Yes, Too Much Money is Chasing Too Few Deals in VC

Anyone in the venture capital business who doesn’t acknowledge that there is too much money chasing too few deals should consider doing something else for a living.  I have been asked this question so often in public forums and private meetings that I now preempt it by asserting that there is too much money chasing too few great opportunities in VC.

But this is also not news– any financial business that delivers superior returns always attracts too much capital, and that marginal capital always drives down returns.  I lived through this in the risk arbitrage business in the mid-1980’s and witnessed it again in the high-yield markets in the late 1980’s. Today, perhaps we are seeing a similar cycle play out in the Leveraged Buyout/Private Equity business and in some pockets of garden variety long-short hedge fund strategies.

It is a fundamental fact of open capital markets that, absent any significant barriers to entry, HOT sectors will tend to attract too much capital chasing performance.  Those marginal dollars will exit the HOT sector when the bubble bursts and things go COLD, and then the people who are really in the business will get back to making money.

In VC, success is not defined by your check writing ability, it is defined by your ability to get into great deals and to actually do something to help your company reach its optimal outcome– that’s what let’s you stay in business longer than a single cycle of being lucky.  If VC’s were judged by the size of their pocket book alone, the industry would hardly resemble its current composition. To that point, very few new early stage venture firms have been funded over the past several years, and I can’t think of any early stage venture firms that have not reduced their fund size from where they were six years ago.

Analyzing the recent Thomson Financial and NVCA private equity performance numbers, Private Equity Week commented today that historical performance numbers are about to take a turn for the worse as the 10-year horizon benchmark data falls into the post-2000 abyss:

10-year horizon VC performance through Q2 2005 was 27.4%, then dropped to 22.7% at the end of Q1 2006 and currently stands at 20.8% (performance data lags by one quarter). Now imagine what will happen once the data begins to include all of the bubble-era Internet and telecom deals. We’ll be looking at brutal ten-year returns at least through 2009, and probably a bit longer. …

The Private Equity Week article goes on to point out that the 3 and 5 year returns for VC are also getting better, which suggests that recent assertions by firms such as Sevin Rosen about the "broken venture model" may be behind the times. Click HERE To read the full Private Equity Week article.

Recent statistics also show that the VC industry is experiencing price inflation in second rounds.  In my view, this is unsustainable given the persisting weak overall exit environment.  Keith Benjamin’s recent post on the weak merger environment makes sense on this point.  Practitioners of venture capital must also be students of the links between the various capital markets.  While I am encouraged by recent results, I am not ready to draw a line straight up, or straight down, based on the M&A data or the recent encouraging IPO data.  One thing that I am sure of is that the tech bubble period was an anomaly and that real companies can and will continue to be built by smart entrepreneurs and VC’s.  Being proactive, selective, and realistic about the constraints of the current and expected future venture investing environment will help boost returns.  Looking in the rear-view mirror and bemoaning the last ten years is, in my view, a waste of time.       

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