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Q1 2014
Stars align for resurgent
venture capital industry
While capital flows into VC may have slowed, investors willing to put money to work
in a time of capital drought look set to reap the rewards, says Weathergage Capital
Published by
Reprint from Limited Partner Q1 - 2014
LP perspectives
“The data contradicts the
prevailing meme that
‘venture is dead’. For
those investors that may
have turned away from
venture capital, I would
definitely urge them to
take a second look”
Weathergage co-founder and managing director Judith Elsea
Q1 2014
Weathergage Capital
Stars align for resurgent
venture capital industry
While capital flows into VC may have slowed, investors willing to put money to work
in a time of capital drought look set to reap the rewards, says Weathergage Capital
T
he stars are aligning in the world of venture capital in a way
they haven’t done since the mid-1990s, according to Tim
Bliamptis, partner at US fund of funds Weathergage Capital
– with the industry seeing a convergence of fundamentals such as
returns, capital flows and a recently-changed exit environment.
In addition, increasing numbers of venture capital-backed
companies are achieving valuations of more than $1bn, and the list
is gaining new names all the time. Despite the recent fundraising
and investment struggles venture capital has endured, now could be
the right time to put money to work. He says, “As an investor we
are taught to look at the fundamentals first, and the fundamentals are
pretty appealing at the moment.”
However, as technologies continue to evolve and change, it
remains difficult to catch the innovation wave. Understandably,
investors prefer to focus on proven winners, says Weathergage cofounder and managing director Judith Elsea.
“Whether you are and LP, a GP or an entrepreneur, the industry
is a demanding one. Technologies change rapidly and it can be very
difficult to catch even one wave of innovation, much less multiple
waves of innovation, which is what we’re experiencing today.
“The best venture capital groups have been able to keep up by
injecting new talent and fresh networks into their firms. Some of the
successful adaptors are incumbent firms and some are new teams
coming to the fore. Regardless of the path taken, ending up with
partners who are potent with the visionary entrepreneurs is key to
long term success.”
Second look
The VC-focused fund investor was founded in 2006, with the belief
that venture capital remains an often misunderstood asset class, with
some of the poor returns the market has suffered stemming from
investors pitching in to an area which they do not fully understand.
Elsea says, “Venture capital is the art and science of adding capital
and other forms of non-monetary value to emerging companies. Nonmonetary value-add sounds straightforward, but it is very hard to do
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well. Accurately gauging a venture capitalist’s effectiveness with his
or her portfolio companies is one of the challenges faced by limited
partners. Another challenge is measuring the relative success of
particular deals and indeed, individual entrepreneurs.
“A comprehensive assessment can only really be done after the
fact. Yet as investors contemplating new VC commitments, we are
required to make this assessment mid-course.”
Elsea was formerly chief investment officer of the Ewing Marion
Kauffman Foundation from 1993 to 2001, where she oversaw a
$2bn investment portfolio, including the commitment of more than
$600m to US early-stage venture capital funds and other private
equity partnerships.
It is hard to argue with the fact that returns in venture capital as a
whole have been declining for a number of years, she concedes. “It
has certainly been true that VC industry returns for the post bubble
vintages (roughly 2000-2006) were considerably below expectations
and liquidity in the form of distributions was not where it should
have been. As a result, the amount of fresh capital committed to
venture capital funds has been in decline for many years.”
However, Elsea is also quick to point out that the value of
current trends in technologies - including the life sciences - is now
showing up in returns. “If you look at the data, venture funds have
outperformed US buyouts by an average 200 basis points since
2006 – and the recent plethora of IPOs and acquisitions is likely to
raise VC returns still further,” she says. “The data contradicts the
prevailing meme that ‘venture is dead’. We think what is dead is
that meme. For those investors that may have turned away from
venture capital, I would definitely urge them to take a second look.”
Floods & droughts
Easier said than done, says Bliamptis, with memories still fresh for
many LPs of venture capital’s underwhelming performance. “The
decade starting 2000 for US venture capital was distinctly average,
and that’s being kind. However, if you look at returns from funds
raised in the second half of that first millennial decade their average
LP perspectives
Tim Bliamptis: “Investors want to buy IPOs again”
Upper echelon
Translating this into a workable fund-investment strategy is clearly
easier said than done, with another key determinant of success
often down to identifying and accessing the outperforming funds
that inhabit the industry’s upper levels.
Elsea says, “It has always been the case that the top firms deliver
the bulk of returns; this is just a fact of the industry. Every now and
then you will get an environment where almost all firms’ absolute
returns verge on the higher end, but that isn’t the norm. It sounds
over-simplified, but the primary job of the investor is finding the
best positioned groups and then getting meaningful access to them.
It has long been the case that investors need to dig deeper than
looking to Silicon Valley and picking the biggest funds or most
recogniseable names. She adds, “Sometimes the best groups are
from the pool of established, brand-name funds but some of the best
positioned groups today are ones that didn’t exist five years ago.”
Alongside a complement of “top performers” that inhabits
Weathergage’s portfolio, the firm also looks to identify differentiated
or interesting funds that it feels have the potential to form the
next generation of winners, with the top quartile far from being an
established constant.
“We are totally focused on how this top echelon of managers
regenerates and renews itself, because if we get it right extraordinary
returns may well follow,” Elsea adds.
Historically, entrepreneurs have appeared closely attuned to
individual brands of venture capital firms. While in some respects
this hasn’t changed, they are now far more interested as to what VCs
can bring to the table when it comes to adding value, and are no
longer going to simply take the money and be grateful for it.
“They want more,” says Elsea. “Increasingly, entrepreneurs are
thinking about how they relate to their investors, and whatever the
profile of the VC, if they can prove that they understand that they can
relate to the company and its own market niche, then this can often
be just as impressive as a brand name.
“They will often respond much more positively to this approach,
and as a result, some of these off-radar VC firms are able to build
similarly impressive networks and portfolios as some of the bigger
players, and potentially could be joining them in the coming years
when returns start rolling in.”
When it comes to investing amid the vagaries of both technology
and venture capital cycles, the firm aims to ensure that it does not
get overextended when times are good. Bliamptis adds, “It’s just
not realistic to try and go to the market and allocate your capital
in drought times and get out of the business at flood times. With
process and discipline an investor can maintain a steady course –
which can add hundreds, even thousands of basis points of value
for a dollar-weighted investor. And at the end of the day, we’re all
dollar-weighted investors.”
While there has been a reasonably robust M&A environment for a
number of years in the US, offering a “persistent and steady engine
of liquidity”, the home-run returns of recent IPOs have done much to
kickstart interest.
“What has happened in the last year, and has intensified towards
the end of 2013, is that venture-backed IPOs have come out of
their coma, arguably kickstarted by Facebook’s IPO back in 2012,”
he says. “A number of companies from the IPO class of 2012 are
currently trading far above their initial offering price.”
He adds, “If you are a public equities manager and the bestperforming stocks from the previous year were IPOs, then you would
be seen to be giving up huge relative performance if you continued
to swear off them. These guys are coming back and investors want to
buy IPOs again.”
Out of the funk
“We are seeing companies with very attractive fundamentals
converging with an IPO market that is heating up. It is not fully
realised, but I am confident that a few more strong IPOs will have a
significant impact on venture capital returns,” says Bliamptis.
The emergence of the IPO industry market from its “funk” could
yet prove to be the last piece of the puzzle for the venture capital
space. However, capital flows remain modest and the asset class
continues to attract criticism for its relative lack of returns.
Harking back to Kaplan’s assertion that drought years yield the
best returns, the current investment environment could provide a
telling illustration, he notes. “We have not seen conditions like this
for 15 years. Whether we go back to the returns that were being
generated in the mid-1990s remains to be seen, but we’ve definitely
turned a page on the dismal returns of the early 2000s.”
And for the LPs, there continue to be mixed opinions about
venture capital, says Elsea. “There is a cadre of investors that are
on top of the increasing returns and recent exit activity, but there
are even more LPs who are not thinking about venture anymore.
Recent positive developments may just be passing them by.”
Q1 2014
Weathergage Capital
returns are up maybe thousands of basis points over the last three
years. They’re already well above the returns of those earlier vintage
years and they’re still climbing. If this IPO market persists returns
are going to accelerate further.
“I would say this pick-up in returns is more than just normal
maturation and the recent vintages have benefited the most.”
Whether venture capital or technology, navigating the ebbs
and flows of these often interlinked industry cycles poses an
ongoing challenge. “If you don’t have a good technology cycle, it
is hard to make returns,” he adds. “If you don’t have a good exit
environment it’s hard to make big returns. And finally, if you have an
overwhelming amount of capital, it tends to depress returns.”
One factor that Bliamptis says intensifies the investment cycle
is the fluctuating pattern of capital floods and droughts. “These are
faced in all investment markets, and whatever your asset class it
behoves you to know which scenario you find yourself in at any
given time,” he points out.
He also refers to research from Professor Steve Kaplan at the
University of Chicago on the relationship between the supply of
capital and the subsequent returns in venture capital. The report
clarified what many people have long suspected. Looking at vintage
years between 1984 and 2008 and finding that returns from funds
that were from years that experienced capital drought historically
produced very strong returns, with average multiples north of three
times net. Meanwhile, the middle years are not far behind, though
the flood years are just “downright ugly”, Bliamptis notes, and barely
more than 1x net on average.
The research paints a pretty clear picture of capital supply as a
strong determinant of returns. By applying this methodology, 2013
looks to be on the “dryer side of normal”, Bliamptis says, and as
such remains “pretty comfortable” with where the supply of capital
is at the moment.
“The key is to have
the discipline not to
overweight the flood
years and have the
confidence to step up
during the drought years”
“By definition, the biggest amount of money goes into these flood
years, and is rewarded with a poor return as a result. This means the
bulk of the capital invested in a cyclical asset class will not have a
positive experience because the bulk of the capital ends up invested
at the peak,” he says. “If you put four times as much into the bad
years as the good years, then on a dollar-weighted basis, investors
get slaughtered. The key is to have the discipline not to overweight
the flood years and have the confidence to step up during the drought
years, though this is easier said than done.
“You can see from some LPs’ track records how drunk they got
during the peaks and how stout a constitution you need to stay with
it when things look dire,” he says. “The Kaplan data shows that
resisting the temptation when things look good and stepping up in
hard times has a huge pay-off.”
VC aims to capitalise as ‘software eats the world‘
The largest driver for the venture capital
industry is the rapid innovation taking place
in the software space, with VC fundamentals
often closely tied to technology cycles, says
Weathergage Capital’s Bliamptis.
“We happen to be at the point in the cycle right
now where there is a confluence of innovation that
is pretty unique,” he explains. “What is happening is
smart entrepreneurs can assemble game-changing
businesses from a toolkit that has been developed
over the last five to ten years.
“Everyone has broadband, super smart phones,
iPads – these things didn’t exist in their current form
ten years ago, and are now available off the shelf
and are enabling entrepreneurs. It is easier than ever
to write software and it is cheap to host it.”
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With the infrastructure largely in place, the
opportunities to start and create valuable franchises
move “up the stack” - to applications that are built
on that infrastructure, he says. For these application
companies, vision and design join technology as
key drivers of value.
“All those pieces are in place and the venture
investment has migrated to how people are putting
these together and what applications are available”
Bliamptis adds, “One of our managers coined
the phrase ‘software eats the world’. We see this
happening one bite at a time. We are seeing
hundreds of software-based companies, each
disrupting a distinct industry and occasionally
creating new ones.
“It is not just the software business, it is all
business, and all industry. Software writ large is at
the heart of so much industry change. This toolkit is
being applied to industries that may not have seen
this kind of innovation in 50 years, if ever.
“On the fundamentals side you have an
enormous wave of creativity across the economy.
An analogy to an earlier age would be Federal
Express, which was made possible by the advent
of jet engines. FedEx is not in the jet engine
business, it delivers packages, and the companies
we are seeing today are not necessarily software
companies, but what they can offer is based very
firmly on software.”
He points out, “Software is not the only driver
we have right now, but it is the biggest, and the
furthest-reaching.”