Five Years Too Late

September 22, 2008

Why Venture Firms Tighten the Purse Strings in a Down Market

Anyone who has raised money during a down cycle like this one has noticed two significant changes in the fundraising climate.

1. Valuations come down
2. VCs make fewer investments

The first is probably fairly straightforward even to those entrepreneurs who don’t like it. When we’re in boom times (like the late 90s, 2005-6 for Web 2.0 or today for Cleantech), deals get bid up and investors pay high prices to get into great and even not-so-great deals. The inverse is also true – in tough times, the leverage shifts and investors hold the upper hand, often getting better terms and lower prices for good companies. That’s just the operation of what is, at the end of the day, a capital market.

The second of these is probably counterintuitive to some and deserves some attention. There is reasonably good evidence that firms are best-served by investing when prices are low and there is less competition for deals. It’s classic contrarianism. Well, aside from the basic truth that most people aren’t contrarians (by the definition of the word), there is another force at play here: When things are good, VC funds invest their funds as quickly as they can and go out and raise another (typically larger) fund. When things slow down, however, venture funds also slow their pace.

Why? Because it’s harder to raise that next fund. Venture funds are hit by an indirect consequence of problematic public markets.

Here’s how it works: Let’s say that you are an institutional investor (like a pension fund) with a $1 billion fund. Part of your fund is invested in venture capital funds. Your allocation to venture capital and private equity is set at 20% (for example). Now further imagine that the other 90% of your portfolio (equities, fixed income, real estate, etc…) goes down by 20%.

So prior to the market going down, you were invested like this:

Equities/Bonds/Real Estate             $900 million 90%
Private Equity/Venture Capital        $100 million 10%

Now, however, you are invested like this:

Equities/Bonds/Real Estate             $720 million 87.5%
Private Equity/Venture Capital        $100 million 12.5%

You are now over-allocated to PE/VC. The problem is that your public-market investments are “marked to market”, meaning that their value changes as the market provides a signal as to a new price. With a publicly-traded security, those signals are provided every business day via price quotations. Venture capital investments, by contrast, are marked to the most recent valuation, and that typically only comes with a new round of financing. There is a significant delay in the marking-to-market of these investments. They will eventually be marked down in this kind of environment, but it takes longer.

The way that most institutional investors respond to this situation is simple and devastating – they stop investing in new funds until their allocation returns to plan. Sure, if a top-tier VC fund comes calling, they’ll find allocation for them, but newer funds raising their first or second fund, funds that haven’t performed particularly well, and other less well-known investors will have a hard time raising capital.

In addition, there is a reduction in the velocity of money that flows through a portion of the Limited Partner base for venture funds. Many wealthy individuals, family foundations and other potential investors in funds use the distributions they receive from successful exits to fund their participation in new funds. In an environment where there are fewer and smaller exits, these investors’ money is locked up in their existing funds, and hence unavailable for new funds. To compound the problem, many of these individuals are technology founders and CEOs who make substantial money from big technology exits, typically IPOs or large acquisitions by public companies. When these types of transactions aren’t taking place, these individuals aren’t potential players as VCs look to raise new funds.

All of this combines to compel venture firms to be more patient and slower-paced with funds, because the bar is set higher for us as well, and we want to make sure that in a climate where fewer venture funds are getting funded, we’ve done only the very best deals that fit closest to our firm’s capabilities.

We know you need the money more than ever in times like this. It’s not personal.

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  1. Seems that the conclusion of your thesis is a slower velocity of venture funding.

    Is a flip side to this analysis also that prices will be lowered as a result of the scarcity – i.e., we have a higher cost of capital. Thus we would expect to see average pre-money valuations decrease?

    Comment by Andrew Weissman — September 23, 2008 @ 9:42 am

  2. Andy – that’s essentially it. Slower velocity of capital through the venture investing industry. This reduction in velocity is the functional equivalent of a reduction in demand for startup companies by investors, and carries with it a corresponding decrease in equilibrium price. Alternately yes, startups have a higher cost of capital and the resulting higher discount rate yielding lower valuations. But either way I think you likely see (most) valuations go down. How this will impact the cleantech investing universe is yet to be seen.

    Comment by fiveyearstoolate — September 23, 2008 @ 10:59 am

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