Venture Capital in 2009 – an update for Q2

in my last post on this topic, I suggested that Q2 was the “tell tale” quarter for the year…and the numbers are in.

the NVCA has just released the Q2 numbers and they’re pretty bleak:

Just 25 venture capital funds raised $1.7 billion in the second quarter of 2009, according to Thomson Reuters and the National Venture Capital Association (NVCA).  This level represents the smallest number of venture funds raising money in a single quarter since the third quarter of 1996 (21 funds) and the lowest level of dollars committed since the first quarter of 2003 when $938.1 million was raised.

Total VC Fund Raising by Quarter

Total VC Fund Raising by Quarter

Total so far this year is right at $6 billion. If we stay at this level, my suggestion that 2009 could be a $10b or less year is still possible.

The key take-away from my perspective is that the cost of capital will remain high and probably increase throughout the rest of this year, at least.

To re-state, I believe this is happening for three reasons:

  1. the asset class is going negative based on the commonly used 10-year rolling average return calculation
  2. there is effectively no exit market via IPOs or M&A…certainly nothing consistent and remotely predictable
  3. there remains a significant liquidity crisis in the limited partner world of university endowments and public pension funds

TechCrunch says:

For startups with proven traction there is still money out there. For instance, Pandora just raised a massive $35 million round last week and we tracked $6.4 billion in venture money going into companies last quarter, a 25 percent drop from the year before but still a healthy rate of investment. VCs are getting more selective about where they put their cash, but when they do they are more likely to bet big.

…to which I say:  when rounds of financing get big, now, in the absence of exits and the squeeze on the VC industry…well, that isn’t necessarily a good idea. And, as coincidence would have it, here’s an example of exactly that:

AdAge asks and answers:  “What Sank (video start-ups) Veoh and Joost? Too Much Cash Too Soon”

There are many reasons why things went wrong: technical missteps, lack of premium content, tough terms from content owners such as CBS and Viacom, etc. But that’s not the whole story. Joost and Veoh had an even bigger problem, one that will likely claim dozens of other media and advertising startups that have been founded over the past three years: too much venture money, too soon.

…and that’s not meant to point any fingers; it takes two parties to do the VC tango: the company and the VC.

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Venture Capital Update for Q1 2009

I’ve said in the recent past that I believe there is trouble in the supply chain of venture capital and that 2009 might be a significantly down year for fund raising with a potential total raise of $10 billion. The National Venture Capital Association just released numbers today that confirm the trend but suggest my $10B 2009 target may be a bit too low. That said, I’m not adjusting the target yet.  The reason this subject is important is because it affects the cost of capital for start-ups and the “ways and means” of how they get started in the first place.

The Q1 2009 VC raise is $4.3 billion, up from $3.5 billion in Q4 of 2008.  That’s better than I would have guessed but it’s still down significantly from the $6.4B and $7.1B in Q1 of 2007 and 2008, respectively.  It’s looking like Q2 will be the real tell-tale quarter that either delivers total funding in the $10B range at the half-year mark or shows a precipitous drop.  I still believe the latter will be the case because VC fund raising takes a considerable amount of time…sometimes as much as 6-9 months to complete. This means that the fund raising that closed in Q1 would have been in progress since mid-2008. Undoubtedly, the global economic situation scared some limiteds off over that time; that said, there was probably enough momentum to carry some of the deals with the bigger, top-tier firms through to closing the fund. TechCrunch has written about two of those top tier funds in their summary of this data.

One other important observation from the data has to do with the number of new and follow-on funds that were involved with rasing in Q1 2009:  only THREE new funds and 37 follow-on funds.  To be clear, the number of new funds raising capital is three times smaller than any other qarter over the past 2 years (there were 10 new funds in Q1 of 2008 and 11 in Q4 of 2008).  VentureBeat has suggested that there is a growing list of “walking dead” VC firms…and I think we’ll start to understand how true that is based on Q2’s data.

Here’s the updated the bar-chart that graphs VC fund raising by quarter starting in Q1 of 2007 through Q1 of 2009:

VC fund raising through Q1-2009

VC fund raising through Q1-2009

Venture Capital Supply Chain

Based on a few recent conversations, it seems like a good idea to review, at a high level, the basic supply chain for Venture Capital and Private Equity.

Perhaps a good starting place: what’s the difference between Private Equity (PE) and Venture Capital?  In my opinion, not too much: Private Equity generically refers to non-publicly available equity investments that INCLUDE stuff like early- and later-stage venture investments.  Therefore, my definition is that venture capital typically refers to earlier stage (private equity) investments; private equity typically refers to considerably later-stage (traditionally debt-enabled) buy-out type of investments from companies such as Cerberus and Blackstone. And, to be clear, when we talk about the amount of capital raised being $30billion and declining, we’re referrring to early-stage venture capital and not the larger PE/hedge fund markets.

The following picture shows the basic supply chain for venture capital:

The flow of money from institutional investors to target companies

The flow of money from institutional investors to target companies

Starting on the left, the folks who fund the venture investors are the institutional investors. Institutional investors are folks like public pension funds (such as The California Public Employees’ Retirement System or CalPERS) and university endowments (the BIG 5 are Harvard, Yale, Stanford, Princeton, and The University of Texas) I’ll have more to say on institutional investors in a subsequent post. These institutions spread investment risk across multiple asset classes that include higher-risk (and theoretically higher-reward) investments such as venture capital and private equity (along with traditional stocks, bonds, real estate, etc.). When they put money into venture funds, they become “limited partners” of those funds.

In the middle, the venture investors raise new funds every 3-5 years (no hard rule here) from institutional investors and occasionally high net-worth individuals. Funds can range in size from small (under $50m) to quite large (over $1 billion); typically the top-tier VCs raise funds that are $300-$800 million in size these days.  Venture funds can and do over lap (this is an important how-VCs-get-paid fact for later discussion); in other words, before one fund runs out, the next fund is raised. In more established firms, many funds can be simultaneously operating at various life stages.  In particular, as funds are depleted by investments in companies, VCs will keep some percentage of that fund “in reserve” for follow-on investments in companies from that fund.

On the right are the companies that receive investment. These can be companies at any stage of life: start-up to age-old brand name like K-Mart. The terms and conditions and desired outcomes depend on the company, the stage of life, and various other factors.

Of course, customers and employees of the target companies an important part of the supply chain but not covered in this post.

Venture Capital in 2009

One quick point of order: I am not a VC but I get the dynamics pretty well. And I have invested in a handful of early-stage companies over the past few years; some with VCs, some ahead of traditional venture capital.

If one considers the amount of total venture capital raised from 2006-2008, and then take a look at the last three quarters of 2008 in the context of the larger macro-economic environment, current liquidity issues in traditional limited partner institutions, and the generic venture business model, there are some interesting implications for the not too distant future. This is the first in a series of posts that takes a look at what’s going on in the supply chain of venture capital.

Total venture capital raised over the past 2 years

Total venture capital raised over the past 2 years

The NVCA reported that $35.5 billion was raised across 327 funds in 2007; $27.9 billion was raised across 253 funds in 2008. During the last three quarters of 2008, you can see a decline (red, dashed arrow) mid-year and then a very sharp drop as the economy started slide (to put it mildly) in Q4 of last year.  During Q4 of 2008, the total amount raised was $3.3 billion compared to $11 billion in the same quarter the previous year.

With a bit of extrapolation, it’s not hard to imagine that 2009 could be a year in which $10 billion or less! is raised across the entire industry.

Here’s why I believe that number is about right:

First, I believe that traditional limited partners are experiencing a liquidity crisis. More on the data and what this means in a future post. But, in short, the businesses that fund the venture capitalists are short on cash for that purpose. Not only are the short on cash, but they’re over-subscribed in their commitments to venture capital funds.

Second, in many cases, these same institutions analyze their investment portfolio, per asset class, on 10-year rolling averages.  Guess what year rolls off next year?  1999 is gone from the average and that was a pretty good year in many venture capital funds.  In fact, with 1999 out of the 10-year analysis, it’s very possible that the over-all weighted returns go from positive to negative.  Pretty obvious what happens if an asset class shifts from positive to negative when it comes to how investors choose to allocate any new funds they may have to put to work.

So what is the implication?  I think that 2009 may look like a $10 billion year at most and 2010 will put up an even smaller number; perhaps only $3 – $5 billion in total.  What this means for the industry is that there is a looming venture capital crisis the likes of which the industry has never seen. It’s going start becoming increasingly obvious and play out over the next 24 months. Many, many venture firms are going to go away.   The cost of capital will go up.

UPDATE: April 18, 2009

There have been a number of recent articles on this topic from TechCrunch as well as VentureBeat.  Even as far back as October, 2008, Business Week blog has reported on mounting tension from the VC world:

(Tom) Crotty hopes the atypical investment approach will insulate Battery (Ventures), but he nonetheless sees a reckoning coming—specifically toward the end of 2010. He points to 2000 as the “last really good year” for venture capital. Looking back, “the one-year, three-year, and five-year indexes are all going to be terrible,” Crotty says. “And once 1999 and 2000 fall off, the 10-year will be, too. It’s going to be painful.”

If the 10-year investment period hits at or below the S&P 500, portfolio managers are going to wonder why they’re investing in such a risky asset class. Crotty estimates that 20% to 30% of the money going into venture will go elsewhere, and that is going to be bad. A lot of firms will go under.

To re-state my concern from the original post:  the VC-start-up supply chain will be disrupted for the asset class performance issues noted above AS WELL AS the general liquidity issues in limited partner land.