There has been an extensive discussion over the unprecedented capital overhang in the venture industry and the impact it has on current deal dynamics. Specifically, many venture capitalists are lamenting the competition over mid- to later-stage investments, thereby requiring them to pay a premium.
They attribute the increased competition to a number of factors. Firstly, since there is a large amount of available capital that needs to be put to work by 2005, firms are striving to write bigger checks that can more easily be absorbed by later-stage companies. Secondly, many firms significantly increased the beta of their portfolios early on in their fund lives, and they are consequently trying to mitigate portfolio risk by investing in later-stage opportunities. Lastly, many funds are now three to five years into their deployment periods, so they are reluctant to invest in early stage companies with longer gestation periods.
With this re-allocation of dollars to mid- to later-stage deals, many are concluding that prices are escalating. Interestingly enough, the most recent data does not validate the higher valuations, because of a confounding factor. However, it does support other conclusions that portend a new environment for entrepreneurs, general partners and limited partners.
In 1996, 38% of capital was invested in seed- and first-stage opportunities, but that number fell to 20% by 2003, according to Thomson Venture Economics (publisher of VCJ). With that said, the median pre-money valuation for all venture investments has declined precipitously over the last three years from a high of $26 million in 2000 to $12 million in 2003. These reductions in valuation have occurred during a period where later-stage investments have risen from 15% of 2000 invested capital to 25% of 2003 invested capital. One reason why venture capitalists’ experience is not reflected in the data is the proliferation of “restart” or “recapitalization” deals that skew the valuation data downward. A significant percentage of these later-stage deals are restarts at a discounted valuation to previous rounds. Thus, investors are, in fact, diverting their dollars away from seed deals and toward expansion-stage and restart deals.
Nevertheless, the growth in recapitalization deals does not completely account for the dramatic drop in valuations, especially given that those investments only account for some of the increase in later-stage investing.
Overhang Is Shrinking
In addition to a generally weak exit environment, the other explanation can be found on the supply side of the industry. Specifically, the overhang is not as large as it would appear. By examining the Thomson data in concert with extrapolations for 2003, it reveals that the uninvested pool of capital has already begun to rapidly dissipate. Industry veterans may recall that there was only about $7.5 billion in undeployed capital in 1992, but it skyrocketed to a high of $97.6 billion by 2001. We estimate that the overhang shrunk to about $49 billion by 2003 and that it will continue to shrink. One of the notable trends is that general partnerships have begun to return undeployed capital commitments for the duration of their current funds so as to maintain long-standing relationships with their LPs.
In addition, there are also an increasing number of first- and second-time funds that were raised between 1999 and 2001 that are now choosing to exit the business before the end of their fund life. Consequently, they are relinquishing their LPs from any remaining capital calls. Thus, not all of the overhang will be invested in deals.
Besides lack of economic incentives in their downtrodden funds, the other motivator for VCs to return capital is the uncertain prospect of raising successive funds. This is borne out by the dearth of new funds raised recently. If one assumes that the typical GP raises a new fund every four to five years, then the total number of funds raised in 2002 and 2003 should be roughly equivalent to the total funds raised in 1997 and 1998. Not surprisingly, according to Thomson Venture Economics, there were 316 funds raised in vintage years 2002 and 2003, down from 534 funds raised in vintage years 1997 and 1998. Therefore, the number of new funds is unquestionably decreasing.
What is surprising is that the mean venture capital fund size in 2003 was $85 million, the highest it has been in six years. However, our research reveals that 2003 was an anomaly, specifically because of an atypical fourth quarter that represented almost half of the capital raised in 2003. During that quarter a number of “top” funds raised capital. The “top five” funds that raised capital that quarter, according to the NVCA, were NEA XI, TCV V, Venrock IV, Domain Partners VI and Three Arch Partners IV. Collectively, those five funds pulled in $3.3 billion, or 64%, of the total capital raised in that quarter, the NVCA says. After normalizing the data for this unusual quarter, we arrived at an average fund size of $63 million. That represents an increase from 2002 but remains significantly below 1996-2001 levels.
Smaller Is Better
The reasons are clear. Successor funds are not always opting to raise larger funds than their previous ones. In fact, many funds are raising significantly smaller funds than their predecessors. In addition, an increasing number of smaller, specialized funds are emerging from the carnage. These focused funds are partially in response to limited partners’ disappointment with GPs who migrated far a field from their original investment strategies or changed their sector focus. The combination of successor funds raising smaller pools and new GPs appearing on the scene will continue to sustain downward pressure on the median fund size.
For this reason, limited partners are beginning to get marginalized, or even squeezed out, of some of the top-tier funds. Consequently, they are reducing their allocation to venture and/or reallocating it to other “alternative assets.” Another strategy is to seek out the “next generation” of general partners who are forming new funds.
In short, 2004 and 2005 will be pivotal years for the industry. As the overhang continues to rapidly contract, a record number of funds will return to the till. Our estimates are that approximately 500 venture funds will go to market in 2004 and 2005, but a substantial number will not prove successful. Our research indicates that an industry bifurcation is unfolding that will clearly delineate new funds from successor funds. The latter group will evidence superior cash-on-cash returns throughout the economic cycle. Performance will be at or near the S&P 500 in the down years, but it will exceed the public markets in the up years. Consistent inter- and intra-portfolio historical performance is not the only criterion. Limited partners are also seeking increased transparency at both the portfolio and company level. The final criterion that is attracting scrutiny is the number of former LPs that commit to the new, prospective funds.
First funds, on the other hand, will be tasked with demonstrating depth in industry knowledge, deal flow and investment acumen. Obviously, this does not augur well for funds that don’t fit into either category. Hence, Mark Hessen’s assertion that, “We anticipate fund-raising activities to increase in the quarters to come as more venture firms look to the future and begin to raise their next funds. That said, the next generation of funds will be smaller than their predecessors, which will create an increasingly competitive environment for limited partners to maintain their allocations in the most respected funds.” As with any industry contraction, pain will be shared throughout the value chain, but the end result will be a more efficient, focused industry.
How It Will Play Out
Conclusions can be drawn for each of the three major stakeholders in the venture capital industry – entrepreneurs, GPs and LPs. For entrepreneurs, seed- and first-stage companies will face continued difficulty in raising capital. Most of this capital is being redeployed into expansion-stage and restart opportunities. Nevertheless, as the industry contracts, GPs have become more discerning and diligent in approaching new investments. Median, pre-money valuations will remain low due to the proliferation of restart deals and the rapid contraction of the capital overhang. Moreover, a portion of this overhang will never be deployed in companies, as LPs are released from their remaining capital commitments.
From the GP’s perspective, this will result in fewer funds with smaller coffers competing for deals in the ensuing years. Smaller, first-time funds will need to demonstrate depth to secure capital commitments and to compete in the marketplace. To that end, an unprecedented number of funds will go to market in 2004 and 2005, though many will prove unsuccessful. With the exception of the fourth quarter of 2003, which was an anomaly, average fund sizes will continue to remain small – typically about $60 million to $70 million.
LPs have become more sophisticated, yet the smaller fund trend will exclude them from some of the longstanding fund franchises. Nevertheless, LPs will seek GPs with superior cash-on-cash returns throughout the economic cycle combined with transparent reporting. With increased competition to access the successor funds, many LPs will either re-allocate to other “alternative assets” and/or seek out the next generation of GPs.
Warren Haber Jr. is a partner in the New York office of Mellon Ventures. He has 10 years of private equity and venture capital experience. Haber focuses primarily on financial services, information services and technology. Prior to joining Mellon Ventures, Haber was a founding partner of Grand Central Holdings, an early-stage venture capital firm. Previously, he was with GE Equity where he was responsible for evaluating early- and later-stage venture capital investments. Mellon Ventures, founded in 1996, is the $1.4 billion private equity investment partnership affiliated with Mellon Financial Corporation (NYSE: MEL), a global financial services company with approximately $2.9 trillion in assets under management.