Buzz: VC Industry Restructuring

My father-in-law started in the brokerage trading business in the mid-1960's. He showed me an industry tombstone advertisement page from 1969 that had over 50 regional and local brokerage firms, along with a handful of the growing national players (like Merrill Lynch). Today, nearly all of them are either dead or acquired and it is dominated by the majors. There are boutiques, a couple of regionals (Blair, Baird, etc) but it is dominated by the large players. The venture business is heading in a similar direction it looks like.

Scale is becoming increasingly important (domain expertise, visability, branding, etc) just as it was in the brokerage business. The challenge is that venture does not scale well. It is impossible, as we all showed in 2000, to do early stage venture from an $800m fund. However, LP's are not interested in backing unproven groups. Groups with history are, again, getting big funds raised. So, I'm not certain how this trend continues to play out since the forces are pushing to larger organizations, but larger organizations ($800-$1B) groups have trouble successfully deploying money early stage and getting solid returns. So, they are likely going to:

-- go later stage and compete with the hedge funds and existing later stage players. This will drive pricing up (as is happening in buyouts) which will hurt returns.
-- go international and chase the China dollar
-- put 50+ investments into a fund and take a portfolio approach.

In short, this is a mess (for both start-ups...too many competitors and for VC's) and why we have pulled back to a regional early stage focus while leveraging the 34 offices worldwide in our network for scale. Below is the recent press release from Venture Economics reporting on the YTD fundraising in venture:

"Venture capital fund-raising activity in the second quarter of 2006 is further proof that fewer and bigger war chests are being amassed by investors.

According to new data compiled by VentureOne, a research unit of Dow Jones & Co., the number of funds closed during the quarter fell dramatically from the year-earlier period, to 23 from 37, but the amount raised remained steady, with $8.2 billion in the latest quarter versus $8.3 million in the period last year.

In addition, barring a second half flurry of small fund closings, 2006 as a whole is shaping up as the year that funds under $100 million were all but forgotten. In the first half of this year, only 28% of the funds closed have been less than $100 million. If that trend continues throughout the year, 2006 would have the smallest portion of double-digit funds raised since 1992, the earliest period tracked by VentureOne.

The percentage of sub-$100 million funds raised has been falling steadily on an annual basis for the past four years, the data shows, from some 71% in 2002, to 63% the following year, 52% in 2004 and 44% in 2005. The median fund size this year sits at a high $170 million.

The largest fund that closed in the second quarter is Oak Investment Partners' Fund XII, which happens to be the largest venture capital fund ever raised at $2.56 billion. And as limited partners clamor to get into brand-name funds, the trend of bigger-is-better shows no sign of slowing down. The third quarter kicked off with New Enterprise Associates raising its giant $2.5 billion twelfth fund. DCM, a Silicon Valley early-stage venture capital firm founded in 1996, closed its largest fund to date, the $500 million DCM V, last Thursday."

Comments

[Nathan Dintenfass]

Over time, does this portend a shrinking of the "bottom of the pyramid" in VC-land? That is, if we see fewer and fewer small funds making small investments where will the dealflow come from for the mega funds? If the "asset class" of VC (and I know some hate to even think of it as such) shows good returns over the next few years we'll continue to see second-tier LPs looking for a way in, and they won't get into the shrinking number of big-name funds -- that means they will have to go down-market to the newer, smaller funds, no? Are we just coming to a new inflection point in the venture investing cycle, or do you really think the days of boutique venture capital are (slowly but surely) coming to an end?

[mbmccall]

Great questions. The LP's are stuck. They want to have a brand firm only strategy (good returns persist studies...) but they can't, as you mention, get their full PE allocation filled as they can't get enough $ into them. So, they are all left at 30-60% of target allocation.

I think we will see more and more "new" groups spin out of brand funds when the younger partners clash with the old guard that won't share economics fully.

It is possible that we will have the brand funds, niche funds and regional funds. It is the groups inbetween that will get squeezed. So, the boutique (like in brokerage) will survive, but the mid-sized fund is in trouble.

It will all be driven by who gets the returns. If the rising/growing new funds can show IRR, then they will continue to populate the middle. If scale and brand really become an decisive factor, then it will become more difficult.

I am as curious as you to see how this plays out...

[Sarah Z.]

The trends mentioned are all very interesting, but I was wondering how the movement of VCs into popular culture fits into this? It seems that CEOs and other company leaders are becoming more and more like celebrities; Even here in Canada we are getting one of those TV shows were entrepreneurs have the opportunity to pitch to VCs on National television (CBC is introducing one called "Dragon's Den" this fall: www.insidethedragonsden.com) They are running commercials for it all the time. To this end, has popular culture and the glorification of entrepreneurs as celebritites had any impact on venture capital activities?

[mbmccall]

Will put it on the hit list. Thanks!