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Sunday
May102009

The 1999-2000 Problem

The fact that venture capital has not produced quality returns for 10 years has been getting a lot of attention lately, particularly as LPs start having to make tough decisions about whether or not to continue to commit to the asset class. When a typical LP looks at their portfolio, what do they see?

Let’s assume that it’s a fairly well established institutional investor who has been in the asset class since the early 1990s. My best guess is that it looks something like this: reasonable commitments and excellent distribution activity from (vintage year) funds up to 1997-1998. Then things hit a wall. The good times ballooned out of control into the “irrational exuberance” (I hate that term) of 1999 and 2000 when LPs went gangbusters committing to VC funds. Needless to say these did not perform well. So next, the tech bubble bursts and you have a massive pullback - there are probably relatively much fewer vintage year 2001-2003 funds in most venture portfolios. Too bad, because these funds, on average, have performed pretty decently. Then investing activity picks up again, you see more 2004 and 2005 funds, which have had acceptable performance and some distribution activity but are still young enough to hold further promise. Commitments probably increase significantly (though not as much as with buyouts) in 2006 and 2007 as the economy was firing on all cylinders. These funds are too young to have produced meaningful returns, as are 2008 funds which most LPs pulled back on investing in due to liquidity issues.

So with this picture of what LPs are looking at let’s go back to the 1999 and 2000 funds: The returns, everyone can find a way to live with. If you’re a 1999 or 2000 venture fund, an IRR of 0% would be above average, and most funds would be happy simply returning commitments at this point. VCs can live with this because most have already moved on: “hey we think we can return all of your capital in what were two really crappy years for everyone, and we’ve learned our lessons and promise not to mess up again.”LPs are probably willing to accept the returns as well. But there’s one problem- so many of these funds have so much capital still unreturned. It’s one thing to have these returns down on paper; it’s another thing to actually achieve them. We’re talking about funds that have to wind down operations in the next year (ok, throw in a couple years of fund extensions, but it’s still going to be a challenge). At year end, the net asset values of 1999 and 2000 funds was some $33 billion – a huge chunk of all venture capital, even after huge write-downs in Q4 of 2008.

What’s going to happen to all these investments and funds? Venture firms are going to have to either get really creative, really lucky, or liquidate at massive discounts. This is a major issue that isn’t talked about enough, but will be over the next couple years, I think. And it raises further questions which don’t have clear-cut answers, like: Will 2005-2007 funds be faced with similar issues if the exit markets don’t improve? And is this more of a fundamental issue with venture capital now? Take, for example cleantech deals and funds – there are already questions around being able to build, develop and exit solar or biofuel companies in five to seven years. I’m not saying venture is dead, there’s definitely a need and place for it, but it’s going to be different. For one, we may be looking at longer fund terms which means more illiquidity and higher return expectations. It may also mean a rise in liquidity options, such as special markets for illiquid assets, and secondary funds specializing in companies or LP interests in venture funds that need to conclude operations.