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The Systemic Risk of Venture Capital
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The debate is heating up about the impending regulations from the government applied to Private Equity (PE) and its sub-class Venture Capital (VC), fought by the National Venture Capital Association (NVCA) and reluctantly supported by the Private Equity Council (PEC). The latter stating that private equity does not represent a systemic risk. Perhaps not, if the council excludes VC from its membership, but VC as Private Equity poses a systemic risk as the gatekeeper to innovation. Why the government is forced to step in The most rational explanation as to why the government is tightening our private equity belts came from Bob Grady, Managing Partner at The Carlyle Group (who worked for the government for a while) at the recent IBF conference. He suspects that the government simply wants to reduce the size of the financial services industry as a percentage of GDP (Gross Domestic Product). Not unreasonable, considering the collapse of our financial system and the discovery of an endless supply of imploding derivatives (and vice-versa). Simply put, the equilibrium between people who create products and those that capitalize on them is out of whack. We need more innovation with fewer derivatives attached to them. VC is a systemic risk Why VC needs to work What has changed Proper assessment of investment risk Smaller funds, feverish syndications, easy exits are all instruments that create more rather than less derivatives to the creation of disruptive value. VCs now sell to LPs a similarly ill-fated pattern of risk as sub-prime lenders sold to their investors. Hence our frequent use of the sub-prime VC classification throughout my blog. As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have actually invested deep rather than wide in information technology (as the included chart points out). For the last nine years that has created a massive number of false positives and false negatives and a continued downward spiral that attracts only entrepreneurs that comply with this risk-deflated investment mold, rather than attract entrepreneurs with truly disruptive ideas (that hold their value in any economy). So, for the last 9 years LPs have invested deep in a risk-averse technology sector while they expected their 10-15% venture share of total allocations to be applied to the inverse. Moving forward New regulations by the government and tougher practices by LPs will make our industry more transparent and aim to create a platform in which the old aristocratic VC model will be replaced by a model that supports a meritocracy at every level of the investment pyramid. That is a fantastic development for entrepreneurs and VCs who are attracted by - and deserve - the merit. Big stakes, big returns, fewer players, better innovation With LPs retrenching (to perhaps another asset class), the VC firm that wants to survive better articulate a clearly differentiated investment strategy with new GPs that can recognize and attract more disruptive (and sustainable) innovation, knows how to commit and helps make its portfolio companies work. A new day Venture Capital as the derivative in the investment pyramid between the assets of the LPs (money) and the assets of the entrepreneur (innovation) needs to provide a better service to both parties (or else it will be tossed out as a “dating service”). Until we fix VC, will it remain a systemic risk to our asset class, economy and frankly our reputation as the most innovative country in the world. Georges van Hoegaerden is the Managing Director at The Venture Company (www.venturecompany.com) in Palo Alto, focused on helping companies with technological and market insight, organizational development, team building, selling and managing growth. This post originally appeared on his blog. |
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June 25th, 2009 at 12:38 pm
VCs really need to get on message with a single point: The problem for the VC market is not fraud; it is the fact that the IPO market is closed, has been for some time, and will be for some time.
June 25th, 2009 at 12:54 pm
Michael, I am not suggesting fraud is involved, but rather the lack of value selection and creation. For many years we’ve cheated even the public markets with valuations that have no value. The cat is out of the bag.
For more background, read my blog at http://venturecompany.com/opinions
June 25th, 2009 at 3:56 pm
The vc industry has always been cyclical and will continue to be that way. The problem has become what seperates vc and private equity is a 1 bbl “venture fund’ really venture capital. The problem with all these statistics is that the NVCA treats NEA the same as a Founders fund when they are really two very different animals. The NVCA needs to keep better track of real venture investing versus the huge follow ons that large vc’s are doing. Force 10 is a great example they have raised 700mm is that a venture deal, I don’t think so.
June 25th, 2009 at 4:58 pm
Georges,
Perhaps I missing the nuance, but to me “valuation that have no value” = fraud. Maybe not in a legal sense, but at least in a common sense.
Nonetheless I appreciate the more subtle point you’re trying to make. All I’m saying is that subtlty will get one nowhere with this Congress, which is up to its neck with health care, energy, and immigration issues. If VCs are going to be heard, then they have to pick a simple message and stick to it. On my view, that message is “Clear the pipe for more IPOs.”
Michael
June 25th, 2009 at 10:32 pm
Bob and Michael, with all respect to the NVCA but I classify their plan as “The autocompany’s plan to fixing VC” on my blog. The NVCA represents VCs who are the root of the problem, and a fix may include cannibalization of the aristocratic structure they’re vested in protecting. Just like with sub-prime lending the issue is not the structure of investments but the type of people making them. You can’t keep blaming the car for the accident, it’s the driver. And its time we hold them (very) accountable.
June 26th, 2009 at 3:03 pm
Georges,
I think this article is spot-on.
The government simply is not responsible for the reduced number of current IPOs. Yes, Sarbox sets the bar higher but given the actual results of the “average” technology IPO over the past 10 years, the bar needed some lifting. Too suggest that the government’s role is to “clear the pipe” for IPOs is to beg for a reduction in the few guard rails that we have - and no assurance that what fills in the gap will not be meaningfully more onerous than what we are removing. To quote a recent George Soros piece in the FT (June 17,2009), “While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to polical influences, therefore, regulation should be kept to a minimum.”
Please VCs and specifically the NVCA, don’t let the fact that the markets have had no appetite for incremental risk during this time of great financial upheaval lead you to call either for a larger government role or for a hall pass/lowering of the bar to make it easier to flip not-ready-for-prime-time companies to the Teachers’ Retirement Account funds. Either of those moves now will most likely bite us all in the bum in years to come.
Respectfully,
JPH
June 26th, 2009 at 3:37 pm
The only people who can solve this problem are investors and as long as they continue to fund all the marginal vcs this problem will not go away. Govt intervention for the ipo market or the venture market is not a good idea.
July 1st, 2009 at 3:30 pm
Georges, these 2 ideas hold great merit:
“the lack of value selection and creation” as the problem and
“As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have actually invested deep rather than wide”
Unfortunately, government intervention can’t fix either of these problems.
Trying to characterize the VC market as “systemic risk” in the sense that the current congress debate involves is simply a turn of phrase. VC poses no systematic risk in the sense that the lending, derivatives, and large PE funds are argued to be, it’s too small and essentially unlevered.
The mere fact that LP’s can identify and not invest in the non “top quartile” funds is evidence of transparency, and if you move beyond transparency into regulating fund size limits, or investment instruments, or industry preferences, etc. we all know that investors will work around the regulations.
The fix must include fundamentals, not regulatory guess work:
1. Better investors (with more operating and entrepreneurial expertise) coming in and outperforming,
2. genuinely intelligent LP’s that don’t use inappropriate historical information as the basis for their allocation s (which has lead to tremendous over funding)
3. and P.S. outstanding entrepreneurs and innovations. Even the best investors only make money on top of that foundation. If congress really wants to help out…..solve the immigration barriers to the U.S. retaining the best talent in the world.
July 1st, 2009 at 3:43 pm
Hi Robert, I am not expecting government regulations to be the panacea, but merely the foundation upon which a meritocracy (across the whole investment pyramid) can be established. Ofcourse LPs need to do their job on regulating/sifting through the mess, hence my other articles. But the origination of problems is not the lack of entrepreneurialism but rather the narrow lens through which VC recognizes it (which I refer to as sub-prime VC). That is why they don’t get great returns.
Best,
Georges
July 2nd, 2009 at 9:57 am
Dear George , This is a very interesting discussion and poses on one level a question I have been trying to answer for myself for a number of years . Is the model of financial analysis and ROI part of the problem in the United states economy or more specifically in the Venture Capital community. When one starts out from a particular point of view , in this case ROI, it drives thought and behavior. Is part of the problem that nationally we do not have enough Science and R+D that is pure vs. based on or looking to monetization ? I think back to my days as a youngster where my father worked as an engineer at Brookhaven National Laboratory and the discussion’s where always about science and discover not returns. I am not a V/C but have worked with venture firms for 20+ years your comments caused me to share this thought.
Sincerely, Bruce MacDougall
July 2nd, 2009 at 10:37 am
Hi Bruce, VC investing is very simple; you invest in upside (rather than downside) and that means that as a VC you need to have the qualifications, experience and guts to understand the risk of upside investing. A topic I describe on my blog frequently.
I see a bigger trend with innovations from the US in general, and that is that unbridled capitalism quickly loses its support for a meritocracy the minute the category starts to get hold. All flock to that category and walled gardens are starting to build. So the systemic risk is that we don’t protect meritocracies that allows our innovations to flourish to its fullest extent. That’s how we are losing the auto business as well.
Science can play a major role in innovation, but the ecosystem of every innovation (in the form of a company) is different. Twitter and Facebook did not require a lot of science, but merely an attachment of technology to macro-economics and human behavior. Great science can be destroyed by a board that in the end applies the wrong business model to the innovation, I am watching one now where that is taking place under the “watchful” eyes of some of the most prominent VCs in the valley.
So, Bruce, the real success of the company is defined by its unique ecosystem. The recognition, creation and validation of that ecosystem with respect to its customers is key in building successful companies. But great science is usually a good starting point, as long as you have someone who can ensure that the benefits of science are creating an urgency to buy for everyday people if you want it to scale quickly.
Feel free to peruse my blog further, lots of articles on how to build successful companies.
Hope that answers your question, feel free to contact me with more questions.
July 2nd, 2009 at 11:56 am
Maybe part of the problem is due to the fact that stellar returns such as the ones we have seen in IT are less likely to happen, as this sector matures (the post states it).
IT was rather deregulated or under a strong deregulation (think telecoms) movement. Biotech, cleantech and some other “disruptive innovation” areas are likely to be more under the influence of regulators and administrative decisions. That makes it more difficult to invest and predict the outcome of an investment.
This is not to go against the post, but maybe try to introduce a nuance - and avoid blaming uniformly all the VCs…
July 2nd, 2009 at 4:16 pm
Cyril,
No, technology is at its early stages of innovation not at a late stage (see my blog). What important here is to separate the regulations of “markets” with the regulations of the financial constructs to support those markets. The latter requires basic regulations such as transparency that together with stronger oversight from LPs to produce the returns this sector warrants.
I do squarely blame the VCs for this issue, they should have regulated themselves (through the NVCA or otherwise) and they have not. Now with deplorable results the regulations (from both parties described above) will be enforced upon them. VC is goal keeper that is to blame for letting too many false positives in and keeping false negatives out. It is time we hold them accountable for the sake of the preservation of our sector and the years of high-yield returns that lie ahead.
Sure, not all VCs do a bad job, but the overwhelming majority spoils it for the rest of them and for the sector as a whole. In the same way sub-prime lending gives real estate a bad rap.
Hope that helps, best
Georges