Download The Venture Capital Industry`s Crisis: A Problem of

The Venture Capital Industry's Crisis: A Problem of Management and Marketing – Not Finance?
by
Michael Segalla, Dominique Rouzies, and Joseph Ghalbouni
April 25, 2010
Working Copy, Please Do Not Cite Yet.
Venture capital firms are facing tough times in 2010. They had a strong marketing proposition during
the 80s and early 90s. The best among them produced excellent returns. But over the past decade their
internal rate of return (IRR) was dismal. Marketing new funds, typically for a ten year period, is more
difficult for some firms. Their main sources of profitability, IPOs of their portfolio firms, are few and
farther between. Their backup strategy, selling their portfolio companies to other firms, is getting
tougher and the prices lower. In short, business is bad and there are not many signs that things are
improving. How did the industry that gave us computers, made the internet useful, biotechnology
practical and alternative energy sustainable get into this mess? Are venture capitalists the architects or
victims of their own success?
The raison d'être of the VC industry is to find promising products or services that are not ready for
primetime. A VC firm provides financing to an entrepreneur, offers guidance and advice, helps hone the
go-to-market strategy, and eventually helps the portfolio firm expand through an IPO or private sale.
For this the VC firm typically takes a 20-30% ownership stake in the new firm. The primary measure of
success for a VC firm is a high internal rate of return on invested capital, but top-tier VCs also take
considerable pride in having created great, sustainable companies that defined their industries.
Over the past decade it appears that the VC industry, as a whole, has failed to reach its objectives. Chart
1 displays a decade's results from both the American and European markets. After a precipitous drop in
2001, liquidation events (an IPO or private sale) were more subdued until the middle of the decade
when M&A activity rose steadily, peaked in 2007, and then declined every year after, perhaps do to the
credit crunch. The value of European liquidity events and US IPOs were modest by comparison.
Chart 1 - Value of Annual IPO and M&A Activity of VC-Backed Frims in the USA and EU
Value of IPO and M&A Activity of VC-Backed Firms
($M)
2000-2010 (Q1)
$100,000.00
$90,000.00
$80,000.00
$70,000.00
$60,000.00
$50,000.00
$40,000.00
$30,000.00
$20,000.00
$10,000.00
$0.00
US IPO Value
US M&A Value
EU IPO Value
EU M&A Value
Source: Dow Jones VentureSource
Time to liquidity is also an important benchmark in the VC industry. It measures how long it takes from
initial investment into a startup to the time when it is sold. Chart 2 demonstrates that both USA and EU
times to liquidity are continuing to increase, undoubtedly due in part to the credit crunch but also to
increased revenue and profit thresholds that must be surpassed in order to make an initial public
offering.
Chart 2 – Number of Year before the Investment is Sold through IPO or M&A
12
Years to Liquidity
10
8
6
4
2
0
2000
2001
2002
2003
2004
Average M&A (US and EU)
2005
2006
2007
2008
2009 1Q 2010
Average IPO (US and EU)
Source: Dow Jones VentureSource
Even if VC funds did not consistently help a high percentage of portfolio firms perhaps they still return
value to their investors through the occasional "big hit" whose high value makes up for other losses.
One often quoted comment by T. Bondurant French, the CEO of Adams Street, is that the 1998 IPO of EBay alone contributed nearly 25% of the total returns generated by the VC industry over the previous 20
years. Other insiders note that 1999 was the best ever year for VC-backed IPOs netting nearly $70
billion. Excluding the top few deals however brings down the IRR to single, sometimes negative, digits
for the decade. The lengthening time to liquidity displayed in Chart 2 adds to the problem because to be
attractive as an investment category, VC needs to offer competitive returns to alternatives on a riskadjusted basis. Of course, part of that risk-adjustment should include a premium for non-liquidity. If
IPOs are harder and take longer to achieve IRR, ceteris paribus, will be reduced unless valuations
increase. The actual results for the American VC industry since 1981 are displayed in Chart 3.
Chart 3 – Internal Rate of Return for US Venture Capital Firms
Internal Rate of Return for US Venture Capital Firms
90
50
30
10
-10
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Internal Rate of Return (%)
70
-30
Source: Cambridge Associates LLC U.S. Venture Capital Index
Chart 3 exhibits the end-to-end returns from 1,287 U.S. venture capital funds, including fully liquidated
partnerships, formed between 1981 and 2009 complied by Cambridge Associates. The consultancy
calculates these returns after deducting all partnership fees, expenses, and carried interest. The flat
dark blue line is a trend line added by the authors to highlight the flat return on VC investments over
nearly thirty years of about three percent. It seems clear that the value proposition of the VC industry
toward its two clients – investors and portfolio firms – is weak. According to research conducted by
University of Chicago economist, John H. Cochrane, it is not even clear that VC portfolio firms
outperformed other small NASDAQ stocks.1 This means that entrepreneurs accepting VC money and
advice did not necessarily do much better than non-VC backed firms. Furthermore, according to the IRR
data displayed in Chart 3, the limited partners investing in VC funds did not overall receive good returns.
Of course an average can hide significant variations. The two largest pension funds in the USA invested
nearly $80 billion in VC funds. The California State Teachers' Retirement System (CalSTRS) calculates
1
Cochrane, J.H. 2005. The Risk of Return of Venture Capital. Journal of Financial Economics, Volume 75, Issue 1,
January 2005, Pages 3-52. Revision of NBER Working Paper 8066.
that their private equity portfolio (which may include non-VC investments) returned 12.55% IRR on $17
billion of distributed investment capital since its inception.2 The California Public Employees Retirement
System (CalPERS), published its VC investment and returns (Chart 4) from the inception of the program
in 1990.3 Its $65 billion investment returned an IRR of 14.43%4 as of the third quarter of 2009 which
returned an investment multiple5 of 1.69x of the invested capital to CalPERS. Strangely, CalPER's returns
were the lowest during the boom years but it did very well during the first halves of the 1990s and
2000s. These two pension funds are the largest in the USA so their IRRs are probably a significant
indicator of the market's financial health.
Chart 4 - CalPER's VC fund IRR and Investment Multiple
30
3
25
2.5
2
10
1.5
5
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
-5
1
1991
0
Investment Multiple (n)x
15
1990
Internal Rate of Return (%)
20
0.5
-10
-15
0
Net IRR
Investment Multiple (n)x
Note: CalPER does not calculate the IRR of its most recent funds (2005-2009) but does benchmark them against the Venture Economics Custom
Young Fund Universe. As of June 2009 it estimates that its most recent investment's IRR is a negative 8.7% with an IM of .1.
2 CalSTRS. 2009. Private Equity Portfolio Performance. http://www.calstrs.com/Investments/portfolio/privateEquity.aspx
3
CalPER 2009. AIM Program Performance Overview. http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/privateequity-review/overview.xml
4
If the IRR were calculated including the young funds (2005 to 2009) it would only be 8.7% with an IM of .1..
5
The VC industry often calculates returns using investment multiples (IM) expressed as (n)x. For example and IM of 3x signifies that the fund
returned 3 times its investment after expenses.
Source: CalPER 2009. AIM Program Performance Overview.
http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/private-equity-review/overview.xml
These realities suggest that the value produced by VC firms was distorted by exogenous events, such as
the birth of the internet. Many suggest that the golden age of the VC industry was from 1980 to 1995
when it was financing silicon and software. Research conducted by University of Chicago economists
Steve Kaplan and Antoinette Schoar found that from 1980 to 1997 VC funds outperformed the S&P 500
on a capital weighted basis.6 The broadening of the internet unleashed the imaginations of many
creating new business opportunities. This lured investors into VC funds. In Chart 5 the source of VC
capital is displayed showing a surge of investment until after the internet bubble crash. Although the
best VC firms offered solid value long before the internet was a household word it certainly appears that
it excited the passions of many investors who poured money into the sector. Perhaps this dramatic
technological innovation spurred our generation into producing its own tulip mania as firms worked to
harness the potential of the invention and before some economic rationality returned.
The data in Chart 5 also shows that much of the money raised for VC funds did not come from
corporations or financial institutions. 7 During the 1990s many investment consultants started
recommending fund investor to diversity their placements by allocating a percentage to venture funds.
Primarily private funds (pension funds among others) but also some wealthy individuals were attracted
by the strong returns and seeking to diversify their portfolios were willing investors.
Chart 5 - Total Capital Under Management by Firm Type 1980 to 2009 (USD millions)
6
Kaplan, Steve and Antoinette Schoar. 2005. “Private Equity Performance: Returns, Persistence and Capital
Flows,” Journal of Finance, Volume 60, August 2005.
7
2010 National Venture Capital Association Yearbook prepared by Thomson Reuters. www.nvca.org
Total Capital Under Management by VC
Partnerships (millions USD)
300,000
250,000
200,000
150,000
100,000
50,000
0
Private Independent
Financial Institutions
Corporations
Total Managed Capital
Source 2010 National Venture Capital Association Yearbook, Data by Thomson Reuters
The downturn trapped many of these investors in what has been described as a “train wreck in slow
motion” due to the 10-year nature of many funds. Whether the train will stay on the track is an open
question at this point. Fred Wilson, a leading VC industry insider, calls this the VC math problem. He
calculates the amount of value liquidity exit events must reach to generate even a minimum return.
Here is his calculation.
"We need $150bn per year in exits and we are getting about $100bn. That
$100bn produces roughly $50bn in proceeds for venture firms per year. After
fees and carry, that $50bn is around $40bn. Which is only 1.6x [investment
multiple] on the investor's capital if $25bn per year is going into venture
funds. If you assume the investors capital is tied up for an average of 5 years
(venture funds call capital over a five year period and distribute it back over
a five year period, on average), then the annual return is around 10%."8
Wilson argues that a reasonable investment multiple for the risk and illiquidity of VC investments is 3x.
This average probably includes a modest number of winning funds, a majority of lackluster ones, and
handful of wash-outs. Fortunately for the industry as a whole this appears to be the case. Of course this
8
Fred Wilson. 2009. The Venture Capital Math Problem. http://www.avc.com/a_vc/2009/04/the-venture-capitalmath-problem.html
was before the enormous bubble crashed but importantly Kaplan and Schoar found that some funds
consistently had poor results and others consistently good results. Furthermore, a recent consultancy
report offers evidence that small funds tend to offer bigger returns than larger funds9.
This suggests that VC firms with superior talent and tight focus offer attractive returns. Exogenous
events may create opportunity but good management is still needed for the harvest. Therefore it
appears reasonable to attribute attractive value propositions more to the talent of the VC partners than
to exogenous events, market cycles, or the competitive landscape. However, this talent must have been
stretched very thin during the heyday period of VC investments. Typically a VC partner can effectively
manage about ten investments at a time. The amount of money raised by the industry during the late
1990's was staggering so the need to hire talented managers who could advise and monitor the VCs
portfolio companies was obviously great. The total number of new deals (i.e., number of companies
backed by VC money) is displayed in Chart 6 along with the total value of these investments. Notice in
Chart 6 that from 1997 to 2000 there is nearly a 250% increase in the number of new deals. Where did
the VC firms find all the talent they needed to manage the explosive increase in portfolio firms? Since
the value proposition of the VC firms is that they bring managerial expertise in addition to money they
needed to find top quality management talent very quickly.
Chart 6 – VC Track Record (Number of New Deals and Total USD Investment)
9
Weber, Sven, Jason Liou, and Aaron Gershenberg. 2010. Dialing Down: Venture Capital Returns to Smaller Size
Funds. SVB Capital Financial Group. April 2010.
$120,000
$100,000
7,000
6,000
$80,000
5,000
$60,000
4,000
3,000
$40,000
2,000
Total Investment (Millions of USD)
Number of New Deals Financed in USA
8,000
Millions
9,000
$20,000
1,000
-
$-
Number of New Deals
Total Investment
Source: Thomson Reuters
It seems highly unlikely that VC companies could fill all those new positions as quickly as they added
portfolio firms. During this period the partners of VC firms must have been overextended. The best of
the VC firms would have an advantage in hiring experienced managers but other lesser known firms
would find it more difficult to attract the best P&L experienced executives. VC insiders affirm that many
of these new hires had less hands-on management experience. Though very smart, a thirty year old
finance major with a newly minted MBA cannot add the same value to a portfolio company as senior VC
partners with a broad range of both operational and VC experience can. It takes at least 10-15 years of
operational management experience to effectively advise portfolio company executives.
Summing up this period is bound to ignore many subtle factors and outcomes. But it seems that we
might say the following. VC firms were major contributors to launching many technology firms in the
1970s and early 1990s returning healthy profits to investors. The opening of the internet in the late
1990s ramped up their IRR spectacularly for the entire decade. Perversely this attracted too much
investment capital too quickly from too many VC investors which in turn funded too many inexperienced
VC partnerships who competed for portfolio companies. Many of these were then sold to over
optimistic buyers in a bubble market. Eventually the bubble popped and the damage is now being
cleaned up by the industry. A brutal epitaph no doubt but substantially supported by the data.
So what is the future of the VC industry? From the perspective of entrepreneurs good ideas will
certainly continue to percolate to the surface of the market and that the smartest entrepreneurs will
pass up the most generous financial terms to have access to the best management advice. According to
several highly placed VC partners, they are running business services firms targeting two very different
customers. They need to better market themselves to entrepreneurs. Simply offering the most
attractive financial backing will not be enough to help develop high value, sustainable portfolio firms.
From the perspective of the limited partners VC firms are already hearing a clear message. The top tier
firms in the VC industry can continue business more or less as normal. They can set the terms, generally
meaning 2.5% in management fees and 30% in carried interest. The next tier must negotiate harder for
their terms and may have to accept lower management fee and two thirds of the carried interest earned
on average by the majors. Other VC firms will have an even tougher time raising new funds unless they
have uniquely specialized strategies. All VC firms will need to spend more time effectively marketing
their skills to investors especially explaining what happened over the last decade.
From the perspective the stock markets and acquiring firms it appears that VC firms will need to set
realistic value propositions. Buyers will be more attentive to the sustainability of portfolio firms and
more judicious about the market potential of the firms' products. Market value will replace market
hype.
In the end it is success that counts in the VC industry. It is also highly likely that VC firms will return to
their roots of being patient, hands-on consultancies that nurture their investments until they are
sustainable while returning healthy dividends to deep-pocketed, risk-taking investors.
The authors thank the generous advice and insights offered by venture capital professionals, executives
from VC-backed firms, fund investment officers, commentary from academics engaged in private equity
research and data made available by the Dow Jones VentureSources, the National Venture Capital
Association.