Thursday, April 30, 2009

Why Venture Capital Is Limited In Scale

Fred Wilson has posted a very thought-provoking piece, arguing that the VC industry is raising too much money. His essential argument is that VCs are raising so much money that the total number and amount of exits cannot possibly deliver a good industry-wide IRR.

I agree with Fred's analysis, but wanted to go a little deeper. This post originally appeared as a comment on Fred's blog.



As an asset class, VC has become terribly overinvested. While the dot com bubble was partially to blame, the hidden cause was the massive rush into VC by endowments and pension funds.

All the major institutional investors were jealous of David Swensen's returns at Yale, and concluded that the reason Swensen outperformed was that he invested in illiquid asset classes like VC.

As a result, the VC industry ballooned to its $25 billion/year size. It was simply a matter of supply and demand.

And at $25 billion/year, VC is simply too big to deliver good returns. True, there are only so many exits, but that too is a symptom and not a cause.

VC companies tend to play in the specific fields of technology and biotech. Both those markets are a certain size; simply pumping more money into company formation doesn't change the fact that the major technology buyers such as Wall Street aren't going to increase their spending more than 5-10% per year.

In the end, all company value comes from the net present value of future cash flows. And cash flows come from customers. And customer spending fundamentally scales with global GDP.

When VC was a small asset class, it had plenty of headroom to grow. But the larger it gets, to closer its returns will get to the overall equity return, with the added negative of illiquidity and volatility.

3 comments:

Furqan Nazeeri said...

That's an interesting story about the guy at Yale...it's like the butterfly that flapped it's wings in Europe that caused Hurricane Katrina! A couple of weeks ago I wrote a post on how there is too much VC focusing more on the "demand side" and the trends there like open source, and cloud computing that are in fact *reducing* demand.

Byron Woodson II said...

The premise is wrong. VC investing may be similar to the Black Swan strategy put forth by Nicholas Taleb. The black swan strategy is a mostly conservative portfolio (85%) with the other 15% put in high-risk. What you're doing is protecting your wealth (85% in slow growth) as well as betting a little (15% high risk) on things that may bring high rate of return.

VC investors are betting that their stable of horses/companies captures a larger share of the wins/market. Though purchasing in an industry may grow slowly, the percentage obtained by their companies grows more than that (that's the assumption at least).

Fred's analysis takes VC investing out of the context of a larger investment strategy (where's the figure saying total investment funds?).

To assume that VC investors are looking at their VC money as their only source of long-term income/return is to assume a very dumb or novice VC investor.

But I'm not in VC, so what do I know?

Chris said...

Byron,

The issue is that the VC industry has ballooned in size such that it's becoming increasingly difficult for it to collectively deliver returns that justify the liquidity risk.

And this applies even to small, nimble funds; those funds need to compete with the bloated megafunds, and thus are subject to similar valuation pressures.