VC’s Hot Deals for LPs May Lack Sizzle

By Yuliya Chernova for WSJ venture Capital

LPs that directly invested in venture-backed startups have done poorly on such deals in the past.

Amid the venture market mania of the past couple of years, some venture firms invited good friends, such as their limited partners, to invest in late-stage rounds of their hottest portfolio companies by using the VCs’ pro rata rights.

Different structures were used, one being a “special purpose vehicle,” created by such firms as Andreessen Horowitz, Firstmark Capital, and Founders Fund, in deals for such startups as Pinterest, Lyft, Palantir Technologies Inc. and others, as detailed by The Wall Street Journal last year. AngelList created an SPV structure for seed-investors to initiate such deals, which Accomplice, Slow Ventures and others have used.

VCs pitched it as a way for their LPs to further capitalize on their relationship and to put more money to work in the “best” startups. It is yet to be seen what kind of favor this was to the LPs, however. The historical record, at least, doesn’t seem auspicious.

Direct investments by limited partners into private venture-backed companies have underperformed the S&P 500 index by an average of about 40% between 1991 and 2009, according to a study published last year in the Journal of Financial Economics.

The authors, Lily Fang of Insead, and Victoria Ivashina and Josh Lerner, both of Harvard Business School, analyzed 390 direct investments by LPs into both buyout and venture fund portfolio companies. “We find that direct deals considerably outperform public market benchmarks, with the exception of venture deals (especially in the 2000s),” they wrote.

The problem, Dr. Lerner said, is that LPs tend to do much more direct investing at peak market years and put money into larger deals.

“The surest way to lose money is to do very large deals at market peaks,” Dr. Lerner said.

Write to Yuliya Chernova at yuliya.chernova@wsj.com

First appeared at WSJ Venture capital