The Millennium. Everyone was apprehensive about it with fears ranging from Y2K problems to terrorist attacks. Worried families loaded up on canned food and filled their tanks with gas. However, what venture capital financiers seemed unprepared for was the implosion of the Internet and subsequent negative impact on VC returns.
As fourth quarter fund reports started trickling into our offices in early January and flooding in throughout February and March, the accompanying letters looked more like the annual reports public investors were receiving from the their stock mutual funds that tanked in 2000. Catch phrases like “unrealized expectations,” “business model invalidation,” “tough times ahead” and “new opportunities beckon” were commonplace. The story of 2000 is that of how quickly valuations fell victim to public market gravity, dragging the returns of private VC returns along with them.
For the year ending Dec. 31, 2000, the venture industry posted a remarkable 32.5% for the year (See Figure 1), which outpaced the public markets. But hidden in the statistics is the fact that most of that return was recognized in the first quarter of 2000. Returns for the fourth quarter showed the largest quarterly loss of 10.2%, which, if compounded would amount to a more than 40% loss on an annualized basis. This is the first quarterly negative dip in industry returns since the 1998’s third quarter IPO downturn and the single largest quarterly negative result that the industry has seen according to the data Venture Economics has tracked since 1970.
This downturn came as no surprise to industry observers and insiders. Everyone knew the market was overheated. The venture industry got seduced into thinking that all Internet investing was technology investing. As one prominent VC general partner recently quipped, “We found out that backing a 23-year-old college dropout with a Web site was not technology investing.” Even so, the industry continued to pour money into new companies and invested over $100 billion in 2000, much of it still going to Internet-related concerns. No one really thinks the Internet is dead, but types of investing and business models are moribund.
In last year’s annual performance article (VCJ, July 2000 pg. 41) it was demonstrated that the fortunes of the venture industry are very closely tied to the performance of Nasdaq. This was as true in 2000 as in the past. In fact, over 65% of the companies going public in all U.S. markets last year were venture backed. Figure 2 is an extension of the statistics in that article, and the correlation that was so marked up to year-end 1999 was seen to be accentuated much of last year. VC partnership returns peaked in the fourth quarter of 1999, even surpassing the peak of Nasdaq’s performance which is unusual, as historically, venture returns have been less volatile than those on the public markets. Nasdaq dipped into negative territory as soon as the following quarter. VC partnerships stayed afloat a bit longer, but shortly thereafter resumed their own nose-dive. By year-end, the three-month returns rejoined Nasdaq in the negative arena, yielding the aforementioned -10.2% return, the lowest since 1998.
All fortunes were not created the same in the industry. Figure 1 provides results over various time horizons for the industry’s various stage categories of investment. It demonstrates that while we’ve gotten used to seeing quarterly and annual returns numbers for the industry, it is still a long-term game and expectations of a 20% return in the long term are usually attainable. Most of the short-term VC boom can be attributed to early/seed-stage investments. This category of investment had all but disappeared in the late 1980s and early 1990s but saw a fantastic revival with the investment in Internet-related start-ups. Investing in a company earlier in its lifecycle entails more risk, which in turn demands a higher potential return. The industry saw that concept validated, as the return for year-end 1999 was a whopping 248%. Everyone knew it wasn’t sustainable, limited partners knew it, VCs knew it, but the industry continued to invest heavily.
Established Funds Display Longevity
Like fine wines, funds also get better with age. Recall the many dotcom Wunderkinds of 1998 and 1999 that tried to recreate the traditional business model. The simultaneous bull market supported such nave experimentation of these idealistic Generation Y companies. After the market began to show signs of decline, wiser, older owls appeared to remind the youngsters that they don’t know it all. Assuming age equals vintage year when it comes to funds, it is the wise owls that know a bit more than the spring chickens who were not able to keep up their momentum. Analyzing funds’ IRRs with respect to their vintage year (See Figure 3) illustrates this point. Funds that began investing in 1990 have similar, steady IRRs when comparing year-end 1999 vis-a-vis 2000. Funds that made initial investments in 1996 begin to show signs of disparity.However, vintage year 1999 definitively shows the widening gap between performing and non-performing funds. As a result, the reputations and fortunes of firms who are older than seven or eight years are probably secure. Even if they had a mal-performing fund formed in 1999 or 2000, it is unlikely to significantly impact overall firm performance in the long run. The same cannot be said for younger firms who were only established during the Internet boom. They will have a much more difficult time attenuating the overall impact the downturn will have on fund performance.
Realizations are Key and Valuations are Illusory
As anticipated, this polarization of funds places firms with earlier vintage years in a dominant position over newer ones. This is dramatically illustrated when examining metrics of unrealized returns versus realized returns, i.e. the amounts of residual value to paid-in capital (RVPI) and distribution to paid-in capital (DPI), respectively (See Figure 4). Over time, as measured by vintage year, it is obvious that unrealized gains as measured by RVPI, increase substantially as we look at younger and younger funds since younger funds have had less time to mature so more of their performance will be unrealized.
If we examine the realization metrics for the industry as of year-end 1999, it is easy to see that the eye-popping returns were purely based on unrealized valuations of VC portfolios. As a result, the dotcom meltdown of 2000 prevented many of these gains from ever materializing. Compare Figure 5, which looks at exactly the same vintage years, one year later.
These changes in valuation of unrealized portfolios can be attributed to the crash of the aforementioned unrealistic valuations. In some perverse manner, VCs moved from the world of venture investment to the world of venture speculation. Valuations of companies should in some way be indicative of present value of their anticipated future cashflows. The capitalization rate used to discount those future flows accounts for inflation and a risk premium and certainty of cashflows. As either of those changes become more uncertain the valuation has to decrease. Valuations during the bubble were largely based on speculation of cash flows that never materialized. Thus the valuations are pushed further and further downward. Hence the New Economy/New Money Millionaires now filing for bankruptcy and sending out resumes.
What is not so evident is that aggressive valuations due to expected shortened investment cycle all but destroyed the “J-curve” – that is the logistic curve of expected performance of funds that would have early negative returns with subsequent higher returns. Funds formed since 1996 have had unrealized valuations aggressively valued right out of the gate by providing at least unrealized returns in the first year of a funds’ life. The public markets, early in the 1990s Internet boom, seemed to validate these aggressive valuations and many VCs started abandoning their time-honored standard practice of keeping values at cost until significant events occurred. But, VCs are not all to blame. LPs often requested that valuations of unrealized investments be “marked to market” to better reflect what was going on in industries such as the Internet. After all, more and more LPs are being compensated on a performance basis and traditional, conservative valuation policies don’t always accurately reflect what is going on in a VCs’ portfolio. The European Venture Capital Association has gone as far as to recommend in their new valuation policies that GPs keep two sets of valuations, a conservative traditional measure and a market-to-market conditions valuation.
In mid-1999, we had conversations with some in the LP community who wanted to see if there were any ways of bringing the performance of their post-distributed stocks into their performance numbers. Venture Economics stops the meter on performance for a stock once that stock is distributed to the LP, as at that point the GP has no control over the investment. However, some LPs were asking questions like: “Why should the small-cap manager down the hall get credit for his investments in eBay or Amazon.com or some other high flying tech stock. After all we provided the original capital for those companies. Can’t we find a way of recognizing that in our performance?” As you can imagine, those complaints have not been heard recently.
The result of all this has been the beginning of a necessary market correction. Fledgling funds that got caught up in the dotcom fever through 1999 are facing a shaky future. In a sample of 31 funds raised in the past three years, 19% have invested 75% of more of their capital and two-thirds of those have not raised a fund since. This could indicate the crowding out of those less experienced funds by the more established ones with more investing experience. Some would consider this a bad thing; however, those who have followed the industry over a longer time horizon would see it as a welcome winnowing out of less capable players.
Implications for Funding
What will the impact of all this be for firms? Seasoned, established firms that hopped on the dotcom joyride need not worry that participating in the market blip will tarnish their reputations. However, it will not be the same for those spring chicken Wunderkinds. Since they built themselves up by riding the wave of the high-tech bubble, they are liable to crack under its demise. Funds that based themselves on the run up of valuations during 1999 will be squeezed by the subsequent decline in the value of their portfolios and thus lose their ability to raise additional capital from limited partners.
Funds Shift Industry Focus
During the Internet boom, VCs got seduced into believing that investing in Internet companies was investing in technology. Since then many business-to-business and business-to-consumer dotcoms have lost their allure as much of their profitability didn’t materialize. Now, after the burn, seasoned VCs who continue to invest in the Internet are moving away from investing in companies that cater to end-users and toward Internet tools and infrastructure. Like people in the oil business, they have found that there may be more fortune in the pipelines and refineries than in drilling the oil out of the ground. Total U.S. investment in the first quarter of 2001 indicates still one third of investment in Internet companies. Computer software is now capturing about 20% of investment dollars.
Even while the press is writing about the demise of the Internet, East Coast VCs continue to make Internet investing their top investment category while California firms have shifted focus to communications first and software second with Internet investment falling to a not-too-distant, but significant, third place. Do the founding Fathers of the high-tech capital in Silicon Valley know something the rest of nation doesn’t, or is the rest of the country simply playing catch up?
Has the Industry Learned Anything?
So what does all this mean? Did the new millennium bring an end to the once lucrative VC industry? Certainly not. One may recall similar troughs following past trends. Personal computers in the early 1980’s, artificial intelligence later that same decade, biotech in the early 1990’s and now the Internet phenomenon. What many experienced VCs feel is that this is an opportune time to exploit the consolidation of the market. The slowdown in investing affords many the time to pick and choose deals more diligently than before in the rush hour of 1999 and early 2000. It also seems that VCs now have more time in growing the plethora of companies they financed in the last two years. Many welcome the relief of having to do new deals and getting on the fund-raising circuit. But there are some hard issues that VCs and the industry have to face:
* How much of recent bad Internet investment do they write-down and when.
* Given the more difficult fund-raising environment and with constrained capital, do they spend the next dollar on new investments or in supporting old investments.
* Do firms formed in the last couple of years with only one or two funds under their belt that have spent most of their capital with little in reserve have a chance of surviving.
* How do firms manage LP expectations.
Some see a silver lining. This is also a period when many faux-VCs (in it for the short term, hoping to make some quick money) may fall through the cracks of this correction, leaving the arena open for the true, long-term players. Of course this will take time. Industry experts estimate the downturn will continue into 2002. However, the aftermath could yield more efficient, higher return investments. Since the beginning of 2001 the percent of profitable venture-backed IPO issues has been steadily climbing. Naysayers feel that VCs are becoming too conservative, thus losing touch with the “risky excitement” the industry was based on. Only time will tell.