The Incredible Shrinking VC Industry

If you don't know Paul Kedrosky and his great blog, Infectious Greed, take a look - you'll become a follower too. This is an interesting article from the NY Times on a speech Paul gave this week at the Kauffman Foundation. The topic: Right Sizing the US VC Industry. And yes, its more of the same: VC must shrink by half to generate the kind of returns that are expected of players in this asset class. Its not news anymore, but its today's reality and we all need to get used to the incredible shrinking VC world.

http://bits.blogs.nytimes.com/2009/06/10/does-the-venture-industry-need-to-shrink-by-half/

June 10, 2009, 8:00 am — Updated: 5:22 pm -->
Does the Venture Industry Need to Shrink by Half?
By Claire Cain Miller

Will the venture capital industry survive? Yes, says Paul Kedrosky, but it needs to shrink to half its current size if it wants to start generating competitive returns again.

Mr. Kedrosky made his case in “Right-Sizing the U.S. Venture Capital Industry,” a report published Wednesday by the Ewing Marion Kauffman Foundation, where he is a senior fellow studying entrepreneurship, innovation and the future of risk capital. He is also an investor and the author of the blog Infectious Greed.

Venture capital’s “poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset,” he wrote in the report. “The sector must shrink its way back to health if venture capital is to provide competitive returns and secure its own future as a credible asset class and economic force.”
Mr. Kedrosky is the latest to pipe up in the debate over the fate of the venture capital industry, as the exit markets remain virtually shut for most start-ups and limited partners reconsider whether they want their money tied up in illiquid venture funds. Many other V.C.’s are also concluding that venture funds must shrink, including the elder statesmen of the industry and limited partners.

Venture capital was healthiest in the early to mid-1990s, Mr. Kedrosky argued, when firms invested $5 billion to $10 billion a year in start-ups. Today, they invest about $30 billion a year. He argued that limited partners — the investors in venture funds — should shrink their investments to help resuscitate the sector.

Though the industry often cites the 8 percent returns for venture capital over the last 10 years, compared with −27 percent for the S&P 500 and −28 percent for the Nasdaq, Mr. Kedrosky said it was more accurate to compare venture to the Russell 2000, an index of small-cap stocks that returned 18 percent over the same period.

To once again generate competitive returns, the industry should slash investment by half, to approach the investment rates of the mid-1990s, when returns were last healthy, he said.
Venture investment swelled during the late 1990s and the dot-com bubble, which “led to a collapse in performance from which the sector has never recovered,” Mr. Kedrosky wrote. Since then, it has been slow to shrink for several reasons, he said. The life of a venture fund is typically a decade and investments are generally illiquid during that time. Venture capitalists collect management fees of a percentage of capital under management, so they are paid more for bigger funds.

He also pointed to “a widespread and incorrect belief that venture capital is a necessary and sufficient condition in driving growth entrepreneurship.” In fact, only about 0.2 percent of the estimated 600,000 new businesses created in the United States each year are financed by venture capital and about 16 percent of the fastest-growing companies are, he found.
Though those arguments will surely make venture capitalists defensive, Mr. Kedrosky is ultimately a fan of the industry and argues that it does societal good by helping many entrepreneurs start companies. To continue to do so, though, “the venture industry must be viable — it must offer its investors competitive returns,” he said. “At present, it is increasingly uncertain whether the U.S. venture industry can and will do that.”

The size of the venture industry is a problem, Mr. Kedrosky wrote, because too much capital causes higher valuations and lower exit multiples.

Another problem he cited was that information technology has matured to the point that new innovations will not be hugely profitable and it costs a fraction of what it used to to start an I.T. company. Still, venture capitalists invest more than half their money in these companies, “because they always have, not because they credibly anticipate improved returns,” he said.

Finally, even if the initial public offering market recovers, venture capitalists will very likely only be able to bring companies with significant revenues and profits to market, but never again young, money-losing companies as they did in the late 1990s when returns shot up, he said.