Benchmark Capital’s Bill Gurley yesterday wrote on his blog that the VC industry is going to shrink substantially over the next several years. Specifically, he argues that large institutional investors will decrease their allocations to venture, although not abandon it entirely (due to CAPM and contrarianism). The typical reaction from readers — including many of you who sent me emails — was appreciative slobbering.
I strongly encourage you to read what Bill wrote. Go ahead, I’ll wait.
Ok, now let me tell you why I think he’s wrong. Not on describing the overall environment (he’s got it nailed), but on what the end result will be.
Specifically, I believe that the number of institutional investors cutting back on VC commitments will be small, compared to the number either maintaining or increasing their allocations. It’s easy for us to get caught up in the doings of big-name, liquidity-challenged endowments like Harvard and Yale, but they really are just a tiny drop in the overall LP bucket. In fact, all the Ivy Leaguers combined probably have less committed to venture capital than does CalPERS alone (and it recently increased its alternatives allocation)…
The most recent Coller Capital Barometer showed that 20% of respondents plan to decrease their alternatives allocation over the next 12 months. This compared to 15% who plan to increase allocations, and 65% who plan to maintain current levels. Not terribly significant.
A counter, of course, would be that allocations have little meaning compared to the actual dollars they represent. This is the denominator effect argument, which helps explain why there has been so little successful VC fundraising so far in 2009. But the denominator swings both ways, and it does appear that the market bottom is behind us (save for the dreaded “double-dip”). Moreover, the sizes of future mega-buyout fundraising efforts have shrunk, thus freeing up new cash for venture when institutions reopen their purse-strings. Some of that extra will get redicted to other sub-asset classes like distressed, but some also is likely to go toward venture funds that have relatively low capital commitment requirements (that extra $100m originally dedicated to KKR could be used for five or six VC fund commitments).
Then there is the presence of funds-of-funds, many of which are contractually obligated to keep putting money to work. When a Harvard or Yale drops out of a legacy VC investment, there is almost always a fund-of-funds lurking to take its place. Some of these fee-doubling aggregators will certainly fall by the wayside, but not many of them. After all, most institutions plan to maintain their alternative allocations at the same time that they’re being hit with budget cuts. The likely result is more outsourcing of investment activities.
Moreover, a new meme is taking hold among some LPs I’ve spoken with – that falling VC investment activity are bringing us back down to 1995 and 1996 levels, which could/should produce outsized returns. It’s a cozy argument, albeit one that ignores how those falling investments are being made by oversized funds. Bill Gurley’s firm, for example, was investing out of an $85 million fund back in 1995. Its current fund size is $500 million.
To be clear, I think the venture industry should shrink. Particularly in terms of fund sizes and GP compensation (many “walking dead” firms will obviously disappear, but new firms keep springing up to take their place). VC returns have been terrible for some time — save for the top 10% — and there is growing evidence that 1996-2000 was the exception rather than the rule. As one LP told me yesterday, “I’m not sure venture really scales.”
But I just don’t see it happening. Instead, I see a lot of hemming and hawing over the status quo, and then almost everyone continuing to follow it. Kind of like what happened after the dotcom bust…