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Venture Capital's Coming Collapse?

Just to add to the gloom-and-doom in the financial markets, Forbes came out with a very critical review of the venture capital industry ("Venture Capital's Coming Collapse") and why the industry will likely undergo a major restructuring in the coming years as funding dries up.  Here's a good excerpt from the article:
The venture capital industry is staring at the most vicious shakeout in its history. Returns are pathetic for most funds, the public offering pipeline on which venture depends for its exit strategy is clamped shut, and with the shares of many big publicly traded tech companies swooning, those firms are less likely to buy up promising upstarts.
To get an idea of how lackluster the returns overall have been:
Joshua Lerner, a professor at Harvard Business School, recently analyzed returns, net of fees, for 1,252 U.S. venture funds going back to 1976. The median return for top-quartile firms was 28%. That included the huge profits of the tech boom, which aren’t likely to recur. The median return for all venture funds was just under 5%, or worse than what Treasury bonds would have given you. “If you’re not with the good guys, it’s not worth playing,” Lerner says.
The top-quartile firms do well, but the distribution is quite wide.  Part of the problem is that there are just too many funds.  And there are a lot of funds that are just living off management fees.  I suppose it's not that different from the mutual fund industry - there are a lot of bad mutual funds collecting 2 or 3% regardless of performance.  From an investor's perspective, a 2 or 3% management fee makes a huge difference over the course of a 10 year fund.  If you're an institutional investor and you've taken a 20 or 30% hit this year, you may be re-evaluating all your investments, including the 1 or 2% you had allocated for venture capital.  As an example, the article mentions California State Teachers' Retirement System reducing their allocation target from 1.3% down to 0.5%.

The following graph from Forbes shows how VC funds last returned more money than they invested all the way back in 1997:


On the exit side, avenues for returns are also drying up these days.  IPO's are gone (although those are cyclical of course).  And M&A activity has declined by 30% overall in the past year and by about 70% in the private equity led space (see data off PEHUB).  Here's some data from both the Forbes article and Thomson Reuters (via PEHUB) on how the exit side has dried up:




Perhaps this will mean that as funding dries up, some of the underperforming funds will close shop leaving only the best funds to survive the downturn.  Investors may be more discerning about historical returns.  Despite the bad climate, for instance, DFJ is starting another $600 million fund.  Money is still heading towards VC and PE.  But it will likely head towards to the top-quartile firms (although the Forbes article mentions that DFJ has not been showing positive returns lately).  Maybe they'll have to change their pitch as well:

Until recently VCs have been able to keep the cash coming despite dismal performance because of the long-shot nature of their business: Investors know that one Google or YouTube could make them millions even if most other bets bomb.

The venture industry promotes that spin. Christopher Douvos is a manager in Palo Alto, Calif. with the Investment Fund for Foundations, an $8 billion investment pool headquartered in West Conshohocken, Pa. He sees the sales pitch of venture capital as “lottery slogans with an Ivy League veneer.” Instead of saying, “Hey, you never know” or “You’ve got to be in it to win it,” the industry talks about “asymmetric outcomes” and “optionality,” he says.
Or, there are contrarians to this whole demise of venture capital argument as well.  Maybe a cleantech IPO boom is imminent and this is a great time to be an entrepreneur and venture capitalist?  There's certainly the whole "creative destruction" argument that I mentioned in my last post.  As an entrepreneur, you're forced to start your company with extreme fiscal discipline.  That's certainly good in the long-run.
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gnp said…
Well, that's depressing - although I've seen similar numbers / coverage recently.
December 31, 2008 at 6:05 PM
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