The Aftermath of the 2008 destruction for Venture Capital

Boy, it’s been a grim year.  Worst fall for Nasdaq since its creation (-40.5%, even worse than 2000), Q4 IPO’s down 89% on Q4 2007, M&A down 77% on the same period, you all know the numbers (if you like visuals, read TC).  Grim, grim, grim.  But what does this mean for the venture industry going forward ?

Those entrepreneurs out there who complain about lack of appetite in the VC landscape will do well to understand thoroughly VC’s own funding cycle and requirements.  Think of it as understanding your client base.  You need to understand how your deal fits within a VC’s investment strategy and how they / we / I can sell this to institutional fund investors.  This is particularly important during the VC’s own fundraising efforts, where all new deals are subject to particularly intense scrutiny from potential limited partners.

So, let’s look at the key drivers  in VC’s ability to raise money:

  • Asset class attractiveness, typically proxied by Return History: unlikely to look rosy.  Typically the industry will look at rolling returns over 5 and 10 year periods.  The 10-year profile still looks vaguely OK but most of the returns were bubble exits, particularly in the US, around the 1996-1998 period.   As these high data points start to disappear from the sample, a depressing sector performance figure is likely to emerge
  • Compelling story: this is more of a problem in the US, where too many undifferentiated tier II funds fight over the same deals.  In Europe good teams can come out with fairly unique investment stories and strategies that should get investors excited.  Look at a Mangrove as a specialist consumer and digital media first round investor or Kennet as a late-stage, first time institutional investor backing self-starters: both have limited competition within their scope.  Hopefully an exciting portfolio reflects a sound and differentiated strategy.
  • Compelling Exits: there is nothing like a few great exit stories to get a prospective investor excited, and it’s much better than playing the ever-hopeful GP whilst peddling your portfolio (oh, checkmate on myself :-)).  Bad news is, there are almost none right now and the market is likely to remain slow.  Whilst some of the big guns are very likely to take advantage of this market downturn to do some startup shopping, expect median M&A values to remain low — they currently stand at around $19M according to VentureWire / DowJones — as well as volumes.   Choosy and cheap acquirors are clearly bad news for VC’s desperately in need of fresh track record.  If the starts in your portfolio get taken out for $100M instead of the $300-500M you had hoped or claimed, what else is going to return your fund ??  For those who did not manage to get big exits in the 2005-2008 window, it gets tough to build an exciting story and investor patience may well be running out.
  • Returns: see above.  I trust a number of VC’s have built solid portfolios that show decent returns with fairly good visibility by now.  I am not sure, however, how many funds can show “hard” cash returns right now (apart from those lucky or smart enough to have participated in multiple fund returning deals like Skype).
  • Existing LP exposure: if you have LP’s invested in for example two of your funds and your average holding period on deals is in line with industry average (currently a whopping 6.5 years apparently), these guys may well be tapped out on your new fundraising effort.  With new LPs looking at returning LPs as a sign of quality and support, too much of that spells trouble.
  • Availability of funds: covered before and elsewhere, but this is really hard to solve.  Liquidity pools are drying up and with no hope of recycling significant capital through exits, it’s hard to see where solace is going to come from.

It is hard to escape the inescapable: with a long liquidity drought and the second serious systemic shock in a decade, the day of reckoning appears to have arrived for many venture firms.  Here I would respectfully disagree with my friend Nic Brisbourne: further shakeup is to be expected, and the industry does not need more VCs.  I would not, however, expect too many dramatic announcements: funds are 10-year+ animals and they tend to gracefully disappear into the limelight over time.  But as partnerships fail to raise funds and prudently increase the reserves to protect their existing portfolio, they may well have to stop investing altogether quite abruptly.  So expect a reduction in the number of active players, a shift in investment strategy towards later-stage, closer to liquidity deals and a general slowdown in venture activity.

As a venture practitioner, what do I make of this ?  I am not sure I ever bought (European) venture as an attractive asset class per se, more of a market segment for investment that I found highly invigorating and where, with the right strategy, some people would manage to make money.  In some ways I must confess that, whilst there is a risk that we fall below critical mass, I find the whole process quite healthy and logical.

All in all, the next few years are likely to provide a great hunting ground for those savvy investors who manage to raise capital, with reduced competition for deals, reasonable valuations, capital efficient entrepreneurs and large corporates axing their innovation programmes.  In fact, there is no doubt in my mind that 2008/2009, just like 2001/2002, will prove to be a great vintage year for newly raised funds.   You know, that old argument about capital scarcity and fewer smart people to cancel each other’s returns might actually hold true.

I am also convinced, by the way, that there can be no better time to start a company.  Slow going for sure, but with great access to talent and time to hone and grow a great business that will take the world over in 2010.  Si, Se Puede !

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