Business as usual. That is what some say characterized the past year in venture capital. There were no wild swings in activity, no new industries garnering substantial capital and no major shakeups at the venture firms themselves. But as those practitioners who have operated in this asset class for the last decade will agree, the venture industry today is anything but usual.
We are emerging from a period of unprecedented exuberance to one of unmatched demand. This environment will create an atmosphere in which responsibility will fall heavily on the shoulders of general partners to make the right strategic decisions for their firms and for the asset class as a whole.
We have rebounded from one of the highest falls in the history of the venture industry. There are those who felt that the downturn lasted forever, but in reality it transitioned very quickly. We moved from fear and uncertainty to normalcy in about 24 months. And now, in mid-2005, we are beginning to see some signs of exuberance again. Yes, signs of frothiness are appearing, but not in traditional places. Today, we see the general partners acting with considerable discipline while institutional investors are eagerly looking for top-performing funds to accept their money. It is this unprecedented demand that will shape the next several years for the industry.
How did we get to this extraordinary place where institutional allocations for venture capital far exceed the capacity of the industry despite poor recent investment results? The overall investment market is much to blame. With lower interest rates and lackluster equity performance, investors are moving further out on their risk spectrum to try to capture some of the higher returns they achieved in the 1980s and 1990s. In the last year interest rates have risen modestly from 40-year lows and the stock market has been drifting sideways for some time, compelling investors to look to hedge funds, real estate and venture capital for returns. Until this global “group think” in asset allocation unwinds, there will not be any reduction in the pressure to invest in venture funds.
Simultaneously, the venture general partners who were burned badly in the tech bust are now raising much smaller funds. To their credit, they are remaining disciplined despite the temptation to take in more money. Consequently, venture firms are in what may seem an enviable position (but is actually a difficult spot) with respect to their limited partners. Many have had to cut back or cut entirely the allocations that their investors would like. Limited partners frustrated at not being able to invest what they would like with their existing managers are often funding new managers. Forty-five first-time managers were funded in 2004 alone. As this continues, it will inevitably put pressure on industry returns. Many of these investors will ultimately realize that with return compression, it doesn’t make sense to have a significant allocation to venture capital. But it will take a decade and, for now, the flow of money into the industry is here to stay.
The reduction in fund sizes and the inflow of money has exacerbated the FOIA debate. This situation is particularly ominous for public pension funds, which are being penalized by Freedom of Information Act (FOIA) disclosure policies in their states. Ironically, this push for greater disclosure of information is not being driven by the limited partners, but by industry outsiders who are motivated by a different set of factors. In some states the media is looking to assign accountability and/or find political connections to poor-performing investments. Additionally, commercial organizations are now looking to develop for-profit businesses by aggregating this type of performance information. In most cases limited partners are finding themselves at the center of a debate in which they never intended to participate. In this period of strong demand, the general partners have the luxury to turn away money if it puts sensitive firm or portfolio company information in jeopardy. And, if they are oversubscribed, it will be easier to exclude an entire class of investors. In any event, FOIA issues are a negative for general partners and limited partners alike, as all sides have to adjust to new and different reporting issues.
The Right Thing
In addition to choosing investing partners for the next decade, firms will face other strategic choices in the coming year. And for an industry that admittedly made its mistakes in the late 1990s, venture firms seem to be doing the right things today.
Leaner and Focused. For most firms, though not all, smaller is better. The downsizing of partnerships places the fund in a healthier position and by and large general partnerships perform better managing an appropriate amount of money. They will also perform better by becoming more focused. The generalist venture firms formed 25 years ago have become more specialized as they realized it wasn’t possible to have the expertise necessary to be successful investing in a broad range of industries. The asset class will now bring in a generation that has more expertise in specific sectors. Simultaneously, entrepreneurs that at one time looked locally for their investors are today seeking the best investors in their sector, wherever they are located, compounding the importance of developing a “brand” in specific spaces.
Thinking Globally, Acting Globally. A venture firm located in a small city investing in local deals may perform respectably, but we are now in a global economy. With exit markets becoming more discerning and so many companies in the same sectors, a global strategy is a prerequisite for a stronger return. It is reassuring to see VC firms flying back and forth to Asia, not necessarily doing transactions yet, but defensively to make sure they understand the dynamics of outsourcing, engineering and global human capital. These are the same general partners who used to brag about not doing any deals more than an hour away from their office! Still, many GPs are backing people who they know already, funding hybrid companies led by Indian or Chinese entrepreneurs who have been in the United States but are now able to operate in their home countries as well. It is a logical, risk-mitigating strategy, allowing the firms to keep their ears to the ground and keep from getting left out of emerging growth opportunities.
Building Brand. In the last 10 years, the top 50 venture firms have been distancing themselves from the rest of the pack from a branding perspective. Despite the relatively low barriers to entry on the fund-raising side, the barriers to entry for access to the best deals remain high. Unlike the buyout market, where many firms see the same deal flow, there is a more proprietary nature to venture opportunities. And unlike 25 years ago, when the entrepreneurs didn’t know the venture capitalists, today everybody knows everybody. This intelligence is facilitated by the media, which are still interested in telling stories from the industry about successes and failures. Consequently, top managers continue to see the better deals and then have repeat entrepreneurs come back to them. The emerging manager, for the most part, doesn’t have access to that franchise. There will clearly be success stories that do not fit this formula. It only takes one win to make a firm, and a firm can live off a single success for several funds. Most top-tier firms have at least one poor performing fund. And the corollary is true: Lesser known firms have stellar funds. However, there is a greater persistency of returns with the top-tier and that is likely to continue.
Bright Future for Innovation
Opportunities to find breakthrough companies have never been better. Those pundits who claim that there is no “next big thing” when it comes to innovation are misguided. One year before the Internet took off, no one saw it coming. However, a series of events was taking place simultaneously that had tremendous consequences. There was a buildup of critical mass of personal computers in homes and offices. These personal computers were steadily being connected by increasingly sophisticated LANs and WANs. The telecommunications industry was deregulated, which lead to a significant investment in the telecom infrastructure, increased competition and decreased costs for communication in general. The browser was invented. Computation power improved dramatically. The commercial Internet was the result of these separate factors coming together simultaneously.
Today we are seeing other intersections. There is a blurring of lines in wireless connectivity, broadcasting, software, tracking, games, media and entertainment. Innovation in the semiconductor space is reducing the size of hardware while increasing power. These are very likely the ingredients for the next new thing-the thing that will change the way we live and work. But what that “thing” is hasn’t crystallized yet.
There is unprecedented demand for venture capital funds, a global ecosystem growing exponentially and a confluence of technologies swirling around one another with the promise of driving the next technological revolution. There has never been a time like this in the history of the asset class. These changes create endless opportunities for those poised to seize them. The venture industry will continue to rely on its own nimbleness, flexibility and creativity to leverage change and achieve the returns it has traditionally enjoyed. Venture capital has never been about business as usual and, hopefully, it never will be.
Bon French is CEO of Adams Street Partners, one of the largest global managers of private equity partnership investments in the world. He is a member of the National Venture Capital Association’s Board of Directors.