On the Decline and (Maybe) Fall of Venture Capital

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Roughly eight years ago, I had lunch with an ex-McKinsey colleague who had started a venture capital firm. His partners were raising a second fund. He was leaving. I wish I had taken notes, but his message was that the industry did not work. He went through the deals done in the previous decade (remember, this was 2004), the returns were concentrated in a small handful of firms. And if you looked at those firms, their returns came from a remarkably small number of deals. I’m pretty sure I’m not exaggerating that his analysis said that if you took the top ten deals out, the industry returns would be subpar. And once you got further in the decade, the returns of these deals would roll off and would no longer be included in the pension fund consultants’ analyses, and thus would lead the industry to be deemed (correctly) to be less attractive and would have less in the way of funds allocated to it. This is critical because if you are in the fund management business, the saying goes that 75% of the work is raising the money.

Confirming the soon-to-be-ex VC’s grim forecast, earlier this year, the Kauffman Foundation, a major investor in venture capital funds, released an extremely critical analysis of both industry performance and the willingness of VC limited partners to accept lousy deal terms and limited (as in unreasonably limited) due diligence on the funds.

Kauffman VC Enemy is Us Report

Despite the enthusiasm of bright young things to get on venture capitalists’ radar, I’ve also seen inventors do everything they can to steer clear of venture capitalists, at least any time before the late stages of their venture (where a round of funding from the right names is enormously helpful in getting a big Wall Street firm to handle your IPO). The view among quite a few more seasoned inventors (and their attorneys) is that VC is too costly in monetary terms and comes with too many strings attached, both in terms of interference and in that they usually over time displace the founding team for not having the right resumes and “look” an IPO. While it is often true that the founders may not have the skills to build a larger organization, I’ve often seen them bring in “talent” which has the right resume but managerially is not all that much better.

Nevertheless, venture capital is romanticized as one of the drivers of the American economy, when entrepreneurship expert Amar Bhide has ascertained that only about 1% of new ventures are funded by VC. A story today the Mercury News (hat tip bob) on how the poor performance of VC this year is part of a longer decline, raises bigger issues about the trajectory of the economy and the role of venture funders in it. It may simply be that (contrary to the McKinsey VC’s forecasts) funding levels have not fallen in line with the industry’s performance, and it needs to shrink further so that there aren’t too many investors chasing too few of the hot deals. It may also be that the VC industry is a casualty of the global financial crisis, in that individual investors remain skittish about the market, and their reservations are reinforced by high frequency trading, which leaves the little guy at a disadvantage. But predictably, even though the article makes it clear that the problems with VC are long-standing, many of the fund operators want to blame it on “uncertainty,” which at least on this coast, means the government.

Some key extracts:

[T]he venture capital industry has been down for more than a decade, long enough and deep enough to make me wonder: Is venture capital in a down cycle or a death spiral?…. it remains difficult to identify a clear path for turning things around for the battered venture capitalists who make Silicon Valley hum.

• Venture capital firms invested $6.5 billion in 889 deals in the U.S. during the most recent quarter ending in September. That’s down 11 percent in dollars, and down 5 percent in the number of deals, from the second quarter, according to the PwC/NVCA MoneyTree report based on data from Thomson Reuters. At that rate, the numbers for 2012 are expected to be below 2011.

• The venture money being raised is going to fewer firms. In the second quarter, the NVCA reported that 80 percent of all venture money was raised by just five funds.

• The number of venture firms has declined from more than 1,000 a decade ago to 462, according to the most recent NVCA numbers.

The article later gets around to the issue we raised earlier, the state of the stock market. Volume is crappy when you back out HFT. And even though mergers are another exit strategy, M&A prices are usually set with reference to IPO prices. Few IPOs results in lower M&A prices (a less robust IPO market means M&A buyers already are likely to be looking at lower prevailing cash flow multiples, plus they can bargain harder because they know the VC companies have fewer options). Again from the article:

So what’s wrong with the VC industry? The problems are many and complex. But they can be boiled down to this: Not enough exits.

For the size of venture capital being raised and invested, there simply aren’t enough initial public offerings of stock to generate the returns that funds need. Compounding that: mergers and acquisitions are also way down this year. That’s another way VC firms and their partners make money on their investments.

Venture insiders blame the global economic uncertainty. They believe that is part of the reason that giant corporations, which have amassed huge piles of cash, are just sitting on it, rather then using it to acquire startups.

“The numbers are way down,” said Ray Rothrock, a partner at Venrock. “All these companies with these fantastic balance sheets, and nobody is really buying anything. With all the uncertainty they’re facing with the economy and taxes, buying little companies is way down on their list. Liquidity is way off and that makes everyone grumpy.”

“Uncertainty” is so disingenuous. How about: “The financial services industry blew up the global economy and it still hasn’t recovered. What little recovery there has been had gone almost entirely to the top 1%. And you wonder why no one wants to invest?”

But over at Slashdot, the headline on this same story (which has all of one mention of the fiscal cliff, close to the end), the headline is “Amid Fiscal Uncertainty Venture Capital Is Way Down In Silicon Valley” and the comments are overwhelmingly about monetary and fiscal policy, not about the state of tech investing. As bob noted, “The fiscal cliff is the “cause of death” to venture capital as the staircase is to the guy who chain smokes and lives on nothing but McDondalds and beer.”

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  1. vlade

    An acquitance of mine is a successufl angel (ex VC) investor. I talked to him a year ago, and he was saying how wrong the whole industry looked. He said that

    – there’s wasn’t many deals (this is UK);
    – the deals that were there were expensive;
    – despite banks pushing finances left right and centre cheaply;
    – and there were few exits – because while everyone thought it was a good time to sell, no one thought it was a good time to buy

    Which is counterintuitive re “too expensive” until you look at the UK housing market which by any measures should have crashed at least as much as the US one but didn’t.

    Re the “few deals carrying the day” – as far as I know VCs (and to an extent even PE) weren’t shy about that? They matra was “you invest in ten, 8 fail, one returns the money and one pays for the rest” – and priced the cash accordingly.

    That said, FFF (family, friends and fools) is still the most common source of funding for first-time enterpreneurs as far as I know.

    1. Yves Smith Post author

      You are missing the math. This is not one good deal per fund. This is only ten super deals across the entire industry driving industry returns AND those were in the dot com era! This is a MUCH more extreme version of the picture than you appreciate.

      In other words:

      1. Pension fund consultants tell investors to allocate assets based on returns for certain asset classes

      2. VC returns are based on averages across industry (they’ll have some secret sauce for determining that, but that’s the idea). And it’s usually based on 10 year prior returns.

      3. Returns were actually the result of a remarkably small # of deals in a not that big time period.

      The Kauffman document explains how the weird way fund returns are reported allows fund managers to look better during their life than they really are. See their discussion of n-curve, as in small n. And most funds raise a successor fund 4-5 years in, before the actual returns for the predecessor funds are known.

      1. vlade

        I agree that the allocation is dumb – if nothing else, the funds have incentives to invest regardless (investors are unhappy when funds don’t, and GPs don’t get fees for uncalled money IIRC).

        I haven’t seen the pdf (can’t access it here), but I’m aware of a fair few deals with exit multiples of over 10. Of course, the mega deals (zyngas, FBs, googles of this world) are few and far between – which is what one would expect.

        If pension funds really believe that every VC will get one (and thus them), they are delusional (I suspect it’s more likely that they try to be “respectable” as defined by Keynes, i.e. going with the herd).

        One of the large problems as I see it is the concentration (which you mention in the article), as fund with blns in AUM has troubles justifying a few mln investment (or it’s easy overbid by large amount, making the return bad) – which is where I’d say the best win/lose ratio can be achieved with decent but not huge multiples (around 10).

        That said, my limited knowledge of a few VC people from smallish funds (10s to 100ml) tend to go with the one-win in a fund pays for it.

        As an aside, sometime ago I run into a paper that was arguing that there’s a sweet spot for a fund size (it was normal investment fund), and it was rather smallish (100s of mln IIRC) – over and above that it gets harder to invest for decent returns sensibly and incentives to “invest”, lever and cheat go up.

      2. diptherio

        Not even 4-5 years, Yves. From page 29:

        “The next funds first capital call begins at a median 27 months of a funds life, still within the investment period of the previous fund.”

  2. Dennis

    VCs and PEs are going to be around forever because people who allocate money to them from pension funds are (a) generally prone to being corrupted and (b) need to hit homeruns from now on to hit those 8% growth targets they are mandated to hit. As long as assets flow out to alternative funds — and there will be plenty of ‘consultants’ and ‘fund of funds’ who suggest these strategies — there will be VCs and PEs

    Which is why you will see more and more asset gatherers who let a small clique of Harvard/Yale/Princeton ex-Goldman/ex-McKinsey types to generate hefty rewards even if they never actually IPO out into anything. After all, every new year brings a new class of MDs/Senior Associates and MBAs who need jobs and validation.

  3. tyaresun

    Forget the returns, you can blame the greedy VCs for a large percentage of still births. These guys do not understand anything and want to dictate everything.

  4. diptherio

    Astounding to me that “since 1997[!], less cash has been returned to investors than has been invested in VC.”

    Can the lie of “rational actors” be made any more clear? Thirteen years of sector-wide negative returns and instit. investors are just now talking about changing their behavior?!? Wow. I only got half-way through the paper, so I don’t know whether or not the authors address the question of why it took their own firm over a decade to figure this out.

    So, obviously we need some new models for modeling market/investment behavior. Rather than assuming that all parties in financial transactions are rational actors, we should assume asymmetric transactions between irrational (or arational) actors, the instit. investors, and unscrupulous, fee-optimizing, system-gaming actors (VC GPs). I bet that any formal working out of such a model would lead to theoretical results more in line with reality than what the mainstream models predict.

    1. Blue Meme

      The return on the S&P 500 since January 2000 is also negative. Is it rational for any of us (other than the folks who “manage” the money) to be in the market?

      1. ScottS

        I would say “no,” it isn’t rational to be in the S&P 500. Especially when the total return on something boring and stable like VBTLX outperforms SPY, why on earth would you touch the S&P 500? You enjoy the roller-coaster quality volatility?

      2. diptherio

        I saw some dude who wrote “The Three Day Work Week” (or something like that) being interviewed. The host asked him if he invested in stocks. His answer, “no way.” Why not?

        “I was talking to a hedge fund investor friend who said to me, ‘would you bet your life savings on a game of one on one with Michael Jordan? how about eighteen holes with Tiger? No? Then why would you gamble your retirement in the stock market against guys like me? You really think you have a chance?’.”

        That convinced me to stay far away (though I invest all my extra funds karma already). I figure the stock market is just like the poker table. If you don’t know who the mark is, then you’re it.

    2. KnotRP

      “since 1997[!], less cash has been returned to investors than has been invested in VC.”

      What is “Webster’s definition of Casino”, for $200, Alex?

  5. Susan the other

    Well, this is very Pogo of the Kaufman Fdn. Good title. I noted on the first page (the only page I read) that although it has been clear for a decade that limited partnerships are a bad VC model, they have been successful even to their sophisticated investors, i.e. the pension funds. Because pension funds are chasing diminishing returns. In the calculus of limited liability partnerships, it could only ever be that limited risk brings limited returns. I think its another example of productivity having reached a certain limit. One, every enterprise is super-productive so competition is almost precluded; Two, productivity can no longer free-ride on the environment; Three, because it is an end of an era there is way too much frantic cash with nowhere to go; and Four, Etc. I wish I could imagine a VC fund that could produce viable returns by investing in lots of low productivity jobs of high social and environmental returns.

  6. Nathanael

    “I’ve also seen inventors do everything they can to steer clear of venture capitalists, at least any time before the late stages of their venture (where a round of funding from the right names is enormously helpful in getting a big Wall Street firm to handle your IPO). The view among quite a few more seasoned inventors (and their attorneys) is that VC is too costly in monetary terms and comes with too many strings attached, both in terms of interference and in that they usually over time displace the founding team for not having the right resumes and “look” an IPO. ”

    This is exactly what my friends concluded. They have a truly revolutionary product, of social value, which should make billisons, and they were willing to take only a small cut of the money (they want fame). But the venture capitalists want CONTROL, not money; they won’t let the inventors actually make the products and put them on the market, and they basically wrecked the first company my friends set up by interfering. So they’ve set up another one and are trying to stay away from venture capital vultures.

    The majority of venture captial people don’t know what they’re doing.

  7. ScottS

    Existential question: Why have venture capital?

    1. Making money
    The document in the original post says that it isn’t beating the public market.
    2. Inventing new things
    The occasionally correct Robert Cringely says VC isn’t necessary to fund interesting projects. Most mad scientists self-fund.
    3. Flattering the vanity of richie riches who have made their money and are now bored
    Getting warmer…
    Is it the lack of exit strategies that is the problem? If the company made things that people are willing to pay a fair price for, why would venture capitalists want an exit strategy unless the VC was retiring or buying a fancy boat or something? Let’s be honest, the term “exit strategy” gives away the fact that we are talking about Pets.com-style pump-and-dumps — otherwise we would be talking about liquidity.

    Speaking of exit strategies, Groupon stock plunges, has lost 90 percent of value since IPO. So is that $60 billion offer from Google still good?

  8. Lambert Strether

    Can’t find the link, in my travels this week I encountered a blog post from a serial entrepreneur in Silicon Valley who’d had success with and without venture capital, and his conclusion was:

    1. With VC, the founders spent all their time raising money

    2. Without VC, the founders spent all their time focusing on the product and customers

    At least for this guy, Door #2 was a better deal in every way, including being able to sleep nights.

  9. Mcmike

    Where does it say that inst/pension fund managers have to perform well? All they have to do is pace the median…. It doesnt matter whether they suck, as long as they all suck together.

    As long as they all allocate to vc about the same, then they will be doing as well as the average lemming. Self fulfilling benchmark.

  10. RepubAnon

    I’ve seen venture capitalists at work at a few start-ups. They invariably bring in “professional managers” and move the company to expensive “Class A” offices where they feel more comfortable. The professional management team knows office politics – and little else. Result: the people who know what they’re doing leave, the business folds, and the VCs blame the founders.

    I remember one start-up where the main servers were down, shutting down the business. When we asked where the IT folks were, it turned out they had been pulled off fixing the server because the newly-installed CEO’s favorite internet radio station wouldn’t play on his computer.

    This, folks, is why the VCs lose money.

  11. OpenThePodBayDoorHAL

    I’d just relate my own personal experience with VCs perhaps as a cautionary tale for those thinking about it.
    We raised $50M for a new institutional financial web service. We grew rapidly and were solidly headed to profitability, and needed one more financing round. This was right at time of the dot-com crash so there was no other funding source available other than our current VC (one of the largest in the business). They gave us a take-it-or-leave-it offer: reverse cramdown 1:100 and my 400,000 shares became 4000 shares overnight. The founders all left, the VCs installed new caretaker management, kept the servers plugged in and two years later sold the company for $530 million. “Caveat venditor”

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