img src=”/vcj/images/Phillip_20Dignan.jpg” border=”0″ align=”right”> A hot topic in venture capital circles today is whether the industry has too much uninvested capital under management, commonly known as “overhang.” Recently, Venture Economics (VE), the publisher of Venture Capital Journal, estimated that the amount of overhang at the end of 2001 was $106 billion. But what is the significance of that number? Does it pose a real problem for investors? Should it change the outlook for the venture capital industry?
While this estimate of the overhang sounds alarming, it is a mistake to look at the overhang number in isolation. To assess its significance and its potential impact on the industry, it is necessary to measure the “ratio” of the overhang (or supply of capital) to the pace of investment (the demand for capital). This provides a more effective measure of uninvested capital. We refer to this ratio as the Reserve Ratio, as it expresses, in years, the amount of capital reserved for future investment.
Holding capital in reserve is a natural phenomenon in the venture capital industry. Over the past 20 years, the average Reserve Ratio has been 2.3 years, with a high of 3.7 years in 1981. The Reserve Ratio for 2001 of 2.4 years is hardly abnormal. Moreover, at current trends and under a number of future scenarios, the Reserve Ratio is likely to remain within historical norms for the 2002-2004 investment horizon.
What Is Overhang?
Overhang represents the amount of available or uninvested capital that has been raised by venture capital funds. VE tracks the total amount of capital raised (Commitments), the amount of paid-in Commitments (Contributions), and the amounts of capital invested by the venture industry. Based on that data, VE developed the following methodology to calculate overhang:
* First, estimate Commitments over a rolling five vintage year basis. For example, for the year ended 2001, Commitments are computed for funds formed from 1997 to 2001.
* Second, estimate Contributions for the same period of time.
* Third, subtract the second from the first to calculate Uninvested Capital (overhang) for the five-year period.
In its May 2002 Viewpoint explaining “overhang,” VE noted that uninvested capital as a percentage of committed capital shows that “the current environment is fairly typical of the nature of the industry.” To wit, its paid-in capital to committed capital (PICC) ratio for venture capital in 2001 was .51, compared to an average PICC ratio of .53 for the venture industry for the past 21 years.
That said, VE expressed concern about the “sheer magnitude of capital raised and deployed in the past five years.” Given the magnitude of this overhang estimate, the industry is now questioning whether the number represents an “exorbitant amount still waiting to be put to work” and whether the venture capital industry can possibly invest that amount profitably, VE stated.
Generally, an excess of uninvested capital poses two threats to investment returns. First, it may lead to unwarranted competition for new deals, which in turn may result in overvaluation of deals. Second, it may lead to over-investment in sectors that cannot support venture rates of return.
Such threats present several possible implications for the industry: a reduction in the amount of capital allocated by institutional investors to the asset class, a continued reduction in the size of current funds, a decline in the number of funds, and a ratcheting down of return expectations.
To assess these issues, one cannot simply use the estimate of aggregate overhang. By expressing the overhang as a ratio of supply to demand, however, we produce a useful measure of the excess/deficit of reserved capital and its potential impact.
The Reserve Ratio
The Reserve Ratio is the result of dividing the aggregate overhang number by the total amount of venture investment in a given vintage year.1 Thus, it represents the number of years of capital reserves given the current investment pace. Figure 1 (see next page) shows the Reserve Ratio for the period 1981-2001.
The Reserve Ratio in 2001 of 2.4 years is consistent with the historical average of 2.3 years.2 During the last 20 years, the maximum observed ratio was 3.7 (in 1981) and the lowest ratio was 1.0 (during the extraordinary 2000 vintage year).
To assess the potential impact of the Reserve Ratio on the venture capital industry, we must consider what may drive that ratio in the future and where it may sit within historical boundaries.
The aggregate overhang is a function of the supply of new Commitments and the amount of Contributions in any vintage year. The level of Contributions in a given year is, in turn, a function of the demand for investment capital.3 That demand is driven by a number of factors-the economy, the stock market, and, particularly, information technology (IT) spending, a primary driver of VC investment.
Over the last 20 years, nearly 70% of venture capital dollars have targeted IT-related investments (IT Investment Ratio), reaching a high of 81% in 2000, according to figures from VE. As a percentage of total IT spending, IT venture investment has averaged 1.3% (IT Spending Ratio) over the same 20-year period, ranging from a low of 0.3% in 1993 to as high as 7.7% in 2000, according to data from IDC and VE. With the growing importance of IT in the economy during the last 10 years, the IT Spending Ratio average has risen to 2.1% as shown in Figure 2 (see next page).
On the supply side, Commitments are driven by investor allocations to the venture capital asset class. The average institutional investor has just under 4% allocated to the class, according to Wilshire Associates. Any change in asset allocation policy will obviously result in an increase (or decrease) in the amount allocated to the venture industry. The allocation is also affected by total investor returns. Even with a fixed allocation percentage, the amount allocated to venture capital will decrease if lower investment returns reduce the institutional base of investment capital.4
Through the first half of 2002, VE reports $3.5 billion of new Commitments and $12.1 billion of new investments. Of the $12.1 billion invested, $7.4 billion, or 61%, has gone to IT-related opportunities. Even in this dismal year, the projected Reserve Ratio of 3.7 years will still remain within the historical high. If we extrapolate the current trends through 2004, the resulting overhang will be $65 billion and the Reserve Ratio 2.7 years.
Is this extrapolation reasonable? On the supply side, the current annualized pace of $7 billion in capital raised is relatively low compared to recent historical standards. However, it is important to link this annual estimate to its key driver: asset allocation. Over the period from 2002 to 2004, $7 billion raised annually would represent a 1.1% decrease in the asset allocation to venture from the current 4% average.
On the demand side, the current level of venture investment-annualized at $24.2 billion-is also relatively low by recent standards. Again, it is helpful to place this ratio in the context of the key driver: IT spending. Based on IDC’s September 2002 forecast, annual IT spending worldwide for 2002-2004 will be approximately $1 trillion. The current annualized IT venture investment forecast of $14.8 billion represents 1.5% of total IT spending, slightly above the 20-year historical average of 1.3% but well below the 10-year average of 2.1%.
The overall level of venture investment is further affected by the IT Investment Ratio. The current ratio of 61% is down from its historical average of 68%.
On balance, at current trends, the absolute overhang amount will decline 38% by 2004, and the Reserve Ratio will remain within historical norms, declining toward the 20-year average.
At what point is the Reserve Ratio a legitimate concern for the industry? And how sensitive is the Reserve Ratio to changes in key drivers? A Reserve Ratio of less than the historical high of 3.7 years should not be of major concern to the investment community, given that the venture capital industry has historically navigated these supply/demand issues quite successfully.
On the supply side, every $10 billion of additional Commitments contributes 0.4 points to the Reserve Ratio. For the 3-year period from 2002 to 2004, the current trend of $21 billion in new Commitments would have to increase to approximately $45 billion to exceed the historical high Reserve Ratio of 3.7 years.
On the demand side, there are several variables to consider, the most important of which is the IT Spending Ratio. Every tenth of a percentage point decrease in the IT Spending Ratio adds 0.3 points to the Reserve Ratio. As long as the IT Spending Ratio stays above 1.2%, the Reserve Ratio will not exceed its historical high.
Another variable to consider is the IT Investment Ratio. If IT investment becomes a more significant portion of total venture capital investment, this will imply less overall investment activity (other ratios remaining constant) and will slow the rate at which the Reserve Ratio shrinks.
An increase of 10 percentage points in the IT Investment Ratio causes the Reserve Ratio to increase by approximately 0.8. Practically speaking, only when IT venture investment reaches 75% or more of total venture investing is there a risk of the Reserve Ratio exceeding historical norms.
While the current environment warrants caution with regard to new private equity outlays, we do not believe over-reaction to the overhang is justified. Instead, the overhang must be placed in proper perspective by measuring it against the pace of investment. Examined in this light, the resulting Reserve Ratio is likely to fall nicely within historical norms at current trends. The absolute overhang figure, while large today, is in the process of a natural correction. What has been forgotten in this argument of late is that the venture industry can never be 100% invested and, therefore, by definition, there will always be a positive overhang. Overall, too much emphasis has been focused on the absolute dollar amount.
Furthermore, there is little correlation between the Reserve Ratio and venture capital vintage fund returns.5 History has shown that it is in periods like the current market downturn that some of the best companies are created. The conditions today resemble the 1987-1991 time frame when the United States suffered a market crash, war and recession. The Reserve Ratio was slightly above 3.1 years in 1990. Over the succeeding years, investment rates outpaced capital contribution rates, bringing the Reserve Ratio down to approximately 2.0 years by 1994. As the overall public market improved, exits were achieved and the performance for venture funds formed in the late 1980s and early 1990s averaged 19.7%.6
The overhang issue has been mistakenly framed. Under a wide range of scenarios, it is likely to do no more lasting harm than a bad hangover. Indeed, a recovery is already in progress.
Phillip Dignan and David Link are partners in Appian Venture Partners, a new venture firm in Denver, Colo.