A Dark Summer

Stuart Ellman

Eric Wiesen

We’ve been hearing it from readers and friends about not blogging more over the past month. And it’s a fair critique.   Sometimes we just have nothing to say.

It is feeling pretty dark in venture capital right now and as we head into summer it doesn’t seem likely that most of these things I’m about to say will change.

Venture capital is basically a funnel. Money goes in, companies are built, value is added (or not, depending on your point of view), exits are achieved, either via M&A or public offerings. Let’s look at each part of the funnel.

At the top of the funnel we see a few things:

•    Many LPs are questioning the venture model or don’t have the funds to participate in the venture asset class.
•    Pension funds are scared to be seen allocating to Private Equity and Venture Capital.
•    New funds aren’t being raised – firms are finding that their returns aren’t sufficient to entice LPs to dance another song with them.
•    Those new funds that are being raised are smaller and further apart.
•    Those who have capital are scared to put it to work, either because they worry that the companies won’t be able to succeed in such a slow environment, or because they feel they must conserve capital for their existing portfolio.

As move into the middle of the funnel, a few observations:

•    Social media deals are having trouble, as the sector was overinvested and many of these investments assumed a business model could be figured out in a more capital-rich environment down the road.
•    Online advertising is struggling badly, and an entire ecosystem of consumer internet and ad tech companies that depended on ad support are having to re-think their businesses.
•    Deals in clean technology or hardware sectors that require significant CapEx are struggling, as the public market required to properly provide these companies with growth capital simply hasn’t come back in a timely fashion.

And finally, the bottom of the funnel:

•    Despite a few promising IPOs, the exit markets are still a mess. The pipeline of companies that “should” be able to go public is lengthy and it will take a while to process this queue. Trade sales are down as the multiples afforded by the acquiring companies have decreased due to a depressed stock market.
•    Over the last decade, venture returns have not been exciting, and it looks like this will continue while the market and the broader economy works on recovering from its leverage hangover. This wasn’t the fault of venture capital or our companies, but we are collateral damage.
•    Even for those companies who may be able to go public, there is little mezzanine equity available, certainly none from hedge funds.

So, what does one do?  I still believe in the venture model.  Motivated, entrepreneurial people will start and build great companies.  Great venture capitalists are wanted, not because of the color of their money but because of the quality of their advice and help.  These two always find a way to meet up.  Exit markets always come around; new companies will grow quickly and people will want to invest in the next Apple or Google.  Some fund cycles have poor returns. Others have excellent returns.  An LP cannot pick the right fund cycle, as the commitments are 10 years.  So in order to play, you need to invest in all the cycles.  New funds not being raised means that those with capital will have lower prices and better returns.  VC’s will carefully put money to work but the asset class will get smaller; it is Darwinism with the VC community.  Pension funds will end up reallocating capital as soon as they start to see returns.  The lack of mezzanine capital means that prices will stay reasonable, even for quickly growing companies.

At RRE, I have many reasons to be happy.  The unallocated capital in our most recent fund is larger than most new funds.  We have some really terrific companies in our portfolio.  I have huge confidence in the team we have put together.  However, in tough times, I am focused on being very tough with new money going out the door.  A follow-on investment has to really deserve the money in order to get it.   The days of keeping a struggling company alive and hoping for a better time is behind us.  New deals will get (and are getting) funded.  In fact, we are closing one this week.  But the bar is very high.

Management teams need to be great, the markets need to be moving, and the price needs to be attractive.  Money will be made over the long term if the right tough decisions are made now. This is one of the many things we learned as a firm out of the last cycle and we are applying it now.