The Great Venture Capital Contraction

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.

"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 haven’t been able to demonstrate why they will outperform other asset classes such as private equity and real estate in the short and the long term."

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 doesn’t 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. That’s where a company needs the most help — and "that’s 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 hasn’t 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 Associates.

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 says.

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, Virginia–based 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 isn’t going away," says Izzet Bensusan, president and CEO of Karbone, a New York–based 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.