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.

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.