How Much Is Too Much?

I was at a conference last week for institutions that invest in venture capital funds. These institutions are called Limited Partners (LPs) in the venture capital business.

The LPs were all very concerned about overfunding of the venture business.

One LP put up a chart that showed from 1992 to 1996, about $10bn per year came into the venture capital business from LPs. Funds raised in those years produced on average 25-40% annual rates of return. So those were good years.

From 1997 to 2001, the amount raised per year soared, reaching $70bn in 2000. Funds raised in the 1997-2001 period aren't yet mature, but the returns plummetted, going negative by vintage year 1999. These are the bad years.

So the argument this LP made is that $10bn is the most that LPs can put into the venture business each year without negatively impacting returns.

There are a few things I don't completely buy about this argument, but the basic reasoning is sound. At some level, the venture business gets overfunded and returns suffer. The question is - what is that level?

I think there were more things going on in the 1997-2001 vintage funds than just overfunding.

1 - There were too many VCs getting funded that weren't actually VCs. There were people who decided they wanted to be VCs, were able to raise money because there was so much out there, and they set up shop and did a bunch of stupid things. If all of that money went only into the hands of experienced VCs, a lot less of it would have been invested, and a lot less of it would have been lost.

2 - The equity markets tanked in 2000. It takes 3-5 years to get a company to the stage where it can be sold or taken public. The health of the equity markets at that time will have a lot to do with the returns that can be generated by a VC. So you had to make investments in the 1993-1997 timeframe if you wanted to take advantage of the crazy prices that were being offered in the 1999-2000 time frame. The "good years" benefitted from that. The "bad years" suffered.

3 - The story on the 1997-2001 vintage year funds hasn't been fully told yet. The equity markets are back. Companies are being sold at good prices again. There is even the hint of an IPO market coming back. Many of the funds raised in the "bad years" will end up in much better shape than anyone can imagine right now.

So that's a long way of saying that this chart needs to be run again in 2005 and then we'll know a lot more about how much money is the right amount. But even then, we'll need some way to show the exit value effect that benefits funds raised 3-5 years before the market peaks.

I think all markets are self correcting. LPs aren't stupid. They will overfund a market for a while, but if returns suffer long enough, they'll cut back and wait until returns come back. That is exactly what has happened in the venture business. Very little money was raised in the past three years. In fact, when you factor in all the money that the big VC firms have given back, it could well be that no net money has come into the venture business since 2000. This has made the business healthy again.

I think $20bn will come into the venture business in 2004. I think it will come in intelligently and rationally. Only experienced VCs will get funded. And I think that level will be sustained for the remainder of the decade. I do not think we'll get back to $70bn any time soon. And I think the venture business will outperform most asset classes during this decade as a result.

Comments

[gordon]

OK- sounds reasonable. So where does the other $50B go? Which asset classes do you think will benefit from the influx of capital? And will they really be "benefiting" or being overfunded themselves? Is overfunding of asset classes a recurring problem that just gets passed from asset class to asset class as the market and LP appetites change?

[Fred Wilson]

the other $50bn stays where it is, in bonds or public equities. that's where the balance of the allocation is and it probably won't move from there to private equity nearly as fast as people think it will.

i believe that markets are efficient over the long run and that overfunding is always a short term phenomenon. it does get passed from asset class to asset class as new investment ideas get generated and become hot. current examples include hedge funds, distressed deebt, and possibly china and india.

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