Guess who a tech downturn could hurt the most

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High-flying start-ups may well be able to weather a financial markets storm after raising monster sums of cash.

However, the foundations, endowments and retirement funds that support them face a tougher slog.

Limited partners (LPs) are the institutions that provide the money venture capital firms use to invest in start-ups. On paper, funds raised over the past half decade look good, thanks to companies like Uber, Airbnb, Snapchat and SpaceX, which are all valued at more than $10 billion.

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There's only one problem: It's all on paper.

Massive private funding rounds at astronomical valuations have enabled the most promising companies to stay private, avoiding the constant scrutiny that comes with a stock ticker.

But venture firms and their LPs need initial public offerings in order to turn unicorn valuations into actual cash returns.

"There's a lot of people who have a huge amount of paper gains, but total distribution to LPs is small," said George Zachary, a partner at Charles River Ventures and an early investor in Twitter, Yammer and Pebble. "LPs are very nervous about this."

Such nervousness was particularly acute early this week after a six-day losing streak pushed the S&P 500 down 11 percent. The index recouped some of its losses in the past two days, but investors remain very much on edge.

Even before the swoon, companies weren't going public. According to CB Insights, there are more than nine times as many tech companies raising $100 million in private rounds as there are hitting the public markets. (Tweet This)

This all leads to a burning question: Did a bunch of richly valued software, mobile, cloud computing and marketplace businesses just miss a giant IPO window?

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It's too soon to tell, but the past week hasn't been encouraging—stock market uncertainty and risky tech IPOs don't tend to mesh. Without the offerings, LPs can't get the liquidity required to make their model work.

"That does become problematic," said Edwin Poston, a general partner at TrueBridge Capital, which invests in venture funds. "There will be a far more steady drumbeat of people saying that they're not going to fund the next fund until you return capital from the previous."

The data are troubling. As of last Dec. 31, the 63 venture funds formed in 2005 were worth 1.48 times their original value, according to Cambridge Associates. However, rich on paper doesn't mean cash on hand: Only 56 cents of every dollar invested had been paid back in cash to LPs as of the end of 2014. That time frame is important because the typical venture fund life cycle, from the time it's raised until investors are supposed to see all the rewards, is 10 years.

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For funds raised between 1999 and 2013, the only year that's generated cash for LPs is 2003, even though all but one of those years (1999) has been profitable on paper, Cambridge's data show.

Poston said he's not terribly worried because the growth rates for start-ups remain enormous and are only getting bigger. The potential market slowdown just means that frothy valuations get reeled in and the 10-year payback period gets pushed back some.

"I don't think capital is at material risk," he said.

Diane Mulcahy, who runs the Kauffman Foundation's venture and private equity portfolios, is more concerned. She wrote in February that venture funds aren't outperforming the stock market by enough to justify the time horizon and the extra years of fees that LPs are paying to fund managers.

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On average, funds are taking more than 14 years to liquidate, and LPs are strapped with the "stranded capital, greater illiquidity and additional management fees--but are seldom compensated for doing so," she wrote in a post on Institutional Investor's website.

The flipside is that many fast-growing start-ups are fully fueled. For those fortunate enough to have built up war chests, staying private is ideal. It involves no wild stock price swings, no annoying quarterly conference calls and no employees hitting the exits because options are hopelessly underwater.

Anaplan, a provider of cloud-based software to help enterprises plan their finances, sales and operations, raised $100 million last year.

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The San Francisco-based company has grown to 500 employees from 20 three years ago, and CEO Frederic Laluyaux said Anaplan has plenty more investing to do before it goes public.

With that in mind, Anaplan raised money from firms with newer funds that wouldn't be feeling the heat from LPs and would thus be able to stay aligned with the company, Laluyaux said. DFJ Growth, which led the latest round, raised a fund just before its investment in Anaplan.

"You make sure you're working with investors who are starting funds, not closing funds," said Layulaux. "You really want to make sure you buy yourself time."

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Even with meager capital returns, LPs have continued to pour money into venture funds with the hopes and expectations that their earlier investments turn positive.

Venture firms raised 74 funds in the second quarter, bringing in $10.3 billion, the most in any period since 2007, according to the National Venture Capital Association. New Enterprise Associates, Institutional Venture Partners and Bessemer Venture Partners have each raised funds of more than $1 billion this year.

Those firms have some of the better performing funds over the past decade, but they also have investments in late-stage private companies like MongoDB, Pinterest, AppDynamics and Pure Storage, which filed for its IPO this month.

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Michael Roth is research manager of Bison, a Boston-based software company that sells analytics tools to private equity funds. In his world, it's pretty clear that LPs are getting antsy. He wrote a blog post in June, before the public markets turned, titled, "Here's why the venture capital crash will hurt."

"It's been a leap of faith over the last few years," Roth said, in an interview. As to how much LPs are discussing the issue with firms in their portfolios, "it's probably one of those uncomfortable questions that no one wants to talk about," he said. "It's the elephant in the room."