Call off the funeral
Since the dotcom bust investors have endured a long period of headlines announcing the ‘Death of Venture Capital’. So why are practitioners telling Martin Steward to expect a new lease of life?
Right now everyone and his grandma seems to be facebooking, tweeting and zygna-ing their way through life. Hot favourite for this year’s Best Picture Oscar is a movie about an internet start-up. Technology is cool! Entrepreneurs are cool! Venture capital (VC) should be cooler than ever!
Try telling that to the people with the money. According to Coller Capital’s latest Private Equity Barometer, limited partners (LPs) feel the environment for venture is changing for the worse. Two-thirds think that only elite VC firms will deliver strong returns over the next decade. One-fifth think even they will struggle. One cannot blame them. Towers Watson notes that even upper quartile VC firms struggled to achieve exit multiples of 0.5-times between 2001-06. Compared with the NASDAQ, that does not look too bad, but next to the leveraged gains from pre-crisis buyout it looks decidedly peaky.
What went wrong? In short, the dotcom bubble. “The huge opportunity set to deploy capital in buyouts simply doesn’t exist at venture stage,” observes Greg Stento at private equity fund of funds HarbourVest Partners. “So when the industry raised $100bn (€73.2bn) in 2000 it got in trouble.” Between 1995 and 2000 VC fundraising rose tenfold. Some money went into successful companies before valuations got silly, but a lot capitalised over-inflated ‘me-too’ pretenders. Moreover, so much capital was raised that ‘me-toos’ milked it for years - a capital overhang plagued VC as late as Q1 2009.
VCs then had to wait a long time to offload these expensive dogs. The median time before an IPO was 9.6 years in 2008; it was just 4.2 years in the late 1990s, according to Towers Watson. In the 2000s VC-backed IPOs halved from 1990s’ levels. The market was in no mood for tech, investment banks lost interest and Sarbanes Oxley pushed up costs. In IRR terms, every extra year you have to hold on can eat away at returns. Investors capitulated. Coller’s Barometer finds 57% of European LPs anticipating a funding shortfall. In the US, VentureSource reports fundraising collapsing from $28bn in 2008 to $13bn in 2009.
But that has driven a Darwinian shake-out: ‘me-too’ VCs drop like dodos as they fail to convince disillusioned LPs to re-up. Analysis by VC fund of funds TrueBridge Capital Partners suggests that 366 VCs completed at least three investments in 2009, down from 470 in 2005. Even well-known names struggle to match their previous fundraising.
“The biggest story is a huge rationalisation of venture,” says Mel Williams, general partner at TrueBridge. “That’s having a tremendously positive effect on the structure of the industry.”
When VCs have less money only the best entrepreneurs get funding - and they face fewer competitors. “In the hot years too many business models float around the same idea and don’t have sustainability,” as Klaus Rühne of ATP Private Equity Partners puts it. These are hot years for certain sectors - many warn of frothiness in emerging markets and industries that inspire Oscar-nominated movies - but industry data suggests that general 2009 pre-money valuations had reached real levels not seen for 20 years. “That is a very strong buying signal,” says David Mott, co-founder of Oxford Capital Partners.
Because valuations have come down, investors can now enter at a later stage of company development for the same price they paid for early-stage entry five years ago, thereby taking much less start-up and technology risk. Add this to the fact that technology development is getting quicker and cheaper and there is a real possibility that holding periods could shorten quite significantly. “We will probably see a reduction of perhaps two years for vintages starting in 2007 onwards,” says Hendrik Brandis, chairman of the EVCA’s Venture Capital Council. “As one major institutional LP said at a recent EVCA event, ‘We need to throw away the rear-view mirror.”
Academics Steven Kaplan and Josh Lerner, in their paper ‘It Ain’t Broke: The Past, Present, and Future of Venture Capital’, have tried to quantify the historical relationship between the amount of capital raised for a vintage and its ultimate returns. They found that average vintage year IRRs come in at 18% minus 28.1-times the capital committed in the vintage year and the preceding year, as a percentage of total stock market capitalisation. “A period of poor returns leads to decreased inflows, which in turn leads to a recovery in returns,” they conclude.
For that mean reversion to occur, two improvements have to fall into place. The first - cheaper valuations - is evident. The second is a better exit environment: that is much less evident now, but as VC fund of funds Greenspring Associates notes, US non-financial companies’ cash reserves are at a 51-year high. What if they decide to stop hoarding and rediscover their appetite for tech acquisitions?
“Right now it’s time to be buying rather than selling - but at the same time the analysis that we’ve done suggests that the next selling opportunity may not be far away, either,” agrees Mott. “The top-10 tech companies sit on an unprecedented $250bn of cash. Some of that will be used on share buybacks and dividends, but a lot will be used on M&A. Intel acquired McAfee last year and IBM has plans to spend $20bn on acquisitions over the next five years.”
There is another story here: one reason for this mountain of cash is the recent collapse in spending on internal R&D. Kaplan and Lerner argue that the difficulties of managing early-stage innovation within a large corporation are leading to alternative ‘open innovation’, via acquisitions and alliances with smaller firms.
Practitioners have seen this trend for 7-8 years in life sciences. “We think consolidation is creating large companies unsuited to supporting creative individuals,” says Sander Slootweg, managing partner at sector specialist Forbion Capital Partners. “They rely increasingly on smaller companies for in-licensing and supporting their pipeline, and ultimately as acquisition targets. We see option deals being put in place that include advice on how to structure clinical trials and so on, so when they want to buy the asset they don’t have to re-do all that work to their own standards.”
Elsewhere this model is not so common. “Open innovation gets lots of coverage in academia and the McKinsey Quarterly, but there is a long way to go,” says Mott. Mott does believe cash will be re-allocated to corporate venture. “Over the last year we have looked at deals and in some cases invested alongside Vodafone, Siemens, Syngenta, BASF, Novartis, GSK, Scottish and Southern Energy, Intel and Nvidia. That’s more than we’ve done in a long time.”
In addition, Mike Chalfen of Advent Venture Partners notes that large tech companies have started handing over some none-core intellectual property to ‘trusted partners’ for commercialisation, on a royalties basis. “I’ve seen four examples in fairly short order,” he says. “It’s a way to offload the cost of development. Among our businesses The Foundry has done this with several [movie production] studios, and significantly grown its addressable market with very low costs.”
All of these forms of partnership should help to realise as well as grow value. As Rühne observes: “It’s about having the networks to know where the likes of Microsoft and Google are focusing and how that is changing, so you know how, when and where you are going to exit.”
Julie Meyer, founder and CEO of Ariadne Capital, thinks this is more of a sea change than we might imagine. “The start-ups of the 1990’s weren’t necessarily solving the problems of the acquirers in the 2000s,” she says. “Now start-ups are digital enablers who are transforming industries by taking infrastructure to the cloud, and creating digital revenue-share streams online… so many will be acquired for their ability to reduce costs, drive new revenue streams, and create high growth in the acquirers.”
None of this alleviates the perennial difficulty that large institutional investors experience with venture: allocating sufficient capital to the best VCs. But the fact is that competition for capital is increasing, industry structures are evolving to make exits easier, and holding periods may be getting shorter.
“Can we get access?” asks Rühner. “That’s not so clear. But if I were an endowment with access to these guys already, then the macro picture would make me very optimistic indeed.”
Amadeus Capital CEO Anne Glover agrees, and adds a warning: “If VCs and LPs stay out of the market for another two years, entrepreneurs will find other funding and this whole vintage will be lost to institutional investors, who yet again will have missed out on great returns.”