Venture Examiner

With 2009 now behind us, full final year-end venture industry data is available. There’s plenty to glean from all the fundraising, investment and exit data. Much of it tells us what we already knew or expected: fundraising and investment are down, and exits have improved, but just slightly. There’s so much you can analyze, but I’ll focus on something I’ve done in the past, which is looking at the “venture capital overhang.” This is the difference between the aggregate capital raised by venture capitalists and the amount invested. It gives us a rough idea of how much capital VCs have available for investment, sometimes referred to as “dry powder.” The chart below shows venture fundraising, investment, the difference between fundraising and investment (as the overhang) and the cumulative overhang for the last ten years.

The cumulative overhang for the last decade for the U.S. venture capital industry totals close to $90 billion, using my methodology and data from PwC, Thompson Reuters and the NVCA. As with so much of the data on the venture capital industry, the calculation is not perfect. Things like management fees and recycled capital are unaccounted for. There’s also the issue of investments made outside of the U.S.  which are not captured in the PwC MoneyTree data.  Rather than focusing on exact numbers, its more important to focus on trends and to look at the big picture.

For one, there’s clearly capital out there for venture capitalists to invest. It’s probably becoming more concentrated across a fewer number of firms - as I mentioned in my last post, good firms will continue to be able to raise capital. The overhang number is down from my previous calculation earlier this year, which signalz to that capital will be a bit scarcer.  Going forward, we should see more years like 2009 and 2003 where the levels of investment and fundraising have less of a gap and less of an overhang is created. Now, you don’t want things going in the other direction, where we have more capital invested than raised because that would of course be unsustainable. But then some would also argue that the huge levels of overhang amassed in years past were also unsustainable, which is probably true.

There needs to be certain level of reasonability maintained in the industry and less overhang will force venture capital firms to be more prudent in deploying capital. This doesn’t mean, however, that great new ideas won’t get funded, because VCs clearly have plenty of dry powder. If anything we’ll see more early / seed stage deals which not only require less capital, but have more potential upside and also bring the industry back closer to its roots of more risk taking. 

2009 was clearly a difficult year for venture firms – continued turmoil in the public markets and the broader economy prolonged the dearth of venture-backed IPO and M&A activity, extending the liquidity drought for venture firms. Illiquidity negatively impacted fund performance, and more importantly the confidence limited partners (investors in venture capital funds) have in the asset class. The drop in confidence is most evident in their commitments to venture funds, which in 2009 fell significantly. According to Dow Jones, “overall VC fund-raising fell 54.6% to $13 billion across 120 funds from the $28.7 billion collected by 204 funds in 2008. It was the slowest year since 2003.” Here are a few things to watch for in 2010 in terms of fundraising:

Commitments to Top Tier Funds:

Fundraising totals for 2009 would have been worse had it not been for New Enterprise Associates (NEA) closing its thirteenth fund with $2.5 billion in commitments. While the fund took longer than expected to close, the fact that it was eventually able to do at a such a large size shows that institutional investors still have an appetite for firms like NEA that have a record of consistently delivering top quartile returns. This will be a theme going forward – we will see the most sold performers (firms such as Sequoia, Kliener Perkins, Matrix, Battery, etc.) continue to be able to raise capital, but fund sizes will still come down. If for some reason we see a top firm unable to get close to its fundraising target, it would be a sign that limited partner perception of the asset class is worse than feared. The shockwaves would be felt across the venture universe.

 The Numerator Effect

Over the past couple of years, the “denominator effect” has been a central issue for most large institutional investors / limited partners. Some quick background for the unfamiliar: If you think of an institutional investor’s allocation to venture capital as a fraction, the denominator is the total value of their total investment portfolio. The numerator is what is invested in venture capital. Stocks and bonds are traded daily, whereas venture capital is only valuated quarterly. When stock prices fell during the recession, it brought down the value of the overall portfolio, or the denominator, but at the same time, the percent actually invested in venture capital went up because the value of venture portfolios 1) are reported on a lag and therefore had yet to be written down in line with the public markets, and 2) didn’t declines as much relative to marketable securities.

In 2010, what we have already seen is that the denominator has rebounded – in line with the stock market (for example, the NASDAQ was up around 40% in 2009). However, the numerator, or value of institutional investors’ venture portfolios has remained suppressed – again, because venture capital valuations are reported on a lag. The real value of the numerator won’t be known until final year-end 2009 data is taken into account, which won’t be until April. Once that happens, institutional investors will really be able to get a true sense of where their allocations stand. This means that the second half of 2010 should see more commitments than the first half.  

 Attrition:

Early in 2009, PE Hub’s Dan Primack released a list of “The VC Walking Dead.” These were venture capital firms that were officially in business but which no longer had enough cash to add new portfolio companies. Presumably that meant they will no longer try or be able to raise subsequent funds.  Expect the list of firms that fall under this category to grow in 2010. The bar for venture firms will be much higher going forward. The amount of capital committed to the asset class will probably never (or not for a really long time) return to the levels of 1999-2000, or even 2007 for that matter. It’s the general consensus that there was too much capital in the venture industry and limited partners weary of the asset class have every reason to be extra judicious with their commitments. That spells bad news for undifferentiated firms, inexperienced firms, and firms with poor track records. 

I've written a few times now about the idea of a crowdsourced venture capital fund - where there would be a large number of small investors, each playing a role in the fund's investment decisions. It’s my belief that as the venture industry evolves, the disconnect that exists between investors, venture capitalists, entrepreneurs, and the tech community can be bridged well through such a fund. If you'd like some more background on what my ideas for a crowdsourced venture fund are you find it here, and here.

 I got thinking about a crowdsourced venture fund again after reading some more about the great stuff Y Combinator does. Y Combinator provides seed funding for startups, but money is just a small part of what they bring - typical investments are less than $20,000. Instead, where Y Combinator really provides value is in their work with the startups they fund. They provide hands-on guidance to help startups become successful, including forming the company, legal issues, developing the product(s), managing the company's growth, and even finding future funding. In an age where the cost of starting an internet company has gotten pretty low, Y Combinator, which has helped spawn great companies such as Disqus, Loopt, Scribd, Xobni, and Reddit, provides something more valuable through its expertise and connections. It got me thinking that a crowdsourced venture fund would need to be able to do something similar.

A crowdsourced venture fund would be best suited for making tech investments; particularly early-stage tech investments where the backing of a crowd (in this case the LP base as well) could help propel portfolio companies. You would also be able to draw from the wisdom of the crowd to help with any problems faced by the startups invested in. Here, you have an instant network, as long as the LP base remains on the tech-savvy side, which you would expect. But what about the nuts and bolts of a company and nurturing it properly early in its life? The truth is that most traditional venture capitalists don't do much there as you would think, which makes YCombinator special. In a crowdsourced fund you would ideally want Y Combinator-type VCs armed with their own connections which, along with input and backing from the crowd, would really create an ideal situation. You would be able to help entrepreneurs effectively through a variety of issues by drawing from the crowd, only having to make sure that the crowd is sufficiently engaged to want to lend support. Part of this is achieved through their investment into the fund itself. Part of it is also making them involved in the investment process.

What would a crowdsourced fund do with a very large pool of capital? It would be able to do what Y Combinator can't do: continue to fund the companies at later stages. Instead of having other venture firms come in for a series A or B round, ownership could be maintained in the companies as they grow. Of course you could always push for a larger ownership with the seed funding as well, but you have to be careful there as you want the entrepreneurs to be motivated with significant interest in their companies.

And what about the vetting investments? Y Combinator has an application process for companies, but for a crowdsourced fund, you would probably want a combination of companies applying for backing as well as the fund's VCs going out and sourcing investments in a traditional manner. Both sources of dealflow would be pooled and, as I've mentioned before, the crowd, or LP base, would be able to vote on the most promising companies, which the VCs would then use as input in making their final decisions. The reason you wouldn't leave it up purely to a vote is that you need to protect the confidentiality of potential investment and so voters would not have complete information when making decisions. You would also use the wisdom of the crowd by voting/collaborating on solutions to problems companies face that can't easily be solved by the VCs and would benefit from having input from the crowd. While the crowd, or LPs, wouldn't be compensated for their participation, they all have their investment in the funds at stake as a motivator.

The thought of a crowdsourced venture fund is definitely idyllic, and maybe even more so if you want to try to do some of the things Y Combinator does, but as capital starts to take a back seat to the other things venture funding should provide, it’s a model that seems to make more and more sense.

Previous posts on Crowdsourcing Venture:

Crowdsourcing Venture

Another Take on Crowdsourcing Venture

The Private Equiteer recently brought up an aspect to private equity and venture capital returns that is often overlooked and unaccounted for: The fact that investors (limited partners) in funds have to set aside or plan around the capital they have committed to a fund. For those less familiar with private equity, investors in funds do not pay in the full amount they decide to invest in a fund right away. Instead, capital is called by the general partner as the fund makes new investments. Rarely do limited partners set aside their full commitment to a fund and hold cash to meet capital calls as they come. Most model around expectations provided by fund managers and hold only the amount of cash necessary to meet capital calls.

The Private Equiteer argues that opportunity cost of holding cash, or the risk of default associated with reserving inadequately should be factored into private equity returns. I would agree that there is some opportunity cost involved, but the simple fact is that virtually no limited partner holds the full amount of a commitment to a fund it has decided to invest in as cash – only for short periods to meet imminent capital calls, which in the grand scheme probably has a negligible effect on returns. There’s also a very limited chance that a limited partner defaults on a capital call. It’s extremely rare, and even if it does happen, there are remedies that would allow the limited partner to continue investing in the fund – rarely would all value be lost.

The reason these two issues aren’t talked about too much is probably because they’re not really major  issues to begin with. Putting aside the risk of default (which is incredibly small), let’s take a look at the effect holding committed capital as cash would have on a fund’s return. If you remember, in my model for a crowdsourced venture capital fund, I suggested that all committed capital would have to be called at the onset of the fund to make things logistically simpler – perhaps as the private equity and venture capital industries evolve, we’ll see more of this. Below I’ve modeled out a hypothetical private equity or venture capital fund’s cash flows under a normal model (which assumes that cash comes in right at the time of a capital call) and also for a model where cash is held/called at the onset of a fund (same impact on returns). I’m using 5% as an interest rate for the cash and the rest of the cash flows for both models are the same. Here’s what we get:

As you can see, there is clearly an impact on the fund’s IRR - a difference of around 1.3% in this case, but with a return multiple of 1.6x under both scenarios. Is this a significant difference?  I would say it’s definitely material, but it depends on the investor. The difference is probably significant enough to impact investment decisions and overall portfolio performance, and its why funds do not call capital upfront (negative impact on IRR, even though all other performance is the same) and why limited partners don’t hold cash. They assume they can earn even more than the 5% I modeled in on their cash. The only benefit derived from calling capital upfront or holding a commitment as cash is eliminating the risk of default, but as I mentioned before, it’s such a small risk in the first place that it does not make sense to protect against in such a way.  That said, I do stand by the idea that for different models such as a crowdsourced fund, you would still want to call all capital upfront, even if you sacrifice a bit of your IRR. 

This year, venture investment into the healthcare sector surpassed investment in the traditionally heavyweight information technology sector for the first time in over a decade. This trend has been well covered and there are plenty of reasons as to why venture capitalists have shifted focus to healthcare (less cyclical, lower valuations, less fundamental change, etc).  What’s interesting about the trend is that there’s been a historical correlation between difficult economic environments and the relative level of healthcare venture capital investing.

Here’s a look at healthcare investment as a percentage of all venture capital investment over the past 10 years: 

What you notice, besides the clear increase in relative healthcare investment over the past decade, is two dramatic spikes: The first in the years following the tech bubble – which is partly the result of VCs shying away from the tech sector while those investing in healthcare maintained their investment pace. Plus, many tech VCs looked for safety in the relative less volatile healthcare sector. The second spike is more recent - starting last year as the recession took hold and what can be considered a small venture bubble burst.  The reasons for this spike are similar as the previous, and as with the previous spike, the absolute dollars invested in the sector have still declined.

What’s also interesting about the two spikes is that they are predicated by a short decline in relative healthcare investment, which makes you wonder - is the relative level of healthcare investment perhaps a leading indicator for venture capital bubbles? It appears so. During bubbles, VCs are more apt to pour cash into what can be more lucrative, but also more risky technology investments.

This recent spike, where healthcare investment has reached almost 40% of all venture investment, is probably just that - a spike. Unlike earlier this decade, the levels of healthcare investment should come back down again as clean technology and IT investment pick up. But the case for healthcare investment remains and we’ll probably see it remain around 30% of venture investment going forward. Demand will continue to be driven by an aging population, continued technological progress, declined pharma productivity and government programs such as those pushing healthcare IT and increased access to healthcare.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters