Bill Gurley to LPs: You are Blowing It

Venture capitalist Bill Gurley of Benchmark Capital has a message for institutional investors: Stop blasting money at what have historically been top-tier venture funds, please. It’s bad for the industry.

“You’re not in the stands,” he told a gathering of limited partners at the Venture Capital Journal conference in San Francisco this afternoon. “You’re in the field. And when you allocate [your capital] obsessively to firms in the top quartile, it will have an impact on how things play out.”

Why is Gurley concerned? In a 40-minute-long speech, he cited plenty of reasons – and reminded LPs of why they should probably be concerned, too.

Gurley started first with the “good news,” pointing, for example, to the ample liquidity in the market today. Indeed, Benchmark has seen seven of its portfolio companies taken public in the last 27 months, including, in the last year, Zillow and Yelp.

Gurley also noted that almost never before have there been so many dominant cash-rich players, including Microsoft, Amazon, Google, and Apple, all of which continue “attacking one another” through acquisitions. (For its part, Benchmark has seen a number of its startups absorbed by big companies at big multiples, including the email marketing company DemandForce, acquired by Intuit in April for $423.5 million in cash; and the photo sharing application Instagram, acquired in April for $1 billion in Facebook stock. Benchmark, which led Instagram’s $7 million Series A in 2011, was the company’s largest shareholder.)

Not last, Gurley cited platform disruption as a reason to feel good about venture capital. “Smartphone and tablet migration is a big deal,” and young companies are figuring out how to take advantage of that shift, while “incumbents can’t figure it out fast enough,” he observed.

But here came the bad news. The biggest problem, as Gurley noted, is that just as LPs began scaling back on weak-performing venture teams (the number of funds has shrunk from roughly 800 in 2008 to less than 500 today), they started pumping more money into those firms perceived as the industry’s best.

“If you ask if people will take an excessive amount of money, the answer is yes,” said Gurley, who noted the increasingly creative ways they will take it, too. (He highlighted, to some laughter, the Sequoia India Growth Fund.)

Yet reallocating the same amount of capital to a shrinking number of firms isn’t good for anyone, Gurley observed, citing analysis that suggests no billion-dollar venture fund has returned more than 2x, and a separate study that has shown an inverse correlation between size and return. Indeed, Gurley likened the strategy to squeezing a balloon, suggesting that LPs have now blown so much money into so few venture firms that something has to give, even if that isn’t yet apparent to LPs.

Gurley reminded the audience, for example, of Groupon’s billion-dollar Series G round, in which 13 firms piled in to the company (using capital that’s mostly been vaporized). He also pointed, with some incredulity, to the voting power that investors have granted certain founders, including Mark Pincus of Zynga, a company whose valuation was once expect to reach upwards of $20 billion. (Its market cap today is $1.91 billion.)

Some VCs did “what [they] need to win a deal, but that reckless behavior can have an impact on the overall market,” said Gurley.

Those days aren’t behind us, either, said Gurley, singling out LPs who “loaded up a bunch of late-stage funds” that are now investing “$20 million to $30 million at a clip,” which “doesn’t lead to great execution on the playing field.” (As recent proof, Gurley mentioned an unnamed company that’s making one million dollars in revenue per month and just received a billion-dollar valuation by its investors.)

When “people overfunded the angel market,” the worst of it was a “bunch of startups that ended up getting acquired by Google,” said Gurley. In contrast, when LPs overfund venture firms, “valuations go way up.”

“For someone who has been in the industry for a while, it’s weird,” he added.

Ultimately, said Gurley, “I’d like to believe that [it’s safe to come out now], but I don’t. Everyone is already armed. [There are] low barriers to entry and high barriers to exit.” And these situations don’t get “wound down.”

Speaking directly to LPs, he added, “You might think you aren’t having an impact, that it’s a distributed industry. But you do impact the market. And just because [firms in the] top quartile have historically had the best returns, [it] doesn’t mean they will if [you] continue to give them unlimited amounts of capital.”