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The new era of venture capital

You already know the about the state of the venture capital industry in 2009: venture investing down (32%), exits down (14%; slowest exit year for VC backed companies since 1995), fundraising down (56%), IPO’s almost non-existent (8 venture backed IPOs in 2009). It’s a bleak picture for the industry overall, even if there’s a group of us that continue to believe this is a great market in which to be investing (and it clearly is). These stats got me thinking about the future of the venture industry and I thought I’d offer up some thoughts on where we might be headed.

First, let me frame the conversation by stating that I agree with Fred Wilson’s assumption that somewhere around $15Bn is the right “steady state” investment pace for the venture industry as an asset class. At this investment level the return profile of the industry maps to a reasonable expectation of inputs and outputs (the money invested in start-ups as compared to the exit activity). By that measure, we actually still have a ways to go to reach that equilibrium in the venture markets.

graphAccording to VentureSource, $21Bn was invested by the venture capital asset class in 2009, and this amount was the lowest investment total in the 10 years of data that I had access to. The system is still a little bit out of equilibrium, however, as this is a far greater total than the amount of capital raised by venture firms in 2009 ($12Bn). In fact looking back at the past five years $14Bn more has been invested by firms than has been raised. While presumably this will lead (eventually) to fewer dollars invested, the VC fundraising average for the past 5 years has been almost $25Bn, suggesting that we still have a ways to go to get to Fred’s $15Bn bogy. 

What’s even more interesting to me is to consider the nature of this fundraising and the ramifications it has on the industry as a whole. I believe what we’re going to see in the venture industry is a bifurcation of fundraising– basically a barbell on the graph of fund sizes. Large, well known, multi-sector and multi-stage “mega-funds” will be able to raise $750MM or greater at one end of the scale, and smaller, more focused funds will raise $250MM or less on the other end – with a relatively small number of funds in the middle.

Looking at the 2009 fundraising data shows that this trend is already taking shape, three well known funds in the former category closed on over $3Bn in commitments

– NEA ($1.24Bn), Norwest ($1.2Bn) and Khosla Ventures ($800MM). At the bottom end of the scale there were numerous funds that raised money in the $25MM$250MM range).  And while there were certainly a few funds raised in the middle (notably Greylock, Matrix, DCM, CRV and Andressen Horowitz) my hypothesis is that fundraising in this size range will diminish over time as LPs move their money either to a smaller number of diversified, extremely large funds or the larger number of smaller, more focused funds (Foundry is clearly in the latter category).

Thoughts?

  • http://intensedebate.com/people/jud_valeski3968 Jud Valeski

    I don't have my head around these numbers like you do, but from my POV, while I believe there are always great ideas out there that often need capital to come to fruition, the rules have changed such that pre-bubble investment levels just don't make sense.

    The problem is on the exit-side. Without a large IPO market (by volume and total market cap size after 12 months), the "free money" model just isn't there. I'd _guess_ that today's total VC injection numbers are simply back to roughly inflation adjusted "sane" levels; with expected, normal, fluctuations.

    • sethlevine

      without question jud. that's actually how fred came to his numbers (click through the link and check out his post for the specifics). he looked at an expected total exit total per year, assumed a % ownership by venture funds at exit and backed into the investment total that would support a reasonable, industry-wide, irr. clearly, an industry adjustment is needed, although we keep saying that that and keep not quite getting there….

    • http://intensedebate.com/people/sethlevine675 sethlevine

      without question jud. that's actually how fred came to his numbers (click through the link and check out his post for the specifics). he looked at an expected total exit total per year, assumed a % ownership by venture funds at exit and backed into the investment total that would support a reasonable, industry-wide, irr. clearly, an industry adjustment is needed, although we keep saying that that and keep not quite getting there….

  • http://intensedebate.com/people/Healy Healy Jones

    Seth, curious to hear your opinion – the big pension funds can supposedly not "afford" to make a number of smaller investments in smaller sized funds. Do you think this will cut them off from the lower part of the barbell? Or will fund of funds step in? Or will big pension funds step up and contribute a huge % of any random smaller sized firm's fund?

    • http://intensedebate.com/people/sethlevine675 sethlevine

      it may for some healy, although it's probably good news for some funds of funds who will be able to take on this management on behalf of some of the larger pension funds and endowments. i suspect it will mean that some pension funds will figure out how to go "down-market" to smaller funds and for others they will make the decision to cut back on their number of commitments and stick to the major brand name funds. the latter is definitely already happening. the former may take a while to develop (and i suspect the same branding will take place at that end of the markets, and part of the price for entry will be a willingness to invest smaller dollar amounts.

  • http://bothsidesofthetable.com Mark Suster

    I think this is spot on and the decrease in venture funds will not only play out well for our asset class but also for the companies we fund. Also, add Greycroft to the list of new funds raised in the sub $150 million range.

    • http://intensedebate.com/people/sethlevine675 sethlevine

      good point on greycroft – shouldn't have left them off the list. and i agree – while this trend may be viewed as bad by some managers (especially those that have yet to shake out of the industry) the overall numbers still need to move down (fewer funds, fewer dollars, fewer partners, etc.) and this will only be good for the overall return profile of the asset class.

  • http://wac6.com William Carleton

    Seth, a bill was approved by the Senate Banking Committee today that has a provision which, according to BusinessWeek, will eliminate 77% of active angels from participating in seed financings. Other provisions will wreak havoc on startup fundraising (see eg WSJ Compliance Watch column from today). If angel financing is ko’d by Sen. Dodd, that impact may have to be figured into any modelling of downstream VC trends.

  • http://intensedebate.com/profiles/evreeland evreeland

    Seth,

    Great post, and I definitely agree with your prediction. I just finished reading Gompers and Lerner's "The Money of Invention," and this the consolidation of the venture capital industry is one of the prediction they make back in 2001. One of the greatest assets a venture capital firm can bring to its investments is the ability to leverage the products and services of its existing investments in order to create synergies that can benefit its portfolio as a whole. This obviously is easier for the mega-funds to do. However, I also agree that the "fringe" funds will continue to exist, since their advantage comes from being able to utilize their specialized industry knowledge, which would be very difficult for an unfocused fund to acquire, in order to provide exceptional insight and guidance to its investments.

    • http://intensedebate.com/people/sethlevine675 sethlevine

      what's funny is that we're just starting to see in the last year or two the contraction in the industry that's been predicted by many since 2001. it's overall good for the industry, but the process has been a reminder that venture capital can sometimes move slowly….

      also, to be clear, funds are the lower end of the fundraising scale in my mind aren't "fringe" – just more focused (the larger funds will necessarily branch out to cover multiple industries, stage and geography (meaning int'l). smaller funds will be more tightly focused in their investment focus (they'll have to be)…

  • http://www.tidalwavetrader.com Brett Grendahl

    great read! the main thoughts I had after reading was, "what about how much less capital intensive it is to launch promising ventures?" How does that influence the market, greater magnitude of new VC-born ventures or a niche, outlier in firms that raise $50MM or less but can seed 50 or more companies?

    • http://intensedebate.com/people/sethlevine675 sethlevine

      that's definitely influencing the trend on the IT side and also giving rise to a group of "micro" funds that i didn't touch on in the article (think about what mclure, clavier, saccca, cohen, etc have set up).

  • http://rikhter.org Vladik

    What about the breakdown per area of investing? I'd be interested to see a matrix comparing primary areas of investing (Life Sciences, WebApps, Cleantech) vs. the size of the funds. I see your point in the small funds, but I'm fairly sure a lot of those are focused into web applications, software, and other low capital intensive businesses. That middle bracket of the $250MM-$750MM funds will exist for early stage investing in life sciences and cleantech, no? The big funds of $750MM+ will of course play in all of those categories.

  • http://www.insidermonkey.com/hedge-fund/ hedge funds

    Hedge funds performed terribly last year. I don’t think they are “hedged” at all. How are they different from mutual funds (other than charging an arm and a leg for their services)?

    • http://www.sethlevine.com sethlevine

      they’re run by “experts” who charge 2 and 20 for their expertise! good question. more expensive for sure and much fewer limitations on what they can and can’t do (mutual funds are relatively locked up). like all asset classes, the averages don’t tell much – the best performers are orders of magnitude better than the rest…

  • sethlevine

    thanks for the thoughtful comment bill.

    i think the biggest challenge for “fund creep” is the natural propensity in the venture industry for LPs to consolidate their holdings. this is a natural behavior (they want to put more money to work in funds funds that return for them) but acts as a pressure to funds to increase their fund sizes as they raise new funds. and as a gp, i can understand the attraction (great fund size=greater management fee). my personal view is towards the greatest total gp return at a more reasonable fund size, but i think this opinion is in the minority (the history of the venture business is that “successful” funds continue to raise successively larger funds). your point on lp investment bit size is very valid. i touch on that in my response to healy's comment below.

    seth

  • http://intensedebate.com/people/sethlevine675 sethlevine

    thanks for the thoughtful comment bill.

    i think the biggest challenge for "fund creep" is the natural propensity in the venture industry for LPs to consolidate their holdings. this is a natural behavior (they want to put more money to work in funds funds that return for them) but acts as a pressure to funds to increase their fund sizes as they raise new funds. and as a gp, i can understand the attraction (great fund size=greater management fee). my personal view is towards the greatest total gp return at a more reasonable fund size, but i think this opinion is in the minority (the history of the venture business is that "successful" funds continue to raise successively larger funds). your point on lp investment bit size is very valid. i touch on that in my response to healy's comment below.

    seth

  • http://intensedebate.com/people/sethlevine675 sethlevine

    it will be interesting to see how things like fas 157 effect this hypothesis. the regulatory overhead makes it harder and harder to operate a smaller fund (which, i agree, can be a rewarding and profitable endeavor).