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 O’Hare 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 O’Hare 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 industry’s expansion?

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 York–based 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.