It’s been said that you can never have too much money. As strange as it sounds, that’s not the case in the venture capital business. VCs are grinding their way through a “bust” cycle, and the more money that flows into the business is only going to make it worse.
The extraordinarily positive returns between 1990 and 1997 triggered an unprecedented influx of capital into the industry, with over $200 billion of new commitments being made in the past three years. Our industry will struggle to invest this amount of money profitably. Until this capital overhang decreases substantially, returns on venture funds will be unattractive. Limited partners who ignore the impact of this capital overhang are likely to make very disappointing commitments to the asset class.
Venture firms are investing at a rate of $7 billion per quarter. If you assume a $28 billion annual investing pace, with a target of a modest 2x return, the industry needs to generate annual returns in excess of $56 billion. As Figure 2 shows, the only year when our industry has topped this level was 2000, when the Nasdaq exceeded 5,000 points. In typical exit years, our industry has generated $15 billion to $20 billion of gains.
Looking at the data another way, at $20 billion of annual gains and with $200 billion of committed capital from 1999 to 2001, our industry has enough capital for 25 years of investing, assuming a 2x return. This spells trouble for venture firms and their limited partners for current vintage funds.
Don’t Call Till 2005
Given the large number of new entrants to the limited partner ranks between 1999 and 2001, it’s possible that these groups will continue to invest aggressively in venture capital firms over the next few years. Nothing could be worse for our industry or for these investors. At this time almost every competent venture firm has raised enough capital to comfortably cover its investment needs through 2005. Another large injection of capital in 2002 will exacerbate the capital overhang, and it will be raised by marginal firms, which will only add to the severity of the “bust.”
When capital is hard to come by, venture firms finance only the best projects, valuations are low and companies make significant progress on small financings. As venture firms generate strong returns on these investments, substantial capital flows into the industry, lowering the bar on new investments, raising valuations and decreasing returns. Over time, limited partners react to the downturn in returns by cutting their capital commitments to the industry, and the “venturous cycle” (see Figure 1) starts all over again.
There was a defined cycle in the venture industry in the 1980s. A “mini-surge” in capital commitments in the early part of that decade (capital increased from $600 million in 1979 to $4.2 billion in 1983) led to lots of bad investments. We learned the bitter lesson that it takes a long time to train a venture capitalist, and giving a checkbook to inexperienced investors across many new firms isn’t smart. This start-up frenzy created a “tragedy of the commons” in over-financed sectors like Winchester disk drives, artificial intelligence, robotics, shrink-wrapped software, and parallel processing. As start-ups failed, venture funds suffered through the “bust” of the mid-1980s, when a half-decade of vintage year funds posted weak returns – 5-10% net annual internal rates of return (IRRs).
In response to these unattractive returns, limited partners reduced their commitments to the asset class and, by 1991, only $1.6 billion was committed to venture capital. This downturn set the stage for strong performance in our industry in the 1990s. The capital run-up of the past several years makes the 1980s “surge” look like a rounding error. Commitments reached $105 billion in 2000 (see Figure 3). Even in 2001, when it was clear the outlook for technology start-ups had deteriorated, an additional $40.3 billion was committed to venture funds. That’s more than the aggregate commitment to VCs from 1970 to 1990.
Early indications suggest that the 1999-2000 vintage year funds will post sharply negative returns. As money poured into venture firms, marginal companies were financed, often at excessive valuations. Most of these companies operate today with very high cost structures – due to high salaries, excess space, and sizable sub-debt payments – and compete in crowded markets. While a good number have already shut down, the bulk of the write-offs lie ahead.
To estimate future shutdowns, consider the following data. Some 14,500 private companies were venture financed between 1995 and 2000, according to Venture Economics (VE), publisher of Venture Capital Journal. During this six-year period (which included the once-in-a-lifetime exit years of 1999 and 2000), about 1,000 VC-backed companies went public and 1,500 were acquired, VE data shows. Another 1,200 were reportedly shut down, leaving about 10,800 active private companies at the end of 2000. Even if the 2001to 2006 period generates as many “good outcomes” as the 1995-2000 boom years, 8,300 companies are likely prospects for shut downs.
Recently, a few top-tier firms have voluntarily cut back the size of their current funds. Limited partners should expect other firms to take similar steps as they gather more data about their ultimate investing pace. However, the total amount of capital taken out of the system via this mechanism will be relatively small (a few billion dollars at most), and, much of that may simply get re-invested into less proven firms by limited partners anxious to put money to work.
Also, while some top-tier funds may voluntarily reduce their fund sizes, it’s highly unlikely that less proven firms (and there were 164 first funds raised in 2000) will follow suit. So, counting on voluntary cutbacks to solve the capital overhang challenge is wishful thinking at best.
Despite the current glut of capital, we can still expect to see many great companies funded in this period, and numerous venture funds will post strong returns. For the industry as a whole, however, we need to act with urgency to proactively manage down this enormous capital overhang. Failure to do so will only serve to deepen and extend the pain of the “bust” phase of the cycle, wasting lots of time, money and effort on the parts of limited partners, venture firms and entrepreneurs.
Ted Dintersmith is a general partner at Charles River Ventures, a $2 billion early-stage venture capital firm based in Boston. He has been a VC for more than 14 years and his investment focus is on the software and services sectors.