In 2017, the VC sector faced a number of issues and may be nearing a watershed in terms of its relevance.
This article examines the causes and consequences of the problems in the industry. Big data, exotic funds, and platforms can help VCs maintain a seat at the table.
Venture Returns Underperform
The returns on venture capital are low. Recent index data from Cambridge Associates shows that underperforms private equity and public markets (Chart 1) with returns below 15% over ten years. You can see that LPs’ patience could be tested by this underperformance, considering a VC fund’s standard target return should be 20.
As has been noted previously, VC returns tend to follow power law distributions. Thus, on an index level, the “home runs” of the masters are diluted by pretenders. Chart 2 (Pitchbook ) shows how the gap between the top and the rest of the pack is increasing over time. The fact that when funds become “successful,” their fortunes rise as they get access to the best deals due to positive signals associated with a check written by that fund supports this view.
Venture capital is a good alternative to public markets and should be considered in diversified portfolios. Data shows that VC return has an inverse correlation with public markets of 28. I think the data shows that the VC sector could split into two distinct segments due to the disparity between returns. The best funds will continue to do business as usual. But for those who are not so fortunate, the access to capital could be reduced as investor optimism increases.
Exiting VC takes more time.
Exits are vital to the VC industry, as they allow managers to realize paper gains and return the proceeds to LPs. The VC industry is suffering from a lack of “positive” exits, which are IPOs and M&A. It is estimated that the median exit time by IPO for a venture-backed company is 8.2 years. The resurgence in the IPO market seems to be just around the corner. Without it, funds are forced to wait or hope for an M&A windfall. The number of exits is increasing, and exit figures are staying the same.
The trend towards longer holding periods will negatively impact IRR and increase the pressure on investors to return capital as quickly as possible. The IPO market is not expected to pick up, and startups are more likely to prefer staying private. Staying private is a better option than going public, especially with large sovereign wealth funds supplying IPO-like capital to later rounds.
Scandals and culture have impacted the VC Market.
In 2017, some of the most prominent cultural issues within the VC industry were brought to light. (e.g. Here; Here; and Here). The VC industry’s position as a Gatekeeper was a common theme. It is a powerhouse that can decide the fate of entrepreneurs and companies based on subjective and irrational measures. Mitch Kapor and Freada Kapor, social impact investors, noted that cultural norms in the VC sector could be contrary to finding compelling investments.
Many VCs will not accept a pitch by an entrepreneur without a warm introduction — the entrepreneur must be introduced by someone familiar with the firm. It shuts out people who are not part of existing professional and social networks. Warm introductions are counter to meritocracy. It’s not about the quality of your idea but who you know.
With backlash comes consideration, and that may result in less–or more stringent–allocations of capital to VCs. Investors can avoid funds by investing via other channels or directly. Startups themselves might also be more cautious about the credentials of those who raise money.
Now, the VC industry is facing more competition.
Up until relatively recently, the only option for a startup that needed to invest a large amount of capital was venture capital firms. In 2018, entrepreneurs had a variety of funding options to choose from.
Other investment institutions, which in the past were passive LPs of VC funds, are now directly investing. Retail investors are now able to participate in the ICO mania. The JOBS Act sparked equity crowdfunding and the ICO craze.
Non-VCs have increased their investment activity in recent years.
The number of LPs investing directly in startup financing has increased from 40-60 deals per year between 2008 and 2011 to almost 100 deals a year.
From $2 billion in 2010, investments by sovereign wealth funds in startups have increased to more than $13 billion.
In 2016, equity crowdfunding in the US was estimated to be at 4 billion dollars a year, with a 100% annual growth.
From 2012 to 2016, the number of corporations investing in startups has more than doubled and now accounts for 24% of US Venture Deal Participation.
Chart 5 shows that in June 2017, ICOs raised more money than Early Stage Investments for the first ever time. In December 2017, projects raised over 1 billion.
Due to their increased popularity, venture capital faces more competition in the market for deals. In a 2017 Preqin study, 49% of VCs reported increased competition. No longer is it a given that a VC would be able to roll out the red carpet when soliciting investment.
Information Advantages for Venture Capitalists are declining.
In the 1990s, mutual funds were introduced. Then, in the 2000s, online brokerage enabled individual investors to manage their equity stock plans. The technology has gradually created resources that have allowed informed investors to compete on an equal footing with institutions. 30% are now self-directed investors in the US. This is the fastest-growing segment.
The VC market shows characteristics that suggest its access to knowledge is also being democratized. These new resources are often free and open to all. For example, take a look at how the “industry tool” has evolved.
LinkedIn has replaced private Rolodexes with LinkedIn.
Crunchbase, AngelList, and other directories provide company information.
What was once a closed and opaque VC industry is now open, resulting in a healthier level of competition. The only thing that new or inexperienced VCs have an advantage over non-venture investor is their reputation and network. As the probabilities and returns show, it’s hard to earn a good reputation.
Investors should ask themselves if they are willing to pay 2% in management fees to fund managers who scour the market through channels that everyone can access.
All the family offices that had traditionally invested in funds were losing interest. It was partly because their children, whom VC had bitten after grad school, were no longer interested in investing. But it was also because they thought that by simply following the rounds initiated by local VC funds, they could avoid having to pay fees and carry expenses.