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What's Broken - Venture Capital or Venture Perceptions?

Posted in Financing

Posted by Peter Rip, General Partner at Crosslink Capital, on his EarlyStageVC blog

 

 

There is an oft-repeated mantra than venture capital is broken.  The evidence cited is the dismal absolute median returns of the venture capital industry.   It is true that the venture asset class has become more competitive in the economic sense, i.e., excess returns are more difficult to achieve.  That is to be expected.   Excess profits attract competitors and returns decline.   But that doesn’t mean all competitors converge to the equilibrium return. It just means that the winners will either have the same strategy as every one else with better execution, or simply better strategies.

 

Cambridge Associates is a leading consulting firm that benchmarks the venture capital and private equity industry.  Nearly everyone uses their data to assess whether investment performance of a VC firm is “top quartile” or not.  The reason is simple.  Top quartile performers garner the lions’ share of the profits.   Between 1994 and 2006 the returns of the top quartile funds compounded in value at rate nearly 7X that of the median venture capital firm.  Cambridge recently compiled some statistics about the venture business which document this. The data are proprietary to Cambridge, but I will share with you a high level view of the results, with their permission.  Of course, the following discussion reflects only my own conclusions.

         

 

Once Upon a Time, Everyone Was Top Quartile

 

The 1994-1996 period was an exceptional time to invest. If you were the first investor in a company in that time period your average internal rate of return (IRR) was over 100%.  Repeat -- your AVERAGE IRR was over 100%!  Not surprisingly, when these excess returns became apparent in 1997-2000, the number of venture firms exploded, as did the amount of capital.  We all know this, and have observed the consequences for the past nine years. The period of 1994-1996 was the Wonder years.  Post-2000 has been more like the Wonder What Happened? years.

 

The prevailing wisdom from the pre-2000 period was that early stage venture capital is the place to be.  That same wisdom today is be anyplace but venture capital because the old model doesn’t work.  The facts from Cambridge shine a bright light on the alleged wisdom and illuminate a more nuanced, insightful understanding of what drives performance.

 

 

Timing is Everything - Who Knew?

 

The data in the table below are a paraphrase of Cambridge’s findings.  (If you want the original data, you'll need to become a Cambridge client).  They categorized over 22,000 venture capital initial rounds of investment in a thirteen-year period.  Each investment round was classified from Seed stage to Public, and they calculated the IRR of the initial VC investments made in each year. For example, if Crosslink led a B round investment in NewCo in 1998 as our initial investment, the outcome of our initial and subsequent investments in NewCo would be attributed to the original 1998 investment decision.

 

 

I have simplified their presentation to indicate which stages in each year led to IRRs higher or lower than the average IRR of all investments in that year.  Basically, it is scorecard of what kinds of investments you should have been making each year.

 

The pattern clearly shows that the miracle years of 1996-1999 were all about early stage.  Here’s where the perception that early stage is everything became axiomatic.  Note that as the business cycle shifted in 2000, the best investments were no longer early stage. They were restarts, PIPEs and some late stage deals.  As the economy began to re-heat in the 2005-2008 period, the pendulum again swung back to earlier stage deals.

 

These data are consistent with our own experiences at Crosslink.  We raised Crosslink Ventures IV in 2000 and Crosslink Ventures V in 2006.  (Elsewhere I have discussed our sector-focused, stage-independent strategy of growth equity investing.)  Our results are consistent with the Cambridge data on venture performance over the same period.    We have found that an ability to move with the market, both by stage and by sector, is a critical factor in achieving top quartile performance or better.

 

 

History is Bunk

 

What are we to conclude from the data?  While market and entrepreneur selection remain fundamental to venture manager success, risk management, time-to-money, and inflection point investing have emerged as perhaps equally determinative of  top quartile performance.  We all know the ‘hits’ nature of the business has been dampened, perhaps forever, but that doesn't mean venture capitalists cannot achieve premium rates of return. The Cambridge data show the business has transformed into a mature asset class where relative performance varies across the business cycle. What’s broken is not the industry, but the outdated perceptions of what strategies drive top quartile performance.

 

The venture industry has disappointed for a long time, or so it seems.  Certainly that is true when measured against the exceptional period where the average IRR was 100%.  Popularity and profits are incompatible concepts over the long run.  Nevertheless, top quartile venture performance is still exceptional, relative to other asset classes. Below is a comparison of the SP500 performance over the past nine years to the venture funds of vintage year 2000.

 

 

Some might counter that the SP500 investment is 100% liquid and venture numbers are merely private equity accounting entries.   However, the $1 invested in the SP500 would be a fully "realized" $0.65 at 2008 year end, while even the median venture fund would have returned $0.48 of cash, plus an illiquid remainder.  The top quartile fund would likely have returned $0.90 or more, trumping the SP500, and still have a substantial upside.  

 

 

Are We Blinded By A Remembrance of Things Past?

 

So is the venture asset class broken?   It doesn't appear to be.  It seems our assumptions of what constitutes "venture performance" are anchored in an obsolete memory of absolute performance, when the world of investing is all relative.  The mythology around venture investing reinforces this belief. Like every business, the successful venture investment strategies require continuous re-invention, not just a repetition of what worked before. Venture capital certainly isn't a license to print money anymore, but it is still the best game in town.  It's just that the rules of the game have changed.

 

 

The Coming Venture Capital Boom

 

No, I am not a Pollyanna.  I see the today’s carnage as much as everyone else.  This year is going to be tough. The destructive firestorm of leveraged, momentum investing has destroyed much of the forest.  But the forest will begin its renewal because Life Goes On, and with it ingenuity, entrepreneurship, and innovation. 

 

This firestorm is like the Year 2000 cataclysm, with a powerful difference.  Like 2000, there are questions about the ‘death of venture capital’ the ‘death of the consumer’ and the ‘death of the Web.’  It’s all bullshit. It's just a cycle.

 

Two phenomena emerged from that last great vc-techno contraction. First, the fire incinerated the weakest companies. It left standing, weakened, but inherently great restart and late-stage opportunities.  Yipes.com was a terrific example, founded in July 1999 as a IP data networking services provider. Left for dead twice with two recaps, the third time was the charm. After raising over $300M during the 1999-2005 period. Much of this capital was wiped out. Yipes gave great returns for the investors who saw the opportunity anew in 2005 (disclaimer: we led this round). Acquired for $300M cash in 2007 by Reliance Communications, Yipes was a great company, originally ahead of its time, and made us 5X in 32 months.  We will see dozens of these opportunities in the coming years, but it requires an investment discipline tethered to public market realities about who are likely buyers, why, and at what valuations.

 

The second phenomenon to emerge from 2000 was the re-invigoration of the Web. As with every wave of innovation, much of the activity became more imitative than innovative as this matured.  YouTube was but the first of hundreds of video aggregators.  MySpace was the first of thousands of social networks.  (If Andy Warhol were alive today, he’d probably be telling us that in the future we will all be our own social network.) The venture money that went into most of these imitations will soon be written off. 

 

Some substantial services were built from this post-2000 renaissance.  Few achieved both scale and profitability as an independent company.  (LinkedIn is one that may have achieved that goal. Facebook?) Nevertheless, there were many successful exits from the web revival, though paltry few in proportion to the amount of capital, media attention and entrepreneurial energy invested.

 

So why am I so sanguine about the prospects for venture capital as everyone seems to sound the alarm about Recession, the lack of capital, and the fear gripping the markets? It is simple:

 

1.                  Venture capital returns are predicated on scarcity of risk capital.  It has been all too abundant. That will change.

2.                  Many good businesses will be left on the beach as the rest are washed out to sea – the remaining VCs will invest in them and both the entrepreneurs and VCs will get rewarded as the survivors gain market share and become successes in the economic recover.

3.                  The economic recovery plan of the new Administration will be massive and favor investments in productivity-enhancing growth sectors like information technology and energy technology.

 

Investments in material sciences electronics will blossom to provide ever-cheaper sources of domestic clean energy, today’s temporarily cheap oil notwithstanding.  (As the world economy recovers, the new capitalists in China and India will buy more cars and build more factories, rapidly returning oil back where it was and beyond.)

 

Investments in broadband, wireless, and mobile multi-core devices and cloud computing architectures will continue to reduce the cost of providing high value services in healthcare, personal entertainment, and even traditional enterprises.  Cloud-based computing will allow enterprises to treat IT as a variable cost, increasing their willingness to adopt by maintaining flexibility without big upfront expenditures. 

 

As the fire continues to rage in financial markets, it is hard to imagine when Opportunity will reappear. But the truth is when everyone sees Opportunity; they are only seeing the reflection.  True Opportunity appears at the market bottom, not at the top.   It’s times like these that test what you believe in, and I believe in the Business Cycle, Human Creativity, and the stimulative effect of massive Government spending. 2009 and 2010 will be great times to invest to reap the benefits in 2012-2014, for those who can judge both business risk and liquidity risk, and have the courage of their convictions.

 

 

The Quiet Disruption in Process

 

Hi. I’m back. Well, at least for a moment.   I’m been radio silent for a while because I didn’t feel I had much to say. Blogger’s block, perhaps. I prefer to think of it as editing in extremis.

 

Over the past few months we have seen the rise of “cloud computing” or “platform as a service” as evolution in the world of IT.   From one perspective it is an incremental evolution.  We have moved from proprietary data centers to hosting environments to platform environments.   The technology isn’t what is revolutionary; it is the economic model.

 

Go back to 1998.  We bought big iron, big o/s, big RDBMS, and big pipes all in service of building web applications.   Open source drastically cut the entry price for a good idea.   We saw an explosion of creativity unleashed in Web 2.0 beginning circa 2003-4.  The cost of entry went from millions to thousands of dollars.

 

Now the cost of provisioning the systems in entirely has gone to zero.  Google Apps is a free developer sandbox for web apps, at least for web apps that meet their design constraints.   I think it is reasonable to assume that the Python-only, non-transactional computing model that Google offers today will drive others to offer other computing stacks that support other flavors of development models, all equally free.  There is a phase transition between cheap and free.  I assume the growth of free application provisioning environments will cause another renaissance on the scale of Web 2.0.  (I will resist the temptation to label it. You're welcome.)

 

Let’s fast-forward another ten years.  If the market price of provisioning an application goes to zero more broadly, who is impacted?  What does this mean for

 

  • SaaS application providers? 
  • Enterprise IT?
  • and vendors like BMC, IBM, and HP that dominate data center automation today?

Perhaps the value will shift from applications to infrastructure. Security, disaster recovery, archiving, etc., will still be needed - as services, not products. Freemium comes to enterprise computing.

 

We all know that the history of computing has been about platform shifts.  Free is the next disruption.  Like all platform shifts, it begins as a small but structural change in the economics of adoption. It ends with the re-alignment of the market, with a couple of survivors, and many more new entrants.