Venture Capital: Who (Not What) Is Broken

Reports of venture capital’s demise are greatly exaggerated. Not a day goes by without a commentator reading the VC industry its last rites. And many of the gloomiest prognostications come from those inside the industry. A recent survey found that 53% of VC respondents felt the industry was broken.

It’s too easy and lazy (and self-serving for some) to claim the VC model as broken. Nineties nostalgia recalls VC as an investment strategy played on Lake Wobegon, where the sun always shined, all portfolio companies were above average, prices always moved higher and everyone came away a winner.

This was a blip in a cottage industry still in its formative years.

I see the VC “model” best defined by its primary activity (principal investments in early-stage, unproven companies with high-potential) and unique structure (long-term investment partnerships with incentives to share the risk and reward). Simply: risk capital, pooled.

Get an Edge or Get Edged Out
How do successful investors profit? By exploiting market inefficiencies. When VC first emerged, innovative ideas might have been plentiful but capital was in short supply. Scarce capital, fewer rivals, better prices, more opportunity: superb returns. The virtuous circle begets more investment professionals, more money and more competition. At least for a while, it all seemed so easy. This perpetual pro-motion machine reached its crescendo in 2000 (witness: Red Herring cover story “Everyone wants to be a VC”). Capital became abundant, and really innovative ideas got scarce. It finally set in that there are not enough billion dollar exits to cover all participants’ flameouts.

This pattern is not unique to VC—whether its convertible arbitrage, distressed debt or property development—when a particular strategy becomes crowded, the opportunity for superior investment returns becomes diminished.

So it should come as no shock that existing VC powerhouses would seek to shoo other prospectors away. “Get along young fella’” the farmers say, “the harvest is gone, nothing left to see here”.

The venture capital field has become more competitive and new profits require creativity—novel financing strategies, investing in virgin territories, looking further ahead of the curve or finding pricing discrepancies to exploit. As Bill Gurley correctly notes, we’ve entered a leaner period during which there will be fewer investable dollars to go around. LPs will be more discriminating with future VC allocations, seeking groups that can demonstrate an edge to take advantage of market inefficiencies.

Survival of the Most Adaptable
But VC is not dead—it’s evolving. To survive, participants must adapt to the changing environment.
The venture world is increasingly being bifurcated into multi-billion dollar, multi-strategy equity managers (NEA, Sequoia, Polaris, Norwest) and hands-on, early-stage craftsmen (Union Square Ventures, Foundry Group and First Round come to mind) more reminiscent of the industry’s roots. This is not to say that groups like NEA are not making seed investments—they are—but when you control $11 billion dollars in committed assets, funds need to be managed differently.

As an industry with assets of ~$0.25 Trillion, VC is a pipsqueak compared to mutual funds (~$19T), PE funds (~$3T) and hedge funds ($2T). Consider: a 5% drop in mutual fund assets is the equivalent of wiping out all VC money ever invested.

Over the course of the past three decades, the private equity industry (more capable of scaling larger asset pools due to the sheer size and depth of investment options) has witnessed profound change. Firms that began as 2-3 person investment/advisory groups (like Carlyle and Blackstone) have morphed into behemoths, bursting with tens of billions of dollars, deployed across diversified strategies, geographies, and asset types (equities, fixed income, real estate, etc).

Hedge funds have undergone the same transformation. What started with the plain vanilla long-short equity fund was re-imagined and re-invented by highly sophisticated investment managers like Citadel that defy traditional characterization.

The Breakdown
The real question is not “is the VC model broken?”, but “which VCs will break down”?

Those larger fund managers that develop rigorous best processes; demonstrate an ability to recruit, nurture and retain talent; and continue to execute innovative investment strategies—will be rewarded over the coming decade. Smaller funds that stick to their knitting, cultivate unique proprietary edges, and focus on opportune niches will also thrive.

But those funds stuck in the middle— riding past glories and fighting the last war, under-investing in their team with no succession plan, and distributing larger sums of capital more indiscriminately—are the “Broken VCs” doomed for extinction.

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in advanced materials, energy technology and semiconductors. Read his past peHUB posts and follow him on Twitter.