The venture capital industry hit town Friday at a lunch meeting held by the ESI-Sloan Congressional Forum with a report on industry progress and an outline for those congressional staffers present of what regulation the industry would like (not much).
The most interesting presentations were the statistics themselves, which showed what a huge, pro-cyclical part the venture capital industry played in the 1999-2000 bubble.
The meeting was moderated by Peter Morici, senior fellow at the Economic Strategy Institute, with presentations from Martin Kenney, professor, Department of Human and Community Development at the University of California, Harry Hopper, partner at Columbia Capital LLC, E. Rogers Novak, founding partner of Novak Biddle Venture Partners and Patrick von Bargen, executive director of the National Commission on Entrepreneurship.
The venture capital industry plays a strong but not dominating part in the financing of new U.S. businesses. Even in 1999-2000, no more than 50 percent of the Initial Public Offerings in the United States had received venture capital funding prior to their offering, and in previous years, the proportion of venture capital funded companies had been lower, around the 30 to 40 percent level.
Microsoft, to take one example, received venture capital funding only at a late stage in its genesis, after MS-DOS was a proven success, mainly in order to ensure that Microsoft’s planned IPO, which took place in 1986, was well sponsored in the financial community and therefore a success.
In other countries, the venture capital industry is a less important factor in the financing of small business, and there is clearly room for the industry to grow worldwide. In Japan, for example, in 1999, venture capital invested domestically was only about 0.25 percent of gross domestic product, compared with 5.2 percent in the United States; this reflects Japan’s less entrepreneurial culture, and the prolonged recession there, but is also likely to be a significant cause of Japan’s failure to climb out of recession more rapidly.
The U.S. venture capital fund industry was founded in the 1950s by professor George Doriot, of the Harvard Business School, and Royal Little, CEO of the textile conglomerate Textron, who put together a fund called American Research and Development, one of whose first investments, in 1957, was a $90,000 investment in the fledgling Digital Equipment Corporation.
The industry was greatly helped by two legislative developments; the 1978 Steiger Amendment, which brought down the top rate of capital gains tax from 49 percent to 20 percent, and the 1981 revisions to the “prudent man.” Employee Retirement and Security Act regulations, which allowed pension funds to invest a portion of their assets in non-tradable assets such as real estate and private equity.
In the 1980s and 1990s, the venture capital industry grew rapidly, but exhibited both a marked cyclical tendency and a tendency to follow financial fashions beyond the point of prudence. For example, in 1987-1988, the industry devoted a huge portion of its resources to financing management buyouts in old-line industries, which increased the leverage in the companies concerned and therefore came under severe stress, with losses to investors, when the 1990-1992 downturn hit.
The reason for this is that venture capital funds are typically collections of very highly paid but themselves relatively capital-poor executives, who raise the bulk of their funding from third-party sources. Consequently, a successful period for venture capital funds leads the funding sources to increase their commitment to the sector, thus, at the top of the market, forcing too much money to chase too few deals. Given the lengthy period — generally at least a year — needed to put together a fund, and the further delay before money is deployed, it is thus natural for the normal business cycle to be exaggerated in the venture capital sector.
As in many investment businesses, the incentives in venture capital fund management are not quite what they seem. The key skill is the ability to attract money; deploying it in attractive investments is less important, managing the companies invested in is also less important, until a key need arises at the time of the fund’s liquidation for specialists who can sell portfolio companies quickly and profitably.
Fund managers are compensated by an annual fee based on the amount of the fund (thus a large fund is much more lucrative than a small one) plus a percentage of realized gains at the end, with gains being calculated in purely nominal terms, so fund sponsors can achieve substantial bonus returns just by matching the public equity market, or even by matching the return on a risk-free asset such as Treasury bills.
This means that it is very difficult to attract venture capital funding to early stage investments, because the monitoring cost of a small investment is too high to be economically attractive. Instead, the most attractive venture capital investments are those with proven technologies, which appear to be no more than one year from an Initial Public Offering in a booming market.
As one would expect, in the late 1990s, there has been a huge rush of money into technology venture capital funds. Gross venture capital investment in portfolio companies, heavily concentrated in the technology sector, soared from $5.7 billion in 1995 to $48 billion in 1999 and $103 billion in 2000. In other words, a 17-year supply of venture capital, at the 1995 level, was invested in companies in 2000, right at the top of the market. Given the valuations prevailing in 2000, it has to be the case that at least 85 to 90 percent of that amount has been or will be irretrievably lost.
There was little sense of contrition at the meeting I attended. Notably, however, the practitioners on the panel were careful to explain that their own companies had pulled back in the feeding frenzy of 2000, which was thus entirely due to the excesses of others, and were now moving forward again, confident of successful investments given the more realistic values that now prevailed.
The venture capitalists were also particularly keen to maintain the favorable treatment of stock options, in both accounting and tax terms, because of options’ motivating effect on entrepreneurs, and in spite of the fact that, if the options are accounted for on a full cost basis, the great majority of venture capital funded companies have been and remain loss-making.
The huge burst of funding in 1999-2000, and the losses resulting therein, have serious implications for the future of the venture capital business. Venture capital funds raise their money primarily from U.S. pension funds and other institutions, which have been increasing their portfolio allocation to private equity in recent years, as returns seemed attractive.
The years 1999-2000 saw the advent of several “mega-funds,” larger by orders of magnitude than funds previously raised, which consequently attracted mega-investments from the pension fund community. This money has now been lost. Investment policy committees will ask awkward questions. Careers will be ruined. The funds, which made the biggest commitment to private equity, will no longer appear the wave of the future, but a bunch of suckers who fell for a bubble.
Imagine then the reaction when the fund managers come round next year asking for subscriptions to their next “mega fund” or even their next normal sized fund.
In summary, the venture capital industry is going to find it difficult if not impossible to raise substantial pools of capital over the next several years. Consequently, the very high remunerations paid to industry participants will disappear — in any case, much of such remuneration is based on investment performance, and for several years, because of the drag from 2000’s investment failures, the observed cumulative investment performance will be poor. While the flow of funds to companies will continue fairly strong for some time yet — the money raised in 1999-2000 was so great that a considerable flow of new transactions can still be afforded — eventually it too will dry up, and the funds will then have very little to do except liquidate investments and return what money they can salvage to their investors at the end of the funds’ 8-10 year lives.
Given the nature of venture capital investing, it is certain that the ultimate sources of money will not know the final results of their investments until the funds are wound up. During the interim period there will be a considerable amount of obfuscation by venture capitalists using inflated “valuations” to pretend that returns are acceptable so that salaries and at least some incentive compensation should be paid.
Therefore, it is likely to be 2008-2010 before the full pain to the providers of money is felt. Allow then a few years for the pain to diminish and those responsible to be transferred to the appropriate branch office in some rural dustbowl, and it will be 2015 before a fresh new generation of pension fund managers has arrived, ready once more to make a commitment of pensioners’ money to the daring new world of venture capital.
As I have said before, there is a strong danger of this recession being not only deep but lengthy. If the economy recovers fairly quickly, it will do so on a very different basis from the bubble years of 1996-2000, with no “easy money” for technological investment and a deep reluctance by young men and women to wreck their careers in hopeless start-ups.
In my view, it will be difficult to create quickly out of the debris from the 1996-2000 bubble a stable 1950s-style economy which is the best that can be expected in the next decade, haunted as it will be by broken dreams and lost fortunes.
Such an economy would be very attractive for the middle-aged, the well-established and the stably employed, but it is likely to take more than a few years to replace the living standards that are being lost in the crash. Certainly the venture capital industry, battle-scarred as it will be by its appalling record in 1999-2000, will be very little help.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.