Investors that built up their venture capital portfolios over the last three years may feel as if a train has hit them. Returns on venture portfolios have and will continue to decline as private market valuations catch up with the public market declines. On the other hand, for new commitments, the light at the end of the tunnel represents an opportunity today to build a venture portfolio invested with greater discipline at lower valuations.
Venture capital, defined as investment in early stage businesses is going through a shakeout in Europe and the US. High returns reported in 1998 and 1999 attracted investors to private equity and venture specifically. Pension funds, corporations and other investors committed $70bn (E80bn) in one year and for the first time matched the capital committed to buyouts.
Investors now face a number of issues managing venture capital in the face of a downturn. The purpose of this article is to look at the venture capital market from two perspectives:
o First, to review the current market and assess some of the issues arising with current venture portfolios;
o Second, to analyse the market for opportunities and outline the criteria investors should follow to evaluate groups, build strategies and access top tier funds.
The second half of the 1990s saw unprecedented returns in venture capital fuelled by strong equity markets and the technology bubble. Venture capital, while a private investment, is correlated with the public markets on a lagged basis due to infrequent valuations. Strong positive equity markets made exits easy through IPOs and trade sales. Likewise, a fall in public markets, particularly technology, predicts the fall in venture portfolios.
Given a majority of global venture investment is in the US, we first analyse this market. However, the global nature of technology means that Europe is not exempt from a similar experience. Chart 1 shows the returns of selected US public equity indices over the last five years including the S&P 500, NASDAQ (OTC) and the Wilshire Internet Index. The later two represent the technology area and are leading indicators of venture capital. The Wilshire Internet Index represents a segment of the technology market that experienced great growth and decline over the period.
We separated the above chart into bubble and bust periods shown in table 1.
US venture returns have also peaked as shown in chart 2. Given the fall in public valuations it is simply a matter of time for reported venture returns to fall.
Not all venture investments have performed similarly. With regard to stage, later stage investments have suffered most. Chart 3 shows the post money valuations for business in three stages.
Early stage valuations increased from 1998 to 2000 but not as much as late stage. Subsequently, early stage valuations fell by less than late stage when the technology market collapsed. Emphasis on early stage provided more discipline and better downside protection. Historically, early stage has been the best performing segment in venture.
Valuation increases also occurred in technology related industries between 1998 and 2000. Communications, internet and software/services valuations are following similar pattern to late stage investments. An investor can also expect to see similar declines in private companies in these sectors.
The rise in venture investments spurred an increase in the size of funds. For example over 30 venture funds raised more than $1bn in commitments. The justification for large sizes were:
o High cash burn rates by internet companies to build brand recognition;
o High capital investment in optical equipment and communication areas;
o High valuations and the desire to support companies through multiple rounds of financing.
Unfortunately, the market decline left a wall of un-invested capital hanging over the market. This still exists and funds are using different approaches to deal with the problem. Investors observe venture capitalists adopting one of the following: releasing limited partners from a portion of commitments, lengthening the investment periods, hiring more partners, making many more investments and shifting investments towards other areas such as life science. We also observe funds shifting some investments from early to late and into investing in public companies although these two changes need to be closely scrutinised.
In summary, venture funds currently in most difficulty include:
o Funds raised between 1998 and 1999, invested aggressively but with few companies that reached IPO;
o Small funds – where not enough capital was raised or reserved – these investors are squeezed out in later rounds;
o Funds exposed to B2B, dot.coms, telecoms etc;
o Late stage funds where the stock prices after IPO declined below last round of financing during ‘lock up’ periods.
One of the key aspects of the success of a venture capital programme is the selection of experienced groups. The difference between selecting a top quartile versus an average manager over the last 10 years has been about 30% per year. This is a large margin and worth the effort to capture. In table 2 we provide a checklist of evaluation criteria. While no firm meets all the criteria it does provide a guide to the desirable characteristics.
The ability to invest with top tier venture capital funds was a major problem in the ‘internet era’. Even with larger funds sizes many new investors remained shut out or cut back by venture firms as existing investors simply increased commitments. However, top venture capitalists have been closed to new investors for some time. The recent declines and lack of substantial flows will return the market to a better balance although institutional investors will continue to find the top tier groups difficult to enter. Starting early to meet with prospective firms and showing a longer-term commitment improves the possibility for access. We anticipate continued access problems in the future as the size of funds will likely not grow and may even shrink while the interest in private equity continues.
While venture investors suffered recently, venture capitalists with ‘dry powder’ or available funds are finding new opportunities with valuations at significant discounts versus 12-18 months ago and in some cases back to levels in 1992/9. With this in mind an investor should remember:
o Existing commitments will take longer to call as investment pace has slowed and exit possibilities are limited.
o Allocating a portion of private equity portfolio to venture diversifies the portfolio because venture is counter-cyclical to buyout funds.
o Building a portfolio through vintage years avoids a portfolio concentrated in companies bought during a high valuation period.
o Selection is especially critical in venture at this time given the high level of excess capital, difficult exit markets, and large fund sizes which may place a damper on returns. In addition, lack of many top tier groups raising money over the next year lowers potential selection value.
Daniel E Allen is managing director and principal at Wilshire Associates in London
1 OTC – NASDAQ, Standard & Poor’s and Wilshire Associates
2 Venture Economics