The effect: The cycle is broken. To fix it, VCs must double their returns on investors’ capital, significantly scale up the VC asset class, or face the prospect of the industry’s shrinking in half. Click here for a larger image of the graphic. The sky is falling on the venture capital rainmakers. Over the past 10 years their quarterly internal rate of return (IRR)—the primary measure of VC success—was dismal, hovering in the single percentage points and sometimes dipping into negative territory. Many firms have struggled to market new funds. Their main sources of profitability—IPOs of their portfolio firms—are fewer and farther between. Their backup strategy—selling their portfolio companies to other firms—is getting tougher and the prices are falling. Investments that once generated cash after just two years now take six to 10 years to reach liquidity. A 2010 New York Times story on lean start-ups cites experts who see a “shrinking role for venture capitalists in seeking and backing promising young entrepreneurs,” as alternatives including angel investors gain favor. Fresh research by Josh Lerner and William Kerr of Harvard Business School bolsters this argument with evidence that entrepreneurs who obtain angel investing are more likely to survive at least four years and show improved performance. Another reason VC’s star is on the wane: Research by University of Chicago economist John H. Cochrane shows that investments in VC portfolio firms did not outperform investments in other NASDAQ stocks during the boom period of the 1990s. In short, the VC business is bad, and there are few signs that things will improve any time soon. We reached out to highly placed VC partners, VC-backed CEOs, and fund managers for wealthy investors and studied the latest data from principle VC industry analysts to understand why venture capital has fallen so far. How did the industry that made computers ubiquitous, the internet useful, biotechnology practical, and alternative energy sustainable get into this mess? And can it get out? A Weak Value Proposition No doubt the venture capital system worked during parts of the past 30 years. Hidden in a three-decade average of 3% quarterly IRR figures are periods of stout performance for VCs. During the golden age of VC investing—the silicon and software era from 1980 to 1997—VCs posted average quarterly returns of 22%. Research by University of Chicago economists Steve Kaplan and Antoinette Scholar found that VC funds outperformed the S&P 500 on a capital-weighted basis over the same time period. But the value proposition of the VC industry toward its two clients—investors and entrepreneurs—has since weakened. For one thing, VC has never recovered from the commercialization of the internet, which brought a staggering 250% increase in deals between 1997 and 2000 and a quintupling of investment dollars. IRR rose spectacularly, but perversely this attracted too much capital too quickly from too many investors, which in turn funded too many inexperienced VC partnerships competing for portfolio companies. Meanwhile, deal activity has dried up. The total number and value of investments in 2009 reached their lowest points since 1997 (see the exhibit “Few Deals”). This has dramatically thrown out of whack investment multiples and returns industrywide. Few Deals VCs are finding fewer promising start-ups: The total number and value of investments in 2009 (2,800 deals, $17 billion) reached their lowest point since 1997, before the internet boom. No Exits And VCs are unable to create IPOs and M&As for the start-ups they do find: The number and value of IPOs has declined to negligible levels, from $10 billion just a few years ago (17 IPOs per week in the U.S. in 2000 have dwindled to 15 IPOs in 2008 and 2009 combined). Further weakening the VC proposition to investors is the lengthening time to liquidity—owing in part to the credit crunch and stricter post-boom revenue requirements for start-ups (see the exhibit “Long Waits”). To be an attractive investment category, venture capital needs to offer competitive returns to alternatives on a risk-adjusted basis. Part of that risk adjustment should include a premium for nonliquidity. If IPOs are harder to create and take longer to achieve, then VCs will need to pay the premium and IRR, ceteris paribus, will fall. That means VCs are now in the unenviable position of offering investors higher-risk, lower-yield investment opportunities. Long Waits The lengthening time to liquidity for both IPOs and M&As lowers VCs’ internal rate of return given that evaluations are declining as well. What’s more, VCs are losing their ability to attract the entrepreneurs that will generate better returns. They’ve fallen short in marketing their relevance to entrepreneurs who don’t need capital as much as they need guidance. Instead of marketing their operational expertise, their well-developed networks of experts, and the personalized attention they can offer, many VC firms have resorted to peddling wildly attractive financing options. “The perception is that top firms have too much money to waste time on small investments,” says the CEO of the VC-backed Silicon Valley firm. “Combine that with the fact that many internet services companies have low capital needs. Why go to big firm when a business angel can cover financing and give more personalized attention?” What’s happening to the industry is, as one VC insider puts it, “a train wreck in slow motion.” And whether the train can get back on the track is, frankly, an open question, thanks to what Fred Wilson, a VC industry expert, calls the VC math problem. He calculates how much cash VCs need to generate from liquidity exit events to recoup even a minimum return for investors. Wilson believes that VC funds need to generate gross investment multiples of 3 (or 2.5 after accounting for management expenses). He estimates that the industry is returning a multiple of only 1.6 on investors’ capital, which translates to about a 10% annual IRR. Essentially, Wilson argues that the venture capital asset class does not scale, and thus the industry must “downsize to get returns back on track.” Is Downsizing the Answer? Whether these changes are structural or cyclical is a matter of ongoing vigorous debate. But to make the math work in the current climate, the VC industry must, above all, get smaller. “[The attrition has] already started,” says a VC partner in San Francisco with more than $840 million in active investments, and “it will be significant both in number of firms and number of investment professionals per firm. I think a 50% decrease in industry size is a fair estimate.” The only truly safe firms are the small number of top-tier firms in the VC industry. They will continue to set the terms for investment, generally meaning 2.5% in management fees and 30% in carried interest. The next tier will have to negotiate harder for their terms and will have to accept lower management fees and stakes. The rest will have an even tougher time raising new funds unless they are able to establish uniquely specialized strategies. Many will likely perish. “This is the story,” said the CEO of a VC-backed firm, who asked to remain anonymous to protect his funding. “Every VC I know thinks there are too many VCs, too much dumb money, too many people bidding up valuations and reducing returns for the top guys. Too many—except, of course, themselves!” But it’s not just size that counts. What industry veteran Gailen Krug calls the “spray and pray” approach—investing in dozens of firms in hopes of a few hits—is on the wane. “We see the thoughtful, quality VCs moving to a more focused approach of investing larger amounts of capital into fewer, more fundamentally sound companies with a higher potential for success,” says Krug. “This shift in strategy dictates that the marketing and fund-raising process must change.” In a sense, the road ahead for VCs appears to be retro. Venture capitalists must return to their roots of being patient, hands-on consultancies that nurture their start-ups until they are sustainable, while returning healthy dividends to deep-pocketed, risk-taking investors. “When we enter an investment, we don’t think about how to sell it,” says Bernard Liautaud, a partner at Balderton Capital, a leading European VC firm, and cofounder of Business Objects, one of the most successful VC-backed firms of this decade. “We think about how to help the entrepreneur build a great company.” How a VC firm accomplishes that goes well beyond handing over a pile of cash. “Forward-thinking VC funds do not stay still; they evolve,” Liautaud says. “I believe in a Darwinian VC ecosystem where the ones who adapt will succeed.”
