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Venture Capital: the Brightest and the Rest

Too much money has been chasing too few great startups.
Economist Staff, The Economist
July 10, 2009

One of Silicon Valley's biggest success stories is doing his bit to lift the gloom hanging over America's venture-capital (VC) industry. On July 6th Marc Andreessen, who made his name in the 1990s as the co-founder of Netscape Communications, the firm behind one of the earliest web browsers, announced that he and a partner, Ben Horowitz, had raised $300m to back promising start-ups. The fund was heavily oversubscribed and attracted money from several other tech luminaries.

His is not the only glimmer of light. On July 9th the latest results from a "confidence index" compiled by Mark Cannice of the University of San Francisco showed that venture capitalists had become more bullish for the second consecutive quarter. The comatose market for initial public offerings (IPOs), an important exit route for VCs looking to unload companies, is also showing a few signs of life. According to Thomson Reuters and the National Venture Capital Association (NVCA), an industry group, there were five venture-backed IPOs in the second quarter of 2009, worth a total of $721m.

Yet the worst is far from over. The downturn has battered many start-ups, forcing their backers to pump in more cash to keep them afloat. The dire state of the IPO market and the mergers-and-acquisitions business means VC funds will have to hold on to firms for far longer than planned. This will almost certainly lead to a dramatic reshaping of the industry. Mr. Andreessen reckons that as many as 300 of the 880 or so active funds in existence could disappear. Observers are on the lookout for "zombie funds," which keep their existing investments ticking over until they mature but stop making new ones.

The NVCA is lobbying hard for changes that it thinks will revive the IPO market. Among other things, it argues that a new generation of small investment banks is needed to support venture-backed offerings. "We can't sit around and wait for the big banks to come to us," explains Dixon Doll, a former chairman of the NVCA. The group also wants regulators to reduce the compliance burden on small firms thinking of going public.

But the proposals fail to address the root cause of the industry's problems, which is that most venture capitalists have failed to find enough decent companies to deliver the returns they promised investors. A recent report by Paul Kedrosky of the Ewing Marion Kauffman Foundation, a research outfit devoted to entrepreneurship, points out that ten-year VC returns will turn negative at the end of this year as the big wins from the dotcom era fade away.

The problem is that although many venture capitalists have been outstanding at raising cash, they have been pretty lousy at investing it. Even after the dotcom bust, endowments, pension funds, and rich families fell over one another in a rush to back funds they hoped would produce the next Google or Genentech. "Everybody and his brother jumped into the business," says Navin Chaddha of Mayfield Fund, a big venture firm. As a result VC funds have been investing, on average, a whopping $26 billion a year in start-ups since 2004.

But much of the money has ended up in me-too companies that will not become the shining stars venture funds so badly need. All that cash has also inflated valuations of fledgling businesses, making it harder for VC funds to turn a profit on them. Many reckon the industry needs to become substantially smaller. Fred Wilson, a venture capitalist who pens a blog on the industry, has estimated that the amount invested each year needs to fall to around $15 billion-17 billion in order to produce acceptable overall returns. Mr. Kedrosky puts the figure at $12 billion.

Investors are already tightening their purse strings. According to the NVCA, venture funds raised a total of $4.3 billion in the first three months of the year, compared with $7.1 billion in the same period of 2008. Only three new funds were launched in the first quarter of this year, compared with ten and 21 in the same period of 2008 and 2007 respectively.

Even existing funds will find it hard to raise fresh capital unless they are at the very top of the industry's pecking order. Josh Lerner, a professor at Harvard University, points out that the top 10-15% of funds have generated a large percentage of the industry's total returns over time, partly because of their experience but also because their reputations make them a magnet for top entrepreneurs. So investors are still likely to compete for a slice of funds run by the likes of Sequoia Capital and Benchmark Capital, two industry leaders.

Does all this mean that Mr. Andreessen's timing is off? Not necessarily. For one thing, his extensive network in the Valley-where he sits on the boards of Facebook and eBay-means he should be able to tap into some of the brightest minds around. For another, funds raised during a recession tend to outperform those created during booms, perhaps because there is less competition around for portfolio companies. It makes sense for Mr. Andreessen to enter the VC business when his peers are heading for the exit.




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