In 1987 a group of the U.S.s most influential venture
capitalists, including Warburg Pincus founder Lionel Pincus and
Kleiner Perkins Caufield & Byers co-founder Tom Perkins,
convened at the Hilton Chicago OHare Airport hotel. Their
then-fledgling industry was coming off some spectacular
results, fueled in large part by the successful venture-backed
IPOs earlier that decade. With the industry having proven
itself and the laws making it easier for institutions to invest
in venture capital, pension funds and endowment managers were
ready to pour money into venture funds.
For the OHare gathering there were several crucial
questions. Was this a sustainable industry? Could it manage a
new influx of capital that might be two to three times what it
was currently managing? Were the investment returns scalable?
And were there enough venture capitalists to manage the
Though there were doubters, the capital providers prevailed
and the money poured in. A quarter century later some of
the same issues are perplexing the venture industry but
this time against a very different backdrop. Now the questions
revolve around how much the industry will need to contract
before it becomes healthy again.
Last year venture capitalists invested $26 billion in U.S.
companies, a quarter of the $105 billion they invested in 2000.
Capital commitments to venture funds, which stood at $103
billion in 2000, were below $18 billion.
The contraction is likely to continue this year, as
investors pay greater attention to smaller and more local
venture funds. Venture capitalists expect institutions to
commit even smaller sums of money. "What you will see is fewer
relationships between venture capital and institutional
investors," says Edwin Goodman, co-founder of New
Yorkbased Milestone Venture Partners.
Many investors who previously might have preferred the
longer-term horizon of venture capital for its once outsized
returns, and as a hedge against short-term volatility, are
turning to the shorter-term public equity markets because they
are just as profitable and much more liquid. For the 12 months
ended September 30, 2012, venture capital funds returned 7.7
percent, compared with the 26.5 percent return of the Dow Jones
Industrial Average and the 29 percent return of the Nasdaq
composite index. Over the past ten years the long-term
sell that used to be venture capitalists big pitch
venture capital funds reported annualized returns of 6.1
percent, compared with 8.6 percent for the Dow and 10.2 percent
for the Nasdaq.
"When you have such a divergence in returns, it is very hard
to make a case for venture capital to your investors for the
short term or the long term," says one Midwest asset manager.
"More important, the venture funds havent been able to
demonstrate why they will outperform other asset classes such
as private equity and real estate in the short and the long
Unable to tout their investment returns, venture capitalists
are emphasizing their uniqueness this year their ability
to specialize in technology niches, invest early, and focus
locally and regionally. "We are going back to what it was,"
says Duncan Davidson, one of three managing directors of
Bullpen Capital, a Menlo Park, California, venture firm that
makes investments in startups funded by superangels. Bullpen
doesnt invest in seed-stage financings. Instead, it
focuses on the subsequent early rounds where the amount needed
is critical but not large enough for the big funds to get
involved. Thats where a company needs the most help
and "thats where a venture capitalist can add the
greatest value," Davidson says.
Venture capitalists are placing greater emphasis on being
local. The globetrotting venture capitalist is a romantic
vision that simply hasnt worked out, says Koleman
Karleski, managing partner of Chrysalis Ventures in Louisville,
Kentucky. And the numbers bear this out. In the most recent
data involving venture capital investment in emerging markets,
the one-year returns were -4.0 percent, according to
Boston-based investment research and consulting firm Cambridge
As in the past when many venture capitalists focused on
regional investments because they could closely monitor them
and stay in physical touch, firms like Chrysalis are focused on
investing in their own backyards. "We prefer to invest in the
under ventured Midwest and South," Karleski
Many of the same investment trends in 2012 are likely to
continue this year. Last year investments in software totaled
$8.3 billion, an increase of 10 percent over the previous year.
By contrast, investments in biotechnology and medical devices
which totaled $6.5 billion were down
substantially from 2011. The sharpest decline was in clean
technology, or cleantech, which saw total investment fall to
$3.3 billion from $4.6 billion.
More money is expected to go into information technology
software- and Internet-specific companies as a
result of the meteoric rise of social media and the demand from
companies such as Google, Apple and Microsoft for new apps and
new products. Conversely, the focus on life sciences and
cleantech in spite of the buzz surrounding those areas
is likely to decline.
"We continue to see the impact of public policy on venture
capital investment levels in very specific ways," noted Mark
Heesen, president of the Arlington, Virginiabased
National Venture Capital Association. "Cleantech investors
began moving toward more capital-efficient deals less dependent
on government support."
The decline in cleantech investment is likely to continue,
with most analysts predicting extended uncertainty around
regulation and reimbursement as well as the levels at which
government expects to support giant cash-guzzling cleantech
projects. Still, "cleantech isnt going away," says Izzet
Bensusan, president and CEO of Karbone, a New Yorkbased
renewable energy and environmental markets research and
advisory firm. However, given the performance of public
cleantech stocks and the time to profitability for others, the
short-term investor focus is more likely to be on solutions and
applications rather than infrastructure.