distributions to paid-in capital, or DPI, approaching 1x.

The presence of so many companies with valuations of $1 billion or more in VCs’ portfolios indicates a bright future for the venture industry, FLAG said. There were 83 privately held companies valued at $1 billion or more as of Thursday, according to The Wall Street Journal and Dow Jones VentureSource.

While venture investors like to swing for the fences, there are good reasons for taking some chips off the table, including that some unicorns might stumble before reaching a mammoth exit. The recent fire sale of e-commerce company Fab Inc. illustrates the risks of gambling on high fliers.

FLAG dug into its portfolio of venture funds and found it held 56 unicorns. Some were in several funds, giving FLAG more than 100 exposures to these companies.

Of those funds, 27% had realized one times or more their investment in deals valued at 10x or more, FLAG said.

“Is that low or high?” asks FLAG Partner Peter Denious. “It’s high relative to history” because general partners in the past rarely sold shares in portfolio companies prior to an exit.

But, he said, venture-growth valuations are relatively high. “In that context the number seems low,” he said.

“I don’t think there is a right answer,” Mr. Denious said. “It’s more about making sure VCs are having the conversation and asking the questions and thinking about what we call portfolio management.”

Write to Russ Garland at Follow him on Twitter at @RussGarland