The Perfect Storm

Stuart Ellman

Will Porteous (my partner and co-professor at Columbia Business School) and I return today from a week in Europe. We came here to teach a graduate seminar in venture capital for the CDTM (Center for Digital Technology and Management) in Munich. CDTM is a joint program of Ludwig-Maximilians University and Technical University, both of Munich. As a point of note, we are extremely impressed with both the quality of students and the effort put in by many of the leading German venture capitalists who participated in the program.

While we were in Europe, we decided to visit a number of our existing Limited Partners and some prospective new LPs. In addition, we just had our annual LP meeting for RRE last week. From this confluence of events, we have gained some timely views on how many leading LP’s are thinking about venture capital, both as an industry and an investing segment.

Obviously, the pitch to these prospective LPs is the RRE story over the past few funds, particularly our two latest funds, RRE III and RRE IV. Without getting into too much detail, we feel good about the choices we’ve made over the past eight years, both because we have chosen some very good companies and because we have made some strategic investing decisions that kept us away from some areas that have performed poorly. As we went out and told our story, we heard three entirely different responses.

First are the LPs who are committed to venture capital. These firms, by and large, are thrilled. Those firms that have a long term approach to venture capital realize the importance of getting into the best performing funds in each segment (the alpha) and staying with them throughout the venture capital cycle. They do not simply seek out venture “exposure” (the beta); they focus intently on how their managers create value over the long term. We hear from them that they are very happy with the choices we have made and look forward to a long term relationship.

The second category of LPs believe in venture capital but do not know if they will have the capital to continue to play in these markets. That will continue to be part of the fallout from the market crash.

The third category are those LPs who are constantly debating where they should allocate money within private equity, whether it should be in LBO’s, growth capital, distressed, or venture capital. These people, for the most part, are skeptical and believe that the venture model is broken. Here is why: they have been the victims of a “perfect storm”.

The bull market of the late 1990’s and the extraordinary returns generated by the venture capital industry led to a wave of fundraising that brought many new Limited Partners into the market. The crashing of the dot-com bubble in 2001 was devastating to the returns of funds raised from 1998 to 2000. It was a once (or maybe twice) in a lifetime complete crash of a market segment. The tech market finally started to show some signs of life for VCs in 2006 and 2007. This led to some optimism and some high valuations being paid during this time period. Then the entire market crash of 2008 happened, taking the IPO and the tech market right down with it. The worst market crash since 1929, again, “once in a lifetime”. But, for VCs and fund investors that may have been in the category since 1999, devastating. As one LP told me, he has been investing in great venture firms for a decade and has not yet made any money. Therefore the model must be broken.

The model has been broken for the past decade because we had two separate once in a lifetime crashes happen during one fund cycle. This is like Sebastian Junger’s “perfect storm”. Most VCs (and by extension, LPs), have been tiptoeing in a minefield for the past decade. What are the odds of this “perfect storm” happening again? Statistically, not very high. Twenty year venture returns are still over 20% annualized. In the long term, risk equals reward. This will happen again in venture.

Here is what I believe: Fewer venture firms will get funded and those funds will be smaller. Supply of venture money will be less and prices will continue to be attractive. As my respected venture friend, Fred Wilson, points out, there are many reasons to believe that tech IPO markets will return. So, lower prices and a rebound in exits. I think we are going to have a great period of venture returns over the next decade. Patience and discipline are the words I am going to try to live by.

Venture Beta

Stuart Ellman

Eric Wiesen

The Q1 numbers on Venture Capital investing were released last week. As is often the case with VC numbers, especially when they’re bad, there was no shortage of press and blog attention to the drop in both venture investing (in terms of capital deployed) and venture liquidity. And the general narrative that initially emerged was largely one of panic and, schadenfreude.

Shortly thereafter, however, people started to dig into the data a little bit further. We want to give big kudos to our NYC brethren, Fred Wilson, for his blog post on this topic. Two interesting analytical slices have emerged from this further examination. First, there was a meaningful disparity amongst geographies, with Silicon Valley seeing a much larger drop (even as a percentage of capital) than sectors in the Northeast like New York or Boston. The second was that certain sectors (like CleanTech) saw a far larger decline than other sectors (like health care).

And in looking at these second-order narratives that have emerged from this major change in venture behavior on both sides of the equation, it starts to become clear that there may be a sort of “beta” attached to different sectors within venture capital, much like there are differing levels of beta within sectors of the public market.

Beta, for those who aren’t familiar with the term, means that while most securities move in the same direction as the overall market, some tend to move more than the market while some tend to move less. A stock with a beta of 2.0 will generally increase by a percentage twice that of the overall market when the market is up, and correspondingly will decline twice as much as the market when the market is down. A stock with a beta of 0.5, by contrast, will only be up (or down) half the amount of the overall market. High-beta stocks are great in a go-go market and really bad in a down market. Low-beta stocks are generally less exciting when things are good, but hurt much less when things turn south.

The data emerging out of the down numbers for venture capital start to suggest that perhaps certain sectors (like health care, thought by some to be a safe source of “singles and doubles”) will generally act lower-beta than others (like CleanTech or the consumer web, which enjoyed massive momentum in the years prior to the downturn). Similarly, areas like New York and Boston start to look generally lower-beta than Silicon Valley. There have been fewer massive high-priced companies in New York, but the fall has been far less precipitous. We can only assume that the beta may be directly correlative with the supply of capital in those regions. In NYC, where there are fewer venture firms, there tends to be less upward (and obviously downward) pricing jumps because there are fewer firms to both jump in and jump out of the markets when sentiment changes. In the NY venture market, we have seen pretty rational pricing over the past few years, while other regions were seeing significantly higher pricing as the funding markets picked up steam. Since our region’s pricing never got too high, it has not fallen nearly as dramatically either. It is reassuring to see Fred’s analysis back this up.