Venture capital overhang is back, but this time general partners aren’t to blame.
The concept of overhang has been around since before Tim Draper was a gleam in Bill’s eye, and basically means that there is too much money chasing too few deals. Kept relatively narrow, it is the very supply-and-demand imbalance that allows financial markets-both public and private-to function. Once expanded to a certain width, however, overhang can negatively affect return rates to the point of market destabilization.
For venture capitalists, the most extreme case of expanded overhang occurred while they sat shiva for the New Economy. Jesse Reyes, director of research for Thomson Venture Economics (publisher of VCJ), says that VC market overhang at the end of 2001 stood at approximately $98 billion. This is nearly double historical averages (adjusted for market size fluctuations), and was exacerbated by an unprecedented decline in VC disbursement levels. Not surprisingly, returns stumbled. The average internal rate of return (IRR) for a U.S.-based VC fund raised in 2001 stands at -18.2%, with a median IRR of -31.4 percent.
In order to combat the problem, many venture firms began to cut their funds. The first such reduction came in January 2002 from Mohr, Davidow Ventures, which told limited partners that it
would not collect $170 million in commitments on what had been an $848 million fund. By the time that Battery Ventures cut $150 million off its seventh fund earlier this year, venture firms had voluntarily handed back over $7 billion in committed capital.
Add to this the slaying of paper dragons like CMGI @Ventures (a trio of $1 billion funds dedicated to early-stage Internet deals), and Reyes estimates that the VC market overhang has shrunk to $60 billion. “I think that we could get to $50 billion by year-end, which is a historically healthy level, although that assumes that [disbursements] are increasing,” Reyes says. “So a better number right now would be around $25 billion or $30 billion, but we’re clearly moving in the right direction.”
Indeed, general partners have done an admirable job in aligning their fund sizes with the decreased capital requirements of entrepreneurs. This not only applies to fund size reductions, but also to target capitalizations for recent fund-raising activities. The so-called “next generation” of VC funds generally includes vehicles that are less than half the size of their predecessors. Even New Enterprise Associates, which closed on $1.1 billion last December, exercised restraint compared to the $2.3 billion it raised three years earlier.
So far, so good. Well, not exactly.
In order for any capital market cycle to operate properly, all of its capital flows should move in a similar direction. The VC market has three distinct capital flows, but only two-portfolio company disbursements and general partner fund-raising-are sharing a raft. The trifecta would include a decrease in available limited partner capital, but so far it hasn’t happened. In fact, the LP community is moving in the opposite direction.
“The capital usually shrinks on all three levels during one of these cycles, like it did in the late 1980s,” explains Thomas Lynch, senior managing director and head of the private markets group at Wilshire Associates. “In this cycle, the VCs have recognized the changing economics, but LPs just haven’t shrunk. It’s good that LPs are finally strategic investors in this asset class and don’t flee when returns go negative, but it really raises the question of whether or not the venture market is going to be large enough for them.”
In other words, limited partners are causing a new type of extended overhang to be visited upon the VC market. And, unlike last time, this latest incarnation will not be soothed by fund cuts. Instead, it’s going to have to hurt.
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