Above the Crowd

What Is Really Happening to the Venture Capital Industry?

August 24, 2009:

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Many are speculating that the year two thousand and nine represents a fundamental turning point for the venture capital industry. Some are arguing that the industry is in dire straits after years of poor performance. Others have argued that the math simply does not work for the industry’s current size. Another theory suggests that permanent challenges with the IPO market call into question the fundamental economics of the VC industry. Lastly, some credible authors have suggested that things are so bad that a federal bailout may be in order.

What is really happening in the venture capital industry? It is indeed quite likely that the venture industry is in the process of a very substantial reduction in size, perhaps the first in the history of the industry. However, the specific catalyst for this reduction is not directly related to the issues just mentioned. In order to fully understand what is happening, one must look upstream from the venture capitalists to the source of funds, for that is where the wheels of change are in motion.

Venture capital funds receive the majority of their funds from large pension funds, endowments, and foundations which represent some of the largest pools of capital in the world. This “institutional capital” is typically managed by active fund managers who invest with the objective of earning an optimal return in order to meet the needs of the specific institution and/or to grow the size of their overall fund. These fund managers have one primary tool in their search for optimal returns: deciding which investment categories (referred to as “asset classes”) should receive which percentage of the overall capital allocation. This process is known in the financial field as “asset allocation.”

Asset allocation is the strategy an investor uses to choose specifically how to divide up capital amongst asset classes such as stocks, bonds, international stocks, international bonds, real-estate funds, leveraged buys-outs (LBOs), venture capital, as well as other obscure classes such as timber funds.  Some of these asset classes, such as stocks and bonds, are known as “liquid assets,” because these instruments trade on a daily basis on exchanges around the world. For these assets, investors can be quite sure of the exact value of their holdings, as the price is set continuously in the market. Also, if they need to sell, there is a ready market to accept the trade. Illiquid assets, also known as alternative assets, include all the other investment classes that do not trade on a daily exchange. These “private” investments (as compared to “public” liquid investments) are considered higher risk due to their illiquidity, but also are expected to earn a higher return. Some hedge funds are included in alternative assets either because they themselves invest in illiquid investments or because they put strict limitations on the trading capability of the institutional investors, rendering themselves “illiquid”.

graphAsset allocation is a well-studied area within the field of finance. A prototypical U.S.-based asset allocation model might allocate 25% to U.S. stocks, 30% to U.S. debt, 25% to international equity and debt, and let’s say 20% to all alternative assets. Within alternative assets, LBOs might be 60%, and venture capital could be as low as 10% (of the 20%). As a result, venture capital could be as low as 2% of a institutional fund’s overall capital allocation. Most people fail to realize just how small venture capital is in the overall scheme of things.

Very generally speaking, experts and academicians have considered it “conservative” to have a smaller allocation to all alternative assets reflecting the risks of illiquidity, the inability to ascertain price, and the higher difficulty in analyzing the non-standard vehicles. It is a fairly straightforward, conservative investment approach to favor liquidity and certainty over absolute potential upside (this is the same argument for holding bonds over stocks).

Over the past decade or so, a large number of very influential institutional funds have substantially increased their allocation in alternative assets. In some extreme cases, these investors have taken this allocation from a conservative amount of say 15-20% to well over 50% of their fund. Many people suggest that David Swensen at Yale was the original architect of a strategy to adopt a much higher allocation to alternative assets. Regardless of whether he was the leader or not, several funds simultaneously adopted this higher-risk, higher-return model. (For a more detailed look at how this evolved and why, see Ivy League Schools Learn a Lesson in Liquidity and How Harvard Investing Superstars Crashed. For an even deeper dive including comparative asset allocation models see Tough Lessons for Harvard and Yale.)

lbo_dataContributing to this dynamic on the field, the early movers to this model were able to post above-average returns.* Also, due to the high disclosure policy of most universities, these above average performances were often touted in press releases. This “public benchmarking” put further pressure on competing fund managers who were not seeing equal returns, which as you might guess, led to them mimicking the same strategy. As a result, alternative assets have grown quite substantially over the past ten years. This is perhaps best seen in the size of the overall LBO market. The included chart shows the money raised in the LBO market over the past 30 years. As you can see, the amount of dollars pouring into this category over the past five years is nothing short of breathtaking.

The market contraction of late 2008 and early 2009 severely compromised the high-alternative asset allocation strategy. The liquid portion of  average portfolio contracted as much as 30-40%, which had two resulting impacts. Initially, this resulted in most fund managers having an even higher portion of their funds in illiquid investments. Ironically this was largely an accounting issue. Most likely, the illiquid pieces of their portfolio had declined just as much, but as illiquid investments are not valued on a day-to-day basis, they simply were not properly discounted at this point (over time they “would” and “are” eventually coming down). But with one’s fund already down 30% or so, no one is eager to further decrement the value. Despite that this may have only been an “accounting” issue, it presented a problem nonetheless, as many fund managers have triggers that force them to reallocate capital if they go above or below a certain asset allocation. This is one of those policies that encouraged selling at a point that may be the exact wrong time, contributing to further declines.

A second and more complicated problem also emerged. It turns out that when an institutional investor “invests” in an LBO fund they don’t actually invest the dollars all at once, rather they commit to an investment over time, which is “drawn down” by the LBO manager (venture capital works in the same way, but once again is a much smaller category). As these funds substantially increased their commitment to the LBO category, they were de facto increasing a guaranteed negative cash flow in the future to meet these draw-downs. Now, with portfolios out of balance, and lack of new liquidity events from the M&A and IPO markets, these funds have cash needs (to meet the draw-downs) that are not offset by cash availability. If anything, the universities and endowments these managers represent want more cash now to deal with the difficult overall economic environment.

To meet these new liquidity needs an institutional investor could:

  1. Sell more of it’s liquid securities. This is problematic because it further compromises the target asset allocation.
  2. Try to sell the LBO commitments on the secondary market. As you might suspect the secondary market is extremely depressed. Some have even suggested that due to the forward cash need on an early LBO fund, an institution might have to “pay” to get out of the position, and to encourage someone else take on the future cash commitment.
  3. Default on the commitment. While this does have penalties in most cases, it would not be out of the realm of possibilities for this to occur if the investor has lost faith in the manager, and it is early in the fund (with more cash needs in the future).
  4. Try to raise more capital. Not surprisingly, donations to foundations and universities are down dramatically due to the overall decline in the capital markets. This makes this strategy unlikely.

As you can see, none of these options are overly compelling.

If this is not bad enough, many institutional fund managers and the groups to whom they report (such as a board of trustees) are now second-guessing the high-alternative asset allocation model. As a result, they may desire to return to the more conservative and more traditional asset allocation of 10-20% allocated to alternative assets. Ironically, they are in no position to rebalance their portfolio precisely because they lack incremental liquidity. Think about it this way – it is very easy to shift a portfolio from liquid assets to illiquid. You simply sell positions in highly liquid securities, and buy or commit to illiquid ones. Going the other way is not so simple, as there is no ability to conveniently exit the illiquid positions.

This is a very long explanation, but the punch line is that as these large institutions adjust their portfolios and potentially abandon these more aggressive strategies, the amount of overall capital committed to alternative assets will undoubtedly shrink. As this happens, the VC industry will shrink in kind. How much will it go down? It is very hard to say. It would not be surprising for many of these funds to cut their allocation in the category in half, and as a result, it shouldn’t be surprising for the VC industry to get cut in half also.

One could argue that poor returns in the VC industry is the primary reason the category will shrink and that, as a result, the VC industry could be cut even further – or perhaps even go away. There are two key reasons that this is highly unlikely. First, one of the key tenets of finance theory is the Capital Asset Pricing Model (CAPM). The CAPM model argues that each investment has a risk, measured as Beta, which is correlated with return vs. that of the risk-free return. Venture Capital is obviously a high-Beta investment category. As of August 3rd, 2009, the S&P 500 has a negative 10-year return. As a higher-Beta category, no rational investor could reasonably expect the VC industry as a whole to outperform in a catastrophic overall equity market. In fact, the expectation would be for lower returns than the equity benchmark. This multiplicative correlation with traditional equity markets is the exact same reason that venture capital outperformed traditional equities in the late 1990’s. The bottom line is that no institutional investor should be surprised by the recent below-average performance of the entire category, all things being equal.

The second reason the category will not be abandoned is contrarianism. Most students of financial history have read the famous quote attributed to Warren Buffet, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” One of the biggest fears of any investor is to abandon an investment at its low point, and then miss the corresponding recovery that would have helped offset previous poor returns. While this mindset will not guarantee the 100-year viability of the venture capital category, it should act as a governor on any mass exodus of the category. The more people that exit, the more the true believers will want to double-down.

So when will this happen? One thing for sure is it will not happen quickly. The VC industry has low barriers to entry and high barriers to exit. Theoretically, a fund raised in 2008, where all the LPs have no plans to commit to their next fund, may still be doing business in 2018. VC funds have long lives, and the point at which they decide to “not continue” is usually when they go to raise a new fund. This would typically be 3-5 years after they raised their last fund, but could be expanded to 5-7 years in a tough market. In some ways the process has already started. Stories are starting to pop up about VC funds that were unable to raise their next fund. Also, some entrepreneurs are starting to discuss favoring VCs of which they can be confident of their longevity. All in all, one should expect a large number of VC firms to call it quits over the next five years.

How should Silicon Valley think about these changes? It is important to realize that there are approximately 900 active VC firms in the U.S. alone. If that number fell to 450, it is not clear that the average Silicon Valley resident would take much notice. Another interesting data point can be found in the NVCA data outlining how much money VCs are investing in startups (as opposed to LP’s committing to VC firms). VC firms invested about $3.7B in the second quarter of 2009. Interestingly, this number is about half of the recent peak of around $8B/quarter. It is also quite similar to the investment level in the mid 1990s, prior to both the Internet bubble, and the rise of the aggressive asset allocation model. So from that perspective, this, meaning the investment level we see right now in Q2 of 2009, may be what it is going to be like in the future.

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future. This is not simply because less supply of dollars will give VCs more pricing leverage. We have seen over and over again how excess capital can lead to crowded emerging markets with as many as 5-6 VC backed competitors. Reducing this to 2-3 players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market. Additionally, at a stabilized market size of well over $15B a year, there should be plenty of capital to fund the next Microsoft, Ebay, or Google.  

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* To date, it is unclear if these “above-average” returns were a result of the liquid half of these portfolios or the illiquid half. As we mentioned earlier, it is extremely difficult to ascertain the actual value of an illiquid investment. In many cases, the institutional fund manager relies on the investment manager of the asset in which they invested to prescribe a value to the investment, even though they may be highly biased. If it turns out a large portion of the “above-average” returns of these early adopters of this more aggressive strategy were on the illiquid side, we may have yet again another example of the dangers of mark-to-market accounting.


  1. Ted Rheingold August 24, 2009

    Hi Bill,

    Great, big-perspective overview. Very needed right now. Thanks for offering the deep understanding.

    The questions running through my mind are:
    Was the VC asset class significantly rewarding to institutional capital for more than a year or two in the last decade? Was it a net gain for the private equity investors over the last decade? Did the quieting of the IPO markets or other changes in the landscape since 2001 turn a profitable investment class into one that was prohibitively illiquid?

    Or was the class a rewarding steady earner that would have kept giving all the PE investors the returns they needed in the years to come if the cash crunch hadn’t moved institutional capital away from the VC class?

    I for one think a more reasonable, strategic, “true believer” VC landscape will be of great benefit to entrepreneurs, VC and institutional funds alike. IMHO the growth in capital since 2004 increased faster than other required resources such as personnel, marketing inventory and post-early adopter customers.

    • Mark Sigal August 25, 2009

      Excellent post, Bill. Logic seems to suggest that more dollars will flow to fewer proven funds, but one wonders whether that mitigates risk (separates the VC wheat from the chaff) or increases it (aligned strategies across fewer funds).

      Also, how this all flows down to the angel investor segment, who long term face a muddier path to getting their companies funded (beyond angel stage).

    • Andy August 25, 2009

      What about the role in Sarbanes-Oxley in all of this? SOX has driven many companies to go public in Europe to avoid the American market. The number of IPOs since SOX passed has plunged, and why not? Going public means adding millions in expenses with no ROI. If the Supreme Court does vacate SOX (it’s being challenged on Constitutional grounds), I’ll bet the VC market explodes.

    • bgurley August 25, 2009

      i think it certainly is a factor, but not everything. It is really hard for American companies to avoid SOX. Rules have relaxed recently.

  2. Jeff Bussgang August 25, 2009

    Bill – this is a great post and a nice summary of why VC will remain a smaller but still very impactful asset class. I think the other overlay worth mentioning is that the sheer pace of innovation remains very high. Medical breakthroughs, the mapping of the genome, miniturization, wireless advancements, energy-related research, globalization – almost everywhere you look, there are major shifts that enable the creation of large, valuable businesses. So long as innovation continues, the VC industry will thrive – whether lean and mean or fat and happy simply depends on the economic cycle.

  3. Adeo Ressi August 25, 2009

    This is a fantastic piece. Can we republish with full attribution and links as an Open Letter on TheFunded, please? Great work!

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  5. William Mougayar August 25, 2009

    That’s a great objective analysis. Is it fair to say that, with this uncertainty hanging over the industry- the resulting effect has been less early stage funding and/or a more conservative approach?
    I’m curious about the current effect on deal flows: quality & quantity, and on valuation ratios.

    • bgurley August 25, 2009

      I am not convinced these things are knowable. Too many variables that are far too intertwined. Also, great entrepreneurs with great deals will always command very high out of market valuations — regardless of the size of the industry.

  6. John Furrier August 25, 2009

    I can’t wait to write a post up on this. Bill you’ve got some great posts that are “Angle Worthy” – on SiliconANGLE.com

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  8. Dan Rua August 25, 2009

    great post Bill…you make a Gator proud.

    Although your punchline focuses on total dollars into the asset class, an interesting follow-up is whether the ultimate result means fewer funds or smaller funds — likely some combination of both. On one extreme, the total dollars could drop by half simply by keeping the same # of funds and dropping average fund size by half — closer to average fund sizes pre-bubble. With the cost of launching companies continuing to drop, it’s possible more, smaller funds is the optimal mix in some sectors.

    Likewise, some have proposed that IRR and fund size have a reverse correlation — particularly in a world where monster IPOs are less frequent. However, larger funds allow LPs to commit larger dollars at a time, and manage fewer relationships. That sets up an interesting dynamic for LPs between effectiveness (pursuing top returns, often with smaller funds) and efficiency (fewer fund manager relationships).

    • bgurley August 25, 2009

      You could be right. However, keep in mind that some costs are fixed (At least in Silicon Valley). If you want to hire 50 engineers, there is a cost to it. I know you can start a web 2.0 company with 10 guys (we have several of those investments), but if it takes off, it needs a decent number of people. This dynamic (I believe) will require a minimum fund size to be in the big deals.

  9. fred wilson August 25, 2009

    there is no question that the LPs will be cutting back their allocations to alternatives and VC will take its share of that cut back.

    i believe this will be very healthy for the business and the <$4bn/quarter of investing seems to be in the right range to me

    let's hope we can keep it at this level

  10. Katherine Warman Kern August 25, 2009

    Really interesting. Thanks.

  11. Bernard Moon August 25, 2009

    Great overview and insights. Thanks, Bill.

  12. Doug Schmidt August 25, 2009

    Exceptional. So good that I am actually transferring it to a new medium called the “printed page” so that I can have it readily available. Although you clearly described the role of the late 90’s IPO market—you just cannot emphasize it enough. What your writing tells us is that supply and demand always matter. In that unusual IPO and Secondary market, not only did VC’s get liquidity, they also got outrageous pricing, which simply created the return for many VC funds. As a middle market investment banker, I remember waiting in line in Boston and NYC at the great stock funds of America, including Fidelity and Wellington. We were stacked up to show them IPOs. And those funds were stuffed to the gills with money from individual investors, 401ks, etc. Supply and demand. Some VC’s have yet to face the fact that this kind of public market may never return in our lifetime. Making money through sales of companies and the occasional IPO is more demanding and weeds out the weak. Also, a trend worth noting that I am sure you see. With fewer funds, the good deals end up more and more in the hands of the larger, name brand funds putting additional pressure on the small and the weak to leave the business—like the maturation of any industry we follow.

  13. Mark Loranger August 25, 2009

    Bill – thanks for the great insight. One thing I’ve been thinking about lately is whether the VC model will completely diverge along the two primary industry/technology lines, Life Science and Technology. This is perhaps a corollary to the fund size question posed earlier.

    From my unscientific observations, it seems that the mega-A rounds are still happening in LS (although less of them) and timelines to exit are built around regulatory milestones with fixed horizons. On the tech side, A rounds and total funding needed are shrinking rapidly; does this also indicate a likelihood or at least an opportunity for quicker exits? If so, could the lifecycle of a technology-focused fund shrink proportionally (understanding that shorter fund lifecycle could be less desirable for the VC)?

    Based in part on your article, my understanding is that the Beta for the quicker-to-liquidity funds would decrease and they could be de-coupled as an asset class from the standard lifecycle funds. If this is the case, VCs on the tech side who are looking to raise new funds could consider a shorter lifecycle model to appeal to the LPs who need to better-balance their allocations. Further, those funds that invest across both sectors may need to split the funds accordingly.

    Perhaps I’m way off here, but would love feedback.

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  16. Talmadge O'Neill August 25, 2009

    From an LP’s perspective, I would venture to say that the vast majority (75%?) of VC funds are not providing alpha. So rather than focus just on asset allocation, I would say there is a move away from under-performing funds and managers in VC, PE and HFs. Unfortunately most LPs can’t get into the top 10-20% of the managers that do provide alpha, but that is no reason to support funds that should not exist.

    • bgurley August 25, 2009

      This would obviously argue for more than 50%.

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  18. Frank Greces August 25, 2009

    Thanks for clarifying in terms that us entrepreneurs can grasp. Lets hope that a majority of the “true (VC) believers” make the cut (vs. a minority) and are around to double down over the next 24 – 36 months. I think that a doubling or tripling of ANY asset class would be a difficult proposition to sustain over the long run. Bring on the leaner and (not) meaner VC model:)

  19. Tom Foremski August 25, 2009

    So it seems that it could be several more years before the VC industry shrinks in size given the size of the funds out there. By then, things could be completely different. the IPO market might have rebounded and new capital returned into the innovation cycle…

  20. Danny August 25, 2009

    best article on the subject in a very long while. Thanks for the insights. Do you know how many of the 900 firms are located in silicon valley?

  21. Navi August 25, 2009

    very impressive arricle

  22. Mark August 25, 2009

    Great post. Much appreciated assessment.

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  28. Nik August 26, 2009


    I just posted saying that “Its All David Swenson’s fault” giving him credit for the sub prime crisis as well 🙂

  29. David Tom August 26, 2009

    Nice post Bill.

    I wouldn’t discount the effect of poor returns as a reason for the coming shrink in the VC universe. I spend my days as a buyer of secondary LP interests in VC and LBO funds. The challenge is that most institutional investors look at their VC portfolio and find very few funds that have returned capital over the past decade. We tend to compare average or “pooled” venture returns to market indices such as the S&P 500. However, only a handful of investors are able to create a venture capital index since they will be excluded from the top funds (such as Benchmark). Therefore, it is more appropriate to look at the median return rather than any index that includes the top funds. According to Venture economics the median return for 1999 vintage funds was -6.19% as of 3/31/09 (other vintage years show similar results). The S&P numbers you quote are at -1.193% for a slightly different period. Moreover, the venture return estimates are also composed largely of highly subjective valuations rather than cash realizations.

    While venture funds certainly have a higher beta, investors should presumably be buying something more than just beta—manager skill (alpha). If an investor just wants beta, they should make leveraged investments in the NASDAQ, which are much more liquid and easy to value.

    • bgurley August 26, 2009

      Fair points.
      I would say that despite this point, the VC industry didn’t shrink after teh dot-com bubble. I would argue this is because teh alternative asset class was growing like crazy. Now, perhaps we finally get rationalization, perhaps because of both issues.

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  34. lace wigs August 26, 2009

    VC is going away, because the banks are competing with private money sources and have many times the advantages of VC lending.

    • bgurley August 26, 2009

      i don’t think this will ever work. Banks will lose a shitload of money if they do this.

  35. Grant Allen August 26, 2009

    This is an excellent post, Bill, and I appreciate you thoughtfully laying out the chain of events that will likely lead to consolidation in the venture industry. I think, though, that you should more accurately characterize why it is that venture is a “high risk” investment class, at least from a financial theory perspective. You assert multiple times that the “these ‘private’ investments… are considered higher risk due to their illiquidity.” Yet illiquidity is only part of the answer.

    The “riskiness” (again, speaking from a financial perspective) of venture-class investments is often mistakenly thought to come from the volatile nature of individual VC investments. These investments are highly binary in outcome (technically speaking, they have high variance) and you can have a company easily go bust just as you could have a given company return a 2x ROIC, turn into a ten-bagger, or perhaps become the next Google. Like with spinning the Roulette wheel and betting on black, your money can be quickly doubled and just as quickly reduced to zero. But this is diversifiable risk, in that across a portfolio of investments you can mitigate, and theoretically eliminate, this risk and should not therefore be rewarded with a return premium. It’s a bit counter-intuitive, especially given the fact that VC firms have limited resources, partner time, and the like, and thus can’t in and of themselves perfectly diversify (LPs can to a much greater degree).

    Your assertion that the CAPM’s beta coefficient (a measure of non-diversifiable risk, or market risk) driving the risk in VC is also a common mistake I hear among VCs. I work in VC, but academic literature points to an average market beta in VC of around 1.8 (so says Sand Hill Economics and Andrew Metrick, my prof at Wharton), which isn’t outrageously high. Stipulating then to a beta of no more than 2, it follows then that there must be another explanation behind that risk that’s driving outsized alpha (at least what were large abnormal returns in the mid- and late-nineties!) and that’s why I mention above that newer models are much better at outlining the drivers of this underlying risk (and concomitantly, the greater returns in venture).

    Some of these drivers of risk include: (1) size (small companies are inherently riskier and have, over time, delivered greater returns; often you’ll see this crop up as a “Small Stock Risk Premium or SSRP factor), (2) value (Fama and French showed a statistically significant difference between value and growth stocks), (3) the uncertainty of future financing (shaky financial footing that presents “Company Specific Risk” or CSR), (3) lack of diversification (private equity is held in large chunks than equities so each investment may represent a sizeable fraction of a given investors’ wealth), and of course (4) illiquidity. It is up for debate how much each of these factors should be loaded, but I can point you to some studies showing that the illiquidity premium is only around 1% of the 11% premium VC has over the risk-free rate. In fact, Pastor-Stambaugh, which has come to be recognized as a better capital cost estimator than the CAPM or even the years old Fama-French model, shows this to be true: illiquidity is only about one fifteenth of the equation. I would also argue that liquidity is much more of a concern in industries (e.g. hedge funds) where futures and/or leverage are involved and where the investor has less say in exit timing, but that warrants a longer explanation.

    Your argument, though, as a generalization of venture capital versus other asset classes still stands. We’ll certainly see consolidation, but I firmly believe those firms that have been able to consistently deliver outsized returns (Benchmark being a prime example) will continue to outpace the S&P by a decent margin and VC, as a class, will continue to garner the interest of sizeable institutional investors. The denominator effect and other portfolio ripple effects that you’ve smartly pointed out have surely made their mark but dollars will continue to flow, even as VC firms shutter or raise smaller funds and deploy less capital into leaner, more capital efficient start-ups. It is a fact that VC has, over time, delivered alpha to those choosing to invest in the class and it would certainly behoove pension funds and other institutional investors to keep investing across a broad swatch of top-tier funds so that they can diversify their own idiosyncratic risk. And I wholeheartedly agree with Jeff Bussgang that “So long as innovation continues, the VC industry will thrive – whether lean and mean or fat and happy simply depends on the economic cycle.”

    In short, venture is here to stay!

  36. Clay Bullwinkel August 26, 2009

    Hi Bill,

    Few things.
    1) Thanks for your thoughtful, community-oriented blog.
    2) Contrarianism and… fear that if they sit out a round they lose their place in line for the next one.
    3) Better VC practices. Other commenters chimed in on this, i.e. the “alpha”. One would think investors will press for it.

    Cheers, Clay (from ASTC fitness room)

    BTW we have a project with a 40-person profitable browser-based Flash 3D MMO RPG developer and regional (Central Europe) publisher. Please let me know if this kind of thing may be of interest to you or friends if we fold it into a U.S. corp. I remember your game industry knowledge.

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  39. James August 26, 2009

    Just curious – where does Real Estate fit in your fund percentages?

    • bgurley August 26, 2009

      Great question. it is not a market i know, but RE LP funds would likely be affected.

  40. T. Cunningham August 26, 2009

    As an institutional placement agent, I would say this assessment is fairly astute and makes many of the arguments that are discussed in institutional circle. It is true that some institutions will continue to invest in VC managers. Many more will not.

    The low returns produced by the vast majority of the VC managers over the course of the last decades or so is one of the primary reasons for the declining interest in VC. If high returns were more consistently dispersed across the VC industry, some of the other structural issues might be worth attempting to overcome. But the returns have been, on average, not all that good compared to other investment strategies.

    So how would you go about putting together a great and successful portfolio of VC managers when the industry itself has not done well in producing consistent returns? In trying to select eventual winners among the many VC managers who solicit them for money, the institutional allocator is faced with the Lake Woebegon effect, where all the VC funds out there seem to claim to be in some sort of “top quartile.” Knowing that the VC industry as a whole underperforms many other strategies, it becomes extremely difficult for them to be sure they can put together a portfolio of managers who will outperform their brethren. You cannot invest in an index in this sub-asset class, and thereby settle for an average return at a low management fee. And even if you could invest to produce an average return, the average return has not been sufficient to provide for a robust illiquidity premium. This is still equity, after all, and it has to compete with all the other equity investment strategies out there.

    So the upshot is that since the institutions can’t be sure of putting together a high performing portfolio of top-quartile VC managers, they have all decided they really only want to be in the top decile, and since those managers are closed to new investors, the entire exercise seems to them to be a bit futile.

    There is another notable institutional constraint faced by allocators. There isn’t much debate that VC is most effective in sub-$1 billion sized commingled pools. Many venture managers would argue that for optimal capital efficiency a VC fund should be no more than, say, $500 mm in size, and there is a sizable contingent of VC managers who would argue that anything over $100-$200 mm is too large to effectively deploy into true VC opportunities. Of course, a lot of those who say such things have trouble raising money, so it’s not surprising they try to turn this into a competitive “strength.”

    That said, by institutional standards, even the larger VC funds are small, and the average size fund is very small by those standards. This presents a problem for larger allocators who generally do not want to be more than 10% of a total pool and yet have a minimum size allocation that would put them over that limit. They do not have the time or staff to manage more VC managers, and even if they did, and their VC portfolio of a large number of $5-10 mm commitments were successful, such an effort would not “move the needle” for them, and would be lost in the context of the overall portfolio managed by the institution.

    I remain convinced, though, that consistent, widespread, long-term high returns would allow institutions to devise strategies to invest in VC. Those managers capable of generating those returns will be able to back to the well. Those that cannot, will slowly die a painful and protracted death. With 10 yr partnerships and another 2-3 years clean up, VC fund managers take a long time to go out of business.

  41. Paul Lippe August 26, 2009

    Bill – Thanks for an excellent post. It always struck me as a fallacy to think of Venture Funds as an “asset class,” just some rear mirror driving by portfolio consultants.
    In its early days (say 1985), the venture industry benefited from several nicely aligned strategic advantages:
    • VCs who had unique and deep operating experience and strategic insight both vertically and in the operation of start-ups
    • An arbitrage opportunity driven by the relative non-availability of capital for start-ups (my old company, Synopsys, was one of three companies funded in its space; in the recent world, VCs were funding 6-8 companies per category;-the likelihood of a home run probably drops an order of magnitude for every additional company funded over three),the willingness of institutions to (periodically at least) pay a premium for public securities at some scale in IPOs or post-IPOs, driven by super post-IPO returns of companies like Cisco or Intel, and willingness of market leaders to pay a premium for M&A
    • A series of fundamental platform shifts (the Microprocessor, the PC, the Internet) that created both new market opportunities and dislocations that leveled the playing field between start-ups and established companies
    But it was always the case that all of the returns of the industry were driven by a very few firms (e.g., KPCB or Sequoia, or as Mike McCaffrey said in 2000 “100% of the returns come from 10 funds”). Since their fund sizes were limited, LPs who wanted to allocate, but were late to the party, had to go down the return tree to invest. But there never was, and never will be, any reason to imagine that Joe Blow VC would have returns correlated with “the asset class” of Pierre Lamond, any more than there is a reason to predict that I would score as many points a game in the NBA as Lebron James because we both play basketball. They were operating in different universes. Classifying VC as an asset class was a fallacy.
    What’s more, at some scale (i.e., today’s scale) the arbitrage is crowded out, we can argue about how much unique insight the average VC has, and Eliot Spitzer/SOX et al have hosed up the IPO market, so most of the structural opportunities are gone.
    So the de-allocation seems entirely appropriate to me.
    When I took Entrepreneurial Management from Irv Grousbeck (not at GSB, then at HBS) in 1983 he kept talking about how the VC industry had to deliver its 30% returns because it took on so much risk. But I kept saying if it really delivered 30% returns, then more and more money could pour in, crowding out the returns. So none of this is any surprise.
    Clearly bootstrapping will be ever more prevalent, and in all likelihood a” Back to the Future” VC industry that is much more operationally oriented and much smaller than today.

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  47. Hans August 28, 2009

    Excellent analysis. What does this mean for the startup community? Funding will become much more difficult. Other sources of cash will become more important. Angels have seen their liquid assets being slashed too, and will therefore invest less as well. Hence startups need to become more adept in getting cash from …. revenues. Think this true for social networking and other web startups, as well as for cleantech and capital intensive life sciences. Business models will change. Will truly disruptive innovations disappear?

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  53. Basil Peters September 1, 2009

    Excellent post and great comments. As an ex-VC, I think it’s actually pretty simple. Traditional Venture Capital Funds grew too large. The graphs on this blog post show it very clearly http://www.angelblog.net/Venture_Capital_Firms_Are_Too_Big.html

    What’s happening to traditional VC funds may seem alarming, but it’s just a healthy correction.

    The second most important factor is that today’s companies just don’t need as much capital.

    The third factor, which is still under appreciated is that the new competitors to VCs are actually the corporate acquirers. I explain this in my new book: http://www.Early-Exits.com.

  54. Ellie Fields September 1, 2009

    Great post. There are other factors than asset allocation, though. We did some research on successful tech companies and found that there’s also a fundamental mismatch between most VC’s expectations and what the IPO market will support today. Simply put, most of yesterday’s most successful tech companies wouldn’t have been able to go public in today’s market. http://www.ipo-dashboards.com/wordpress/2009/09/the-slow-death-of-venture-capital/

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  57. Robert H. Heath September 2, 2009

    Bill –

    Thanks for an exceedingly well-organized and insightful article. At a gut level, a halving of the VC industry seems about right, and you’re surely correct that the asset class will never go away.

    I do agree with Grant Allen, however, that Beta (in the CAPM sense) may generally be misapplied to the VC asset class. Venture investments are undoubtedly more volatile than large-cap stocks, but Beta is a measure not of an investment’s volatility per se, but of the correlation of its returns with the broad market of investable assets.

    Since much of the risk of a start-up tends to be “binary” as Grant Allen puts it, much of the risk of an individual VC investment would seem to be firm-specific, hence generally uncorrelated with the broad market. (I made this observation in an obscure footnote to an equally obscure article published by the NVCA a decade ago.)

    As Grant Allen also points out, firm-specific risk is also diversifiable, hence uncompensated according to CAPM theory.

    Finally, with regard to an individual VC investment, any attempt to calculate Beta is fraught with measurement challenges, as objective valuations (based on arm’s-length, third-party investments) are few and far between for VC-backed companies, which doesn’t give you many data points to calculate a correlation coefficient with the market.

    Measurements of the Beta of Venture Capital as an asset class also seems problematic to me. If the (objectively measured) returns of the universe of VC investments are based on exits (IPO or sale and subsequent distribution of shares or cash to LPs), I think you end up with spurious correlations since the timing of exits is correlated with market windows, which themselves are correlated with strong market performance leading up to the exits. Since IPO’s, as a whole, underperform the market for the three years following their launch, I suspect a longer post-IPO observation period would likely reduce any Beta calculated based on the IPO or LP distribution date.

    When I used to interview MBA’s for investment banking positions, one popular interview question was, “How would you use the CAPM to value the Space Shuttle Program?” The preferred answer was “I would’nt.”

    At any rate, it seems plausible to me that the enduring appeal of venture capital as an asset class may have as much to do with its non-correlation with other investable assets as with its absolute or relative return.

    If you (or your readers) can link to any good articles regarding CAPM and Venture Capital, I’d be grateful.

    • bgurley September 2, 2009

      The thing i would point out is that there IS a correlation to the public markets because of (1) IPO frequency – which ebbs and flows, and (2) M&A is much more fruitful when large public companies have rich values, are trading at 52-week highs, etc.

  58. Frankie Tan September 3, 2009

    To add to Allen Grant’s comment, another significant, I think, beta driver in technology (VC) investment is operating leverage.

    Brealey & Myers (2000) showed the mechanics by which high operating leverage (high fixed costs projects) invoke high beta of project cash flows due to the multiplier effect of high fixed costs on variability of project revenues.

  59. Mark Montgomery September 4, 2009

    Institutionalization of the entrepreneur process was a dangerous game from the beginning, and asset allocation for a process that is so dependent upon other factors is indeed behind most of the mess that has been created in the past decade- loss of trust, copying of IP, substantial numbers of VCs with no experience other than in financially engineered markets, very little actual entrepreneurial experience, and on and on. I started screaming over ten years ago– the industry looked more like the government in recent years. Thanks for the work, Bill- MM

  60. Dave September 6, 2009


    Your analysis is excellent. Is the key takeaway that VC just does not scale and in fact should be declining in size as the development costs decline?

    Set aside biotech and cleantech, which have their own issues but are hugely capital intensive. The first generation of large VC funds raised circa 1998-2000 was to invest in dot coms and telecom infrastructure, neither of which exist anymore as large scale investment opportunities.

    The cost of IT investments of all shapes and sizes have decreased massively while the number of truly scalable game changers have also decreased (lots of successful small businesses does not equal a great venture model). VC funds have stayed roughly the same in people size and increased in dollar size which makes no sense if the funds need to invest less per investment. Either the funds need to be smaller or the number of heads needs to increase. VC funds are not PE/LBO funds, again a class with its own problems, that can range across asset classes and simply go and buy bigger businesses when they have more capital. VC funds are fundamentally limited in how large their investments can be.


    • bgurley September 7, 2009

      i actually do not agree with the argument that startups are cheaper today. It may be cheap to bootstrap something to early success, but when you start hiring people, those people costs more today than they ever have.

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  62. Mark Montgomery September 8, 2009

    Bill is correct about the cost of building sustainable tech companies today– I’ve been doing it non-stop for 15 years, including an incubator, seed fund, and VC fund – now enterprise software. All the chatter about low cost of entry was quaint in 1996, when it was briefly true for web services. The obstacles have grown higher and thicker ever since, although in part falsely due to over-investment and predator price wars. The real challenge for most, including my current venture Kyield, is the cost of sustainability, and that’s due primarily to global consolidation of industry, legal barriers built over decades, scaling up to competitive levels, and last but not least– apathy in customers who rant about being abused, but rarely do anything about it proactively. Those that do of course — early adopters– are often market heroes. .02- MM

  63. Alan Peters September 9, 2009

    Thanks, Bill. Maybe you can help answer a standing question for me.

    Pension funds and traditional institutional capital sources are shrinking, sure. Why aren’t funds being raised from new under-tapped sources like sovereign wealth, Native American tribes, Middle Eastern Emirs?

    I asked one VC about it, he said his problem with Sovereign wealth is that they want to spend too much money.

    If that’s the case, surely it wouldn’t be leading to a contracting industry?

    My instinct is that it has more to do with number of VC players and likely returns due to increased ease of entry into VC’s big sector: software.

    Would love to know your thoughts.

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  66. Petrean September 20, 2009

    Great website, adding your to my RSS !!

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  71. Adrian Scott September 29, 2009

    fyi Buffet -> Buffett

    hope this helps.

  72. Pingback: The Great VC Ice Age is Thawing (for now) – Part 1 of 3 « The SiliconANGLE

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  78. Rosella Cooper February 1, 2010

    I Will have to come back again when my class load lets up – even so I am taking your RSS feed so I can read your site offline. Thanks.

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  87. Stacey Colon May 27, 2010

    If only I had a greenback for every time I came here… Incredible read.

  88. Telefony October 5, 2010

    I am a frequent reader of your blog posts. I liked the recent one and other posts on your blog so much that I have subscribed to the blog’s RSS feed in Thunderbird. Even thinking of stealing some ideas and put them to work. Keep all the good work going by posting more informative posts. Thank you. Time well spent on this post.

  89. Luther Lore December 8, 2010

    Even though this post is a bit older, I still found it to give some really great info after stumbling across your blog. You would hope that in the end, the fall of Silicon Valley would knock some sense in to some people.

    • Georges van Hoegaerden December 10, 2010

      In the same way the collapse of our financial system has people scrambling about regulations rather than redesign our economic model so these issues don’t occur? Don’t bet on Silicon Valley recovering by itself. The collective wisdom of GPs verbalized by the playbook of the NVCA gives us a good idea that protectionism, rather than self cannibalization is at the top of their minds. And therefor change in Silicon Valley will have to come from the outside.

  90. card December 12, 2010

    Thanks for an exceedingly well-organized and insightful article. At a gut level, a halving of the VC industry seems about right, and you’re surely correct that the asset class will never go away.

  91. Kris Pearson December 28, 2010

    In the same way the collapse of our financial system has people scrambling about regulations rather than redesign our economic model so these issues don’t occur? Don’t bet on Silicon Valley recovering by itself. The collective wisdom of GPs verbalized by the playbook of the NVCA gives us a good idea that protectionism, rather than self cannibalization is at the top of their minds. And therefor change in Silicon Valley will have to come from the outside.

  92. שוק ההון January 13, 2011

    New research from DowJones shows that US Venture Capital fund-raising has hit a seven-year low. During 2010, firms raised $11.6bn across 119 funds, a 14% drop from the $13.5bn collected by 133 funds in 2009, according to Dow Jones LP Source. In the fourth quarter, 15 funds raised $2.4bn, a 48% drop from the…

    • שוק ההון August 2, 2011

      Look at how the market reacts now, even economic plan

  93. ana March 5, 2011

    will be much better next year i think

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  99. James Harris April 22, 2013

    Nice facts described…..! But I don’t agree with the statement that startups are cheaper today. That costs you a lot.

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