Mixed Signals

Usually you can gauge the health and general attractiveness of venture capital by looking at what’s going on with fundraising, investment levels, valuations and exits. What is deemed healthy or attractive in most cases depends on whether you’re an entrepreneur, venture capitalist or limited partner, but it’s typically pretty clear if times are good or bad for you. Recently though, it seems as if the indicators are sending very mixed signals. Here’s a quick overview of what’s happening:

Fundraising: Fundraising has been brutally difficult for venture firms ever since 2008. It seemed as though the situation was improving in the first quarter when we got off to the best annual start for fundraising since 2001. However, the quarter’s improvement was really driven by three firms raising billion dollar funds – Bessemer Venture Partners, Sequoia Capital and JP Morgan (their Digital Growth Fund – not really a venture fund in the traditional sense). Non big-name firms have had real difficulties raising funds, as evidenced in the second quarter of the year which featured the lowest number of funds garnering commitments since the first half of 1995. It can be argued that this is actually a good thing (for limited partners at least) since historically, lower fundraising has been correlated with higher returns.

Investment Levels: Venture investment activity has been volatile since 2008 but generally has displayed an upward trajectory, in both, the number of deals and total dollars invested (in fact, in the second quarter investment in Internet-specific companies rose to the highest quarterly level since 2001). A couple things are troubling. For one, investment continues to outpace fundraising and at some point will have to come down as many firms currently deploying capital will be unable to raise new funds. Another issue is that the rise in overall number of deals is being driven by seed and early stage investments while the rise in overall dollars is being driven by later stage deals. This means companies in between are competing for a smaller pool of capital. It can be argued that this is good thing because only those companies with proven models are making it to later stages, but I think the dynamic is also reflective of the overly rapid institutionalization of seed investing and a huge interest that formed around specific later stage companies.

Valuations: According to the Fenwick & West Venture Capital Barometer, Silicon Valley companies funded in the second quarter of 2011 showed an average price increase of 71% - up significantly from the 52% reported for the first quarter and the highest such result since 2007. With the third quarter seemingly very unsettled it should be interesting to see where things go. Anecdotally, seed and early stage deals still seem to be commanding high valuations. This is in part due to a huge influx of capital competing for deals as so many more venture firms and individuals are jumping into seed investing.

Exits: The exit market often reflects what’s happening in the public markets and broader macro environment and so right now there seems to be a lot of uncertainty. Officially, according to NVCA statistics, we are on pace to have the best year for VC-backed exits (both via M&A and IPO) since at least 2007. However, a lot of the activity is being driven by Chinese companies and it seems as though exit activity seems to have slowed in the third quarter (we’ll know officially soon). Large companies still have lots of cash but seem to be getting more selective again. The IPO window looks to be shrinking and many companies that have recently IPO-ed have not performed so well post-IPO. Good companies are definitely “exitable” but the bar seems higher than it was just a few months ago.

So what do we have? Fundraising data indicates it might be a great time to be an investor in venture capital. Investment levels are telling us that venture capitalists are excited about young companies but valuation data tells us that deals are as pricey as ever. The exit market had been great through the first half of the year but things are starting to look shaky – in line with the public markets and the macroeconomic environment. On one hand things are great, on the other, maybe not so much. The only way I can make sense of it all is to remember that the venture industry is significantly more cyclical than most people realize. We clearly were headed up out of a trough but now I think the industry is in a holding pattern trying to figure out whether or not it should continue moving upward or if it’s already peaked. It’s important to note that venture capital returns of late have been great.

What I think will happen is that the lower fundraising levels (which are, or should be, the “new normal”) will eventually lead to a slowdown in investment activity and, in turn, a decrease in valuations. All of this can be considered good or healthy in many respects.  The exit market is hard to predict and hedges a lot on the macro environment but it’s safe to say that good companies can still be attractive acquisition or IPO candidates. On the whole though, I doubt even an amazing exit market will lead to a boost in fundraising so investment activity should really remain steady or decline. Perhaps the industry data has just been hard to make sense of because the effects of the “new normal” levels of fundraising haven’t yet trickled down to investment valuations. It should be very interesting to see how the rest of the year shakes out and where all the variables stand at year – only then do I think we’ll know if we’re moving out of this holding pattern and in which direction. 

The Rise of Funds of Funds Another Sign of The Times

The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.

 

Source: Dow Jones Private Equity Analyst

We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds  managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.

In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).

Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.

A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments.  In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape. 

Fundamental Shifts in Venture Capital Becoming Clear

I was about to do an update on the Venture Capital Overhang I’ve been tracking, but instead of the typical chart this time around I thought it’d share something interesting that stood out - for the last three quarters we’ve now seen US venture capital investment outpace fundraising (and the quarter before it was almost even):

The only other time in recent history where we’ve seen investment activity even come close to surpassing fundraising was  in 2003 following the bursting of the tech bubble. What does this mean? We have numbers clearly indicating that a fundamental shift in the industry is underway. In previous posts, I’ve mentioned how fundraising could not forever outpace investment as dramatically as it had been doing so over the past decade (creating an ever increasing “overhang” of un-invested capital, or dry powder).  Fundraising has now slowed dramatically, while venture capitalists rightfully continue to invest in what is a good environment to be doing so in.

A drop in fundraising was expected, but we may now have a “new normal” for fundraising levels. There is clearly a new standard for raising capital now, especially with so many limited partners still skeptical of the asset class. At first a fundraising slowdown was blamed on the “denominator effect,” and later it was said that many limited partners were waiting to get a clearer picture of their allocation balance before beginning to commit again. But the truth is that most limited partners will not return to commitment levels of the past and therefore we will see a natural attrition of firms in the future.

Investment may outpace fundraising for a while - until fringe firms run out of capital and are unable to raise new funds. Just as I had said fundraising could not outpace investment forever, the converse holds true as well and we surely will not see investment outpace fundraising forever either.  Think of this period (of investment outpacing fundraising) as sort of a market correction. When we had huge overhangs of capital, venture capitalists knew there were others out there with capital to deploy as well which drove up valuations and reduced returns. What we should see after this correction is fewer firms - this means higher quality firms will remain, investing in better deals at better valuations and generating better returns.

The differential in fundraising and investing should be interesting to monitor. Too large of a crossover into fundraising outpacing investment again may signal another bubble, while a leveling out should indicate a healthier venture capital industry.

Note: Data from PwC, Thompson Reuters and the NVCA.  And for clarity, the VC overhang now stands at $88 billion – down from $89 billion at the end of 2009. 

Venture Capital Overhang: Shrinking

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. 

Venture Fundraising in 2010

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.