In the ten years since Silicon Valley exploded and asset allocation modelers scrambled to pile venture capital assets onto their portfolios, a lack of returns coupled with an excess flow of investment capital has brought the VC sector to an unhealthy position—in short, too many investment dollars chasing too few bankable ideas. With companies backed by venture capital funds having long ceased producing the kind of jaw-dropping returns enjoyed during the dot-com boom, most VC players have determined that the market is set to undergo a significant downsizing.
The challenge facing VC at the moment is twofold: excess capital commitments and investments have clogged the market; and extremely limited returns on this capital have punished investors for their patience. Since 2000, there has been approximately $250 billion in committed capital circulating through the market, with around $25 billion to $30 billion invested during each year in the past five years. These figures dwarf the ten-year period leading up to the dot-com explosion, when total capital commitments hovered around $50 billion, with annual investments not breaking $20 billion until 1998.
The inflated investment figures have only led to trouble, says Steve Dow, a general partner at Sevin Rosen Funds: “Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” Indeed, the number of participants in the game—all $250 billion worth—has remained relatively stable since 2001, while the number of winners has dramatically decreased—five-year returns have rotated around the zero percent axis since 2004. When compared to the years leading up to the dot-com revolution—during which investment figures were low, but returns were high—the last five years have marked a remarkable depression from VC’s former profitability. “Before the dot-com bubble, the ratio of winners to losers was such that the winners were making much more than the losers lost,” says Dow. “Now, the sector isn’t so consistent.”
“Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” -Steve Dow, general partner, Sevin Rosen Funds.
The poor returns for VC stem from a remarkably poor exit market, during which IPOs and M&A transactions have netted very little for the industry’s investors, with the average exits steadily decreasing. “We haven’t had a normal IPO market in a while,” explains Paul Kedrosky, senior fellow at the Ewing Marion Kauffman Foundation, which released a report in June pointing to the need for a “right-sizing” of the VC industry. “Without a solid IPO market, returns in venture are horrible; the exits have been terrible in the public markets and the private markets can’t compensate.” “You’re essentially taking one of two exit routes and shutting it down,” says Matt McCall, co-founder and managing director at Draper Fisher Jurvetson Portage Venture Partners. “You lose half of your ability for liquidity.” While IPO market conditions look to be improving, it may be a case of too little too late for many venture capitalists.
Compounding the weak state of IPOs are tight credit conditions, which have made it more difficult for venture funds to raise money. “VC investors are now worried about the solvency of their backers; they don’t want to make capital calls and find that their investors are backing out,” says Kedrosky. “So, rather than making investments, the VCs are just holding off on the whole thing.”
Clearly, VC is in a perilous state. A poll administered by executive search firm Polachi found that 53 percent of respondents—the majority of whom were partners or managing partners of their VC funds—agreed that the industry as a whole was “broken.” The same poll found that 92.7 percent of these executives said they were concerned about the weak state of exit markets. The consensus view on how to fix VC is that the industry must undergo a real downsizing, with committed capital and new investments both declining to a manageable level.
According to “Right-Sizing the U.S. Venture Capital Industry,” Kedrosky’s report for the Kauffman Foundation, “whether it realizes it or wants to, the venture industry has to change…it seems inevitable that venture capital must shrink considerably.” Such a view is reinforced across the industry, with nearly all VC players gearing up for such a change. “Less funds will be raised,” predicts Dow. “And the venture firms, living off the fees from previous years, will slowly fade away as they fail to raise what they need.”
“Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.” -Paul Kedrosky, senior fellow, Ewing Marion Kauffman Foundation
The general assumption across the industry is that VC needs to shrink to half its current size in order to remain viable. The Kauffman report concludes that VC investment will fall by half to around $12 billion annually, with committed capital under management dropping about $100 billion from its current level of about $250 billion. Draper Fisher’s McCall predicts that much of the fat will be cut from middle-sized funds of between $150 and $300 million, but that all funds will see their capital pools diminish.
The need for an adjustment in the size of the VC industry is not ignorable, says Kedrosky: “Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.” But, as is the case with most shifts within the greater capitalistic structure, an exit from the VC sector may be inevitable for many. “The dot-com boom was a distortion,” says Kedrosky. “Before long, we’re going to see an inflation-adjusted version of the period just before that.” McCall predicts that stabilization of the industry could take between five and eight years, but that IPOs will likely reinvigorate themselves before then—which means that VC funds will have to maintain a disciplined investing approach if they are to make it to greener pastures. “The industry as a whole fluctuates between fear and greed; when there’s greed, in a strong IPO market, that’s when people start acting unwisely.”