NVCA: A Quiet, But Critical Year for VC –

As the venture industry looks out over 2005, some may predict that an unremarkable, albeit successful, year lays before us. With a return to stable investment levels, a gradual improvement in the exit markets and an active fund-raising environment, we might expect to hear more of the same from 2004-discipline, sustainability and a return to normalcy.

Yet, contrary to conventional wisdom, 2005 is poised to be quite an interesting year indeed as a confluence of forces are promising to converge and impact our industry in significant ways. And ironically, those events that we do not hear about in 2005 may prove to be the most compelling of the year.

Industry Bifurcation

Structurally, the venture capital industry will begin to transform in 2005, though not in the way that many would have guessed. The 2001-2002 predictions that asserted we would see a monumental reduction in the number of venture capital firms were wrong (see chart, next page).

Not surprising to many of us, the industry has not seen even a noticeable decline in firms this decade. One factor that is driving this sustainability is the creation of new venture capital firms by industry veterans. We believe this trend will continue in 2005 as pension funds such as CalPERS have publicly stated their interest in investing in these “first time” funds.

Thus, the paradigm shift that many have been looking for will not be a VC industry cut in half by size. Rather, we are beginning to see an industry cut in half by type of firm. That is, we will begin to see a bifurcation of the venture capital industry in which firms fall into one of two categories: large, global, multi-sector firms or smaller, highly focused firms that concentrate on a particular region or industry sector. The success stories will likely be clustered at the ends, while the group in the middle will have to compete aggressively for the best deals. Firms will need to choose a strategy that maximizes opportunities while facilitating an efficient cost structure.

Return to Stealth Mode

2005 will be the first full year of a new business cycle for the venture capital industry. With new funds closing during the last 12 months, we will see a further shift toward seed and early stage investing. At this time in a new fund’s life with little pressure from limited partners for exits, venture capitalists are actively looking now for the home runs of the coming decade.

Along with this move to investing in young startups comes another phenomenon: a shift into stealth mode. As venture capitalists seek and find those fledgling companies that someday may be the Federal Expresses, Intels and Genentechs of their era, they will be highly reluctant to share this information for some very good competitive reasons. Thus, we should not mistake the lack of portfolio company news in 2005 as “no news.” To the contrary, the silence of 2005 will be deafening come 2010.

FOIA Pressures

The convergence of early stage, stealth investing and the Freedom of Information Act (FOIA) battles will form an even larger lightening rod this year, as pressure will be placed on all sides of this issue. The Texas Attorney General’s recent assertion that portfolio company information should be made available to the public has galvanized our industry nationally to protect this sensitive information. It is one issue to call for the release of venture firm returns; it is another to require young companies to release data that will irreparably harm their ability to compete.

If these issues are not resolved, public pension funds will likely see fewer opportunities to participate in venture capital investment. The trend of venture firms declining public money will continue as our industry simply will not jeopardize its portfolio companies and other LPs. Consequently, this year there will be more pressure put on state legislators to limit disclosure so that public pension funds can continue to enjoy the returns that come with investment in alternative assets. The high demand from institutional investors, both domestically and overseas, to participate in U.S. venture capital will allow many firms to be more selective as to who they choose as their limited partners.

The Depletion of Dry Powder?

The demand for venture capital inevitably begs the question, “Is there too much money out there?” The “dry powder” number often cited by the media that equates to venture capital raised, yet not invested will dissipate considerably this year. Committed capital that was sitting on the sidelines from late 1990 funds will expire or flow into new funds.

Additionally, if the investment and fund-raising activity levels continue at the same pace as 2004 as expected, the industry will disburse more money that it raises, further contributing to the dry powder decline. However, the press need not worry about losing a favorite topic for fodder. There are many in the industry who believe that there is still too much liquidity in the system and that annual investment levels would be better at $15 billion than $20 billion. The debate here will continue, but the industry should settle into a level of raising and investing at equal levels in 2005.

A Better End Game

The exit markets will continue to improve in 2005 even in light of Sarbanes Oxley issues and a questionable economy. Much of this is due to IT companies, which still make up 60% of venture investment, finally being able to get sales and income traction. We can expect to see some very solid IPOs emerge this year. Some of these companies will be the phoenixes of the dot-com era, having survived extremely difficult times and emerged as stronger organizations.

The public will be receptive to these companies, and they hold the promise to be major economic generators for the U.S. economy in years to come. Mergers and acquisitions of venture-backed companies will also see more favorable valuations this year as larger companies may adopt a longer-term strategic view of their organizations, as opposed to quarter-to-quarter earnings perspective. All of these trends should bode well for the industry and translate into distributions back to limited partners.

Eye on the Ball

Yes, 2005 should be the best year of the decade thus far. The industry is stable and will make some very good investments in the coming 12 months. At the other end of the life cycle, the tenacity exhibited during the last three years will be rewarded as returns are realized this year. Yet, most of us are hesitant to rest on our laurels, as there will be considerable dynamics at play behind the scenes this year that could make or break the rest of decade.

At the end of the day, discipline and sustainability will always be the name of the VC game, even though these sentiments don’t make the headlines. But without these tenets, there will be no headlines worthy of making. Here’s to an interesting year.

Mark Heesen is President of the National Venture Capital Association. He may be reached at mheesen@nvca.org.