An Institutional Investor’s View of the Evolving

US Venture Capital and Innovation Ecosystems

[Redacted Version]
5/6/2010

Chris Douvos
 Disclaimer Time!

The following presentation is for discussion purposes only and is incomplete

without the accompanying oral commentary

The views expressed in this presentation are not necessarily those of my

employer

The information presented in this presentation is provided to you for

informational purposes only and is not intended to be and should not be
used or considered as an offer, recommendation, or a solicitation to sell or
an offer, recommendation or solicitation to buy or subscribe to any financial
instruments, investment management services, or advisory services

This presentation is for your entertainment only

Etc, etc, etc

© Chris Douvos – see disclaimer 1 Edited/Redacted Version May 2010

 Agenda

I: The Many Hats of the Institutional Investor

II: Introduction to the Institutional Investing Process

III: Venture Capital in the Asset Allocation Process

IV: Whither Venture Capital Allocations

V: Venture Capital and the Future of Innovation

 Background: The Many Hats Investors Wear
The role of Limited Partners continues to
evolve as markets shift

2001 List 2009 Addendum

High throughput screener Whipping Boy / Apologist

Professional skeptic Referee

Investigative journalist Therapist

Panhandler Accountant

Self-appointed pundit Public Market Investor

Counselor / Teacher Bargain Hunter / Street Peddler

© Chris Douvos – see disclaimer 3 Edited/Redacted Version May 2010

 Agenda

I: Speaker Background

II: Introduction to the Institutional Investing Process

III: Venture Capital in the Asset Allocation Process

IV: Whither Venture Capital Allocations

V: Venture Capital and the Future of Innovation

 Institutional Investing: A Multi-Asset Class World
Institutional investors ponder two questions: 1) Where
do we play? 2) How do we play?

 Institutional investing orthodoxy suggests that asset allocation is

the driving force behind portfolio performance

 Most of the energy in institutional investing shops is oriented

toward execution of asset allocation strategies
 Yale’s outperformance relative to asset-class benchmarks over long
horizons has served as an inspiration to many, although few have
matched Yale’s success

Investing is about optimizing discomfort; some investors

have wider comfort envelopes than others

© Chris Douvos – see disclaimer 5 Edited/Redacted Version May 2010

Institutional Investing: Modern Portfolio Theory 101
The asset allocation process seeks to exploit the
proposition that some securities zig when others zag

Return Profile When Correlation Return Profile When Correlation

of Assets = 1 of Assets < 1

Security 2 Security 2
Expected Return

Expected Return
50/50 Mix of
Securities 1 and 2

50/50 Mix of
Securities 1 and 2

Security 1 Security 1

Risk (Standard Deviation) Risk (Standard Deviation)

Proponents: Perhaps the only free lunch in all of finance?

Detractors: Is the optimization process simply an “error maximizing”

exercise plagued by the garbage-in / garbage-out” problem?

© Chris Douvos – see disclaimer 6 Edited/Redacted Version May 2010

Institutional Investing: Pay No Attention to that Man
Yet the asset allocation process tends to be more art than
science and can be influenced by non-economic factors

Heterogeneous
Expectations
(or not!)

50/50 Mix of
Security 2
Securities 1
Principal and 2
Career
Agent
Risk!
Issues Security 1

Portfolio
Constraints

© Chris Douvos – see disclaimer 7 Edited/Redacted Version May 2010

 Institutional Investing: The Real World
When it comes to the motivations of investors,
maybe the English have it all figured out?

“Worldly wisdom teaches that it is better for the

reputation to fail conventionally than to succeed
unconventionally.”

– J.M. Keynes

“Over 90% of decisions in the asset

management business first take into account
the career risk associated with those decisions”
– Jeremy Grantham

© Chris Douvos – see disclaimer 8 Edited/Redacted Version May 2010

Institutional Investing: Conventional Wisdom ’95-’08
You can’t get fired for buying IBM (or for
copying Swensen)

Yale’s pioneering approach to investing

in “alternative assets” has produced
significant outperformance over a variety
of market environments

Some, however, haphazardly

implemented Swensen’s ideas without
rigorous analysis of their own institutions’
strategic and tactical advantages and
weaknesses

© Chris Douvos – see disclaimer 9 Edited/Redacted Version May 2010

Institutional Investing: Conventional Wisdom ’09-??
During the downturn, the overhang of illiquidity was so acute that
people have started rethinking exposure to locked-up strategies

As alternatives became mainstream, the perception of their risk declined.

As markets crumbled, many

[chart redacted]
institutions pleaded with their
private equity managers to
suspend capital calls while others
looked to sell their LP interests.
Strategic reviews of allocations and
portfolios are commonplace today

© Chris Douvos – see disclaimer 10 Edited/Redacted Version May 2010

 Agenda

I: Speaker Background

II: Introduction to the Institutional Investing Process

III: Venture Capital in the Asset Allocation Process

IV: Whither Venture Capital Allocations

V: Venture Capital and the Future of Innovation

 Institutional VC Investing: In the Rearview
VC-backed firms have reshuffled competitive landscapes and
account for about 20% of US GDP and 12 million domestic jobs

While VC-backed firms have grown faster and created more jobs,
we must ask if they will continue to be good investments?

© Chris Douvos – see disclaimer 12 Edited/Redacted Version May 2010

 Institutional VC Investing: Dreaming Big
The outsize returns earned by some venture capital investors
continue to attract investors looking for portfolio octane

Who are the patron saints of venture capital investors?

Curtis Sharp and Lou Eisenberg
The First NY Lotto $5M winners Many investors describe VC
using lottery slogans with Ivy
League veneer

“You gotta be
Optionality = in it to win it!”

Asymmetric
Payoff =

© Chris Douvos – see disclaimer 13 Edited/Redacted Version May 2010

 Institutional VC Investing: Out on the Frontier
Venture Capital is the longest-dated, furthest out-
of-the-money option that most investors own
Maybe this is what a lottery ticket looks like?
Hypothetical Mean/Variance Optimization
Constrained and Unconstrained Efficient Frontiers
VC
Unconstrained
Efficient Frontier Emerging LBO / Growth
Expected Return

Equity Cap
Real
Assets
Domestic Developed
Equity Equity
Fixed
Income Absolute
Return

Constrained Efficient Frontier

Risk (Standard Deviation)

Perhaps, all you need is a dollar and a dream?

© Chris Douvos – see disclaimer 14 Edited/Redacted Version May 2010
 Institutional VC Investing: Threading the Needle
Skillful (or lucky!) investing is more richly rewarded in
VC than anywhere else while losers are punished
US Venture Capital Top/Bottom First Quartile VC Funds vs ROW
Quartile Returns Funds Formed 1980-2002 Net Cashflows
140 $80,000
120 Upper Quartile
100 $60,000
80 Lower Quartile First Quart
IRR (%)

60 ROW
$40,000
40

$1000s
20
$20,000
0
-20
-40 $-
-60 80 84 88 92 96 '00
$(20,000)
[Data Somewhat Dated]
$(40,000)

Source: Thomson Venture Economics Source: Thomson Venture Economics

Being in the “top quartile” defines victory, but what about . . .

 Predictability/Persistence? Evaluation horizon? Data issues? Brand
fetishization? Opportunity costs v. other assets? Etc?

© Chris Douvos – see disclaimer 15 Edited/Redacted Version May 2010

 Institutional VC Investing: Chasing Performance
A once-sleepy corner of finance has been transformed by good
performance and increasing comfort with alternative assets
US Annual Venture Fundraising 1980-2009
$120,000

$100,000

$80,000
$ Million Invested

$60,000

$40,000

$20,000

$0
1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009
Source: Gompers & Lerner/NVCA/Thomson Reuters

© Chris Douvos – see disclaimer 16 Edited/Redacted Version May 2010

 Agenda

I: Speaker Background

II: Introduction to the Institutional Investing Process

III: Venture Capital in the Asset Allocation Process

IV: Whither Venture Capital Allocations

V: Venture Capital and the Future of Innovation
 Whither Allocations: Why Bother?
Yet after a decade of unspectacular returns, many institutional
investors are considering throwing in the towel
Venture Capital Returns for Percent of Institutional
Horizons ending 9/30/2009 Investors Targeting VC
40%
40%

35%
30%

20% 30%

10% 25%

0%
20%

-10%
15%
-20%
9-yr
8-yr
7-yr
6-yr
5-yr
4-yr
3-yr
2-yr
1-yr
15-yr
14-yr
13-yr
12-yr
11-yr
10-yr

10%
2007 2008 2009 2010

Source: Cambridge Associates Source: Probitas Partners

While VC has outperformed public markets over the last 10

years, returns have not met lofty expectations

© Chris Douvos – see disclaimer 18 Edited/Redacted Version May 2010

 Whither Allocations: Waiting in Vain?
The lure of the quick flip attracted some investors, but company
building is typically an arduous and protracted process

Median Time from Initial Equity Funding to Exit

9

8
M&A IPO
7

6
Number of Years

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
Source: Dow Jones VentureSource
* 2009 data is through Q3

© Chris Douvos – see disclaimer 19 Edited/Redacted Version May 2010

 Whither Allocations: Invited to the Party?
The skewness of returns implies that even when times seem to be
good, cash returns are still concentrated in the hands of few
Median Disclosed M&A Consideration Compared to Median Equity Raised Prior to M&A
$100
$90

Median Amount Raised Prior to M&A

($M)
$75
Median Amount Paid ($M)

$47
$50 $43
$40
$34

$25 $20 $21

$19 $20 $20 $21 $20 $22

$17

$0
2003 2004 2005 2006 2007 2008 2009*

Source: Dow Jones VentureSource / * 2009YTD data is through Q3

Recently, mean M&A deal value has frequently topped $100 million,
although median values typically languish at less than half that level

© Chris Douvos – see disclaimer 20 Edited/Redacted Version May 2010

 Whither Allocations: The Artihmetic Challenge
Ongoing realities in exit markets will continue to make the
arithmetic of VC challenging for conventional funds

Illustration of Traditional Venture But creating that magnitude of value is

Firm Arithmetic daunting when:
Company mortality rates are high
Imagine a Seeking Needs to
Typical 3x, or Generate $1.2B
$400M fund ~20% IRR in proceeds
Billion dollar exits remain rare
Add in
fees &  Excluding 2000, average disclosed M&A
carry activity (including healthcare) stood at about
$16B annually
Thus, must But only
create at least own 20% of Now needs to
$7.5B in start-ups (if Generate $1.5B This decade, the ratio of acquisition value
company value lucky) to capital raised has hovered around 2x

The VC business remains structured for bubble-era outcomes;

investors know that bubbles rarely form twice in the same place
© Chris Douvos – see disclaimer 21 Edited/Redacted Version May 2010
 Whither Allocations: The Access Challenge
Building a venture capital program has proven more
challenging than most investors anticipated
The benchmark of success is investing in “top quartile” funds . . .
. . . But what’s the capacity of the “top quartile” in a given year?

 Some suggest that it’s $2.5-$5.0 billion

 But an LP new to venture investing won’t have relationships with many
presumptive quartile-one firms (assuming that winners repeat) and will have a
hard time muscling into that club

 Coping Strategies:
“My job is to invest in second quartile funds and avoid the bottom quartile”
– Unnamed public plan investment pro
Emerging Managers?

Does participating in VC even make sense for the

“average” investor?

© Chris Douvos – see disclaimer 22 Edited/Redacted Version May 2010

 Whither Allocations: Other Threats to Innovation
Some investors worry that the prospects for innovation
in the US have become increasingly cloudy

Legal / Regulatory
 Sarbanes-Oxley
 Class actions
 Anti-trust activism Financial Markets
 Patent reform uncertainty  Increasing after-tax cost of capital
 Systemically important VC?  “Hollowing out” of mid-cap tech
 Tumult at SBA sector
 Self-inflicted wounds
Raw Material  Banking / research dislocation
 Science / Math education  “Great de-listing machine”
 Decline of corporate R&D
 US brain drain
Repats / Sea Turtles
H-1B visa issues

© Chris Douvos – see disclaimer 23 Edited/Redacted Version May 2010

 Whither Allocations: New Growth Opportunities
As the world economy matures, US-based tech companies have
lost their position as the first choice for growth-oriented capital

Scandinavia:
Canada: Corp Tech / comms
tax rates innovator
falling UK: Tech-savvy Russia:
early adopters Resource-rich

Emerging
Europe: Low
Latin America: cost EU access
China: ‘Nuff
Beneficiary of
said
nearshoring?

India:
Africa: Services
Strong offshoring
Brazil: expected GDP
Strong domestic driving Australia:
growth domestic
growth engine & China Proximity
commodity rich growth Singapore: boom
Significant
Cluster Support

Map Source: CIA World Factbook

Many international markets also offer compelling start-up

opportunities, with 70% and 58% of VCs predicting that venture
activity will increase in China and India, respectively
© Chris Douvos – see disclaimer 24 Edited/Redacted Version May 2010
 Agenda

I: Speaker Background

II: Introduction to the Institutional Investing Process

III: Venture Capital in the Asset Allocation Process

IV: Wither Venture Capital Allocations

V: Venture Capital and the Future of Innovation

 The Future: Fewer Funders
Four-fifths of venture capitalists surveyed believe that the
industry will shrink by at least 15% over the next five years

Predictions of VC Industry Shrinkage, 2010-2014

<15%

16-30%

31-50%

51-70%

Source: NVCA

The tumult associated with shrinking and disappearing firms

will impact even extant portfolio companies in insidious ways

© Chris Douvos – see disclaimer 26 Edited/Redacted Version May 2010

 The Future: On the Frontier of Discomfort
As the industry begins to shrink, firms on the margins of survival
may shun the longest-dated, most challenging technologies
Percent of VCs predicting that investment in Percent of VCs predicting that investment in
given stages will decrease in 2010 70% given segments will decline in 2010
35%
60%
30%
50%
25%
20% 40%

15% 30%

10% 20%
5% 10%
0% 0%
Source: Source:
NVCA NVCA
Newer

Older

General Level of

High

Low
Maturity of Company
Capital Intensity

These predictions portend continuation of some long-standing trends

that made funding conditions tough for certain types of start-ups

© Chris Douvos – see disclaimer 27 Edited/Redacted Version May 2010

 The Future: Living Uncomfortably (Case Study)
Semiconductors had once been a fertile ground for investment,
but many VCs have shied away due to their capital intensity

Once, there were dozens of firms that regularly invested in semis,

but today those numbers have dwindled to fewer than ten.
Meanwhile, foreign entities have sought to get up the curve

In many capital intensive segments, US venture-backed companies

are competing against focused ground-seeding by governments

© Chris Douvos – see disclaimer 28 Edited/Redacted Version May 2010

 The Future: Capital Flows
Some governments have tried to aid entrepreneurial activity and
innovation and these efforts are attracting private capital

As overseas ecosystems gather steam, institutional investors seek

opportunities to gain leverage for their capital

Zhongguancun, China Wuxi, China HITEC city, India Biopolis, Singapore

Despite some of these success stories, however, the history of

government success in fostering technology clusters is spotty

© Chris Douvos – see disclaimer 29 Edited/Redacted Version May 2010

 The Future: Still the Spot
Yet, despite current investor pessimism the US remains the
most attractive place for entrepreneurial activity
IESE Global Venture Capital and Private Equity Country Attractiveness Index

Source: IESE (http://vcpeindex.iese.us)

While the US continues to lead the world, shining in areas like innovation
and labor market flexibility, the country’s position is eroding in areas like
taxation, capital markets, and burdens of starting and running a business
© Chris Douvos – see disclaimer 30 Edited/Redacted Version May 2010
 The Future: Bringing Sexy Back (?)
The dynamism of entrepreneurship will continue to attract
outstanding people and engender new business models

Despite the cloud of uncertainty looming over the VC landscape,

the great strength of the entrepreneurial community has been its
ability to pivot into promising new areas
© Chris Douvos – see disclaimer 31 Edited/Redacted Version May 2010