Shrinkage – Expanded Upon….

Poor investment returns have had as similar of an effect as cold water – the VC industry is shrinking. As a follow-up to comments I posted this past weekend, I wanted to look deeper into recent fundraising data and see what other implications one might draw.

Since 1980 the VC industry has raised $495 billion across 4,333 funds or 1,670 firms (firms typically raise more than one fund). Today the industry is thought to actively manage right around $200 billion of capital and industry analysts estimate that there are about 770 active firms in the US today. There are 415 firms which are members of the National Venture Capital Association (where I am a board member).
VC funds tend to be fully committed within the first 3 – 4 years of being raised, although it may actually take quite a few years – upwards of 8 – 10 years to be fully invested (because of reserves for follow-on investments in existing companies) and at least take that long to be fully liquidated. Most VC funds have a contractual 10 year life. Firms are deemed active if they have raised a new fund in the prior 8 years per the NVCA.
In 2010 nearly $21.8 billion was invested in 3,277 deals but only approximately $12.3 billion was thought to have been raised by VC’s to invest – thus the shrinkage issue. Between 2007 and 2009 roughly 100 venture firms left the industry each year – in 2007 there were just over 1,000 firms – not terribly surprising given the global economic meltdown. Perhaps a more interesting metric though is the number of funds raised; the high water mark in 2000 saw 635 new funds raised (six hundred and thirty five – over 2 per day not counting weekends) which declined to 157 in 2010. In 2000 all those funds invested in 7,970 deals – simply staggering.
More stats. Since 2004 more than $166 billion was raised by VC’s and $168 billion was invested (since 2005, $149 billion raised, $147 billion invested) so things seem to be in reasonable balance. The analysis is tricky because how long it takes to actually invest a fund once raised but the industry has a nice ability to recalibrate itself quite quickly.
So as the economy recovers we would naturally expect to see the amount raised and the amount invested to converge – but we did not see that in 2010. In fact – other than for 2001 – we have never seen such divergence. What happened?
The venture industry this year reported for the first time 10 year returns data which was quite negative – which while expected – sent shockwaves through the LP community. As of September 30, 2010 the 10 year aggregated VC returns according to Cambridge Associates was -4.6% (the 1, 3, 5 and 15 year returns were 8.5%, -2.1%, 4.3% and 36.9%, respectively). Of course LP’s do not and can not invest in a VC index – they get to carefully select specific VC managers – but the message that the VC industry is now structurally challenged and/or unattractive took hold with many large institutional LP’s this past year.

Some other interesting implications and insights when one stares hard at the data…
Average Fund Size: Since 2000 the average VC fund raised was between $130 – $150 million, even throughout the “billion dollar fund” craze. In 2010 the average fund size was $80 million – an incredible decline – which may reflect the “micro VC” or “Super Angel” phenomenon or it may preview that a structural shift is upon us.
Average Deal Size: The average deal size has interestingly remained consistently between $6.25 – $7.5 million over the last 5 years or so. In 2000 it was $12.4 million which clearly reflected all the capital which flooded into the VC marketplace ($107 billion was raised that year – just under $100 billion was invested). My guess is we should expect to see average deal size drop significantly over the next 18 months.
Total Number of Deals: In 2008 there were 4, 025 deals – in 2009 there were 2, 927. Interestingly there were 3, 277 deals in 2010 which reflected the activity of the “Super Angel” as well as the profound waves of exciting innovation across all sectors including cloud computing, cleantech, consumer internet, personalized health, etc. My guess is the pace will remain around 3,000 new deals – maybe down slightly – per year in the near to medium term; deals will just be smaller on average.
This is not just a VC problem – entrepreneurs will have fewer sources of capital to access, there will be fewer cool companies offering great jobs, new medicines/games/applications/devices will not be created. As we collectively witness this recalibration maybe it is time to get out of the cold water and stop shrinking.
What do you think?

8 Comments

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8 responses to “Shrinkage – Expanded Upon….

  1. The negative historical returns are arguably worse than the data suggests. To wit, if you take the one super-duper-extraordinary, likely-will-never-happen-again year of 1999, the 15 year number will fall by a ton.

    also, one year returns are kind of meaningless

    my grand unified theory? i would guess that its not that innovation has declined (in fact its accelerated, i think) or that the current generation of funds or LPs is any less talented or hardworking than predecessors. probably also the opposite — so many more super smart people are interetsed in the field.

    rather, as it does with simply everything, i fear the internet has commoditized technology innovation ideas and startups — and therefore venture investments.

    historically successful venture investments involved intellectual property, usually developed for at least some time, in secret, or away from the spotlight. now the fashionable “meme” is, ideas don’t matter. and patents work against innovation. god, i hate those memes, but so many smart people believe them I have to concede the world has changed. and if ideas dont matter and IP is a negative, then venture returns almost by definition are radically reduced

    my $0.02

    • We really should hang out! I am in near complete agreement. the internet has disrupted everything – including – ironically – the VC industry. That is in part why my firm is so focused on innovation with deep IP which is somewhat insulated from the internet (semis, cleantech, personalized medicine/diagnostics) or we believe that the company can ramp really freakin’ fast.

      I only included the various years’ returns to illumminate the pattern. having said that I believe if we have a great window of liquidity, many large LP’s will come thundering back into the asset – like they did in 1999 – and the cycle will be at risk of repeating itself all over again.

      But yes, one-year IRR’s is like knowing what your one year olds’ IQ is. not relevant.

      love the feedback, steve.

  2. Michael – great post as always.

    I fear that the shrinkage will continue until the venture industry’s returns numbers get dramatically better than they have been.

    Your point about LPs not buying the index is a great one. Though the data shows that even the top performers struggled in the last decade.

    As per Cambridge, top quartile VC returns for 2000-2010 vintage funds have been 9% (net to LPs, pooled mean, US venture)

    That is down from 80% net IRR for top quartile VC returns for 1990-1999 vintage funds

    By the way, the mean net IRR for those decades was -0.2% for the last 10 years and 43% for the 90s.

    So, the spread between top quartile and the venture “index” shrank alot from the 90s to the last decade.

    2000-2010 surely contains lots of funds within the meat of the J-curve and we all know that we suffered two recessions in that time period, so the macro situation was a major headwind for VC.

    And of course, outside of commodities, I’m not sure if many other asset classes did better in the last decade than 9% – I’m sure one of your readers will know for sure.

    All of that said, I am hopeful that the venture industry’s best players will innovate their models to adjust to the new reality. Plus the shrinkage itself – as painful as it is – will lead to better returns.

  3. David Lavallee

    Michael,

    Thanks for the honest and insightful post. It seems to me that if LPs are fleeing the asset class at a gallop, that is precisely the time to plow $ back into venture. The simple math would suggest that smaller aggregate dollars chasing deals will lower the valuations at investment and increase returns. I could also argue that increased focus of VC and mgt talent on a smaller number of companies will improve results.

    From my (biased) perspective, the decline in the exit environment has had a dramatic effect on returns. For the most part, small tech companies are now dependent on the acquisition whims of 20-30 large cap acquirors. The decline in the IPO market really hurts exit valuations. Throughout the ’90s – not just the boom years – we were able to take companies public on much smaller valuations. We took Amazon public on $30m in revenue, BEA on $60m in revenuve and VeriSign on $10m in revenue. These yielded $100B in value eventually. How many of these types of potential stars were sold to Cisco, EMC and Microsoft for sub-$100m in the last 10 years never to see the IPO markets?

    Best,

    David

    • thanks David. we really need firms like yours to fix the liquidity issues. the “Spitzer” reforms crushed VC’s abilities to get liquid predictably and repeatably.

      fewer vc firms will hopefully begin to right-size the top of the funnel issue by creating fewer, more unique early stage companies which buyers (large companies and public investors) will find differentiated and novel – therefore, valuable!

      all you need to do is fix wall street, david!

  4. Pingback: DreamIt Ventures announces its NYC leader — Technically Philly

  5. Jason Jamijian

    Michael,
    Great post. As founder of a service company I sold and an MBA candidate, I’ve been in the running for some VC internships. Lately I’ve been asking myself how well the VC industry is doing as a whole? You just provided some great insight. I attend a lot of start-up events in Boston? Do you make it to any? I’d love to meet sometime and share my background. How can we connect?

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