LPs commit money to new funds before the first investment is ever made. What type of information does the seller (VC) have that the buyer (LP) does not?
Not totally correct. VC firms often have many concurrent funds. So while they're investing out of fund 1, they're raising for fund 2.
And they're using Fund 1 early returns (often paper returns) to make the case for why the LP should invest in Fund 2.
Felix Salmon summed up the phenomena well here:
"In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves."
One of the challenges is that the buyer (LP) is usually managing billions of dollars (e.g. a pension fund or large endowment), and venture is only a tiny fraction (a couple of percent) of his total asset base. It's difficult for those LPs to have expertise in an asset class that is such a small portion of the portfolio. The obvious objective criteria is past performance but understanding the potential of a team requires a deeper understanding of what makes firms successful.
The studies have been done, and there is a much stronger correlation between past performance and future performance in private equity than in the public markets. In the public markets for active fund managers, there is almost no correlation. For vc funds, there is a decent correlation. My hypothesis is that the reason for the difference is information inefficiency. In the public markets, everyone is oerating with the same information, so it's hard to create a sustained advantage. In the private markets, one fund may have access to information (seeing companies no one else sees, knowing customer or acquirers, etc). Success often begets success because funds with successes get positive press which leads more entrepreneurs to go to them.
> The studies have been done, and there is a much stronger correlation between past performance and future performance in private equity than in the public markets.
I can't find links to the papers themselves, but the research was published by Lerner and Stahlman at HBS. They looked at firms that had top quartile venture funds and then looked to see what percentage of them remained in the top quartile in the subsequent fund. For public market managers, the measure was the same but on a year over year basis rather than fund over fund.
And they're using Fund 1 early returns (often paper returns) to make the case for why the LP should invest in Fund 2.
Felix Salmon summed up the phenomena well here:
"In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves."
His article here - http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture...