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As published in Venture Capital Journal
September, 2005
PROSPECTIVE VENTURE CAPITAL RETURNS 2010 –2020
Look for Early Stage Returns to Surge
By Edwin A. Goodman
Having suffered from the aberrations of the 2000 bubble and the consequent debacle, I firmly believe that Venture Capital has recovered and returns will revert to their historical mean as reflected in the chart below under the final column - 20-year performance. However I anticipate significant deviations from the pattern in the course of the next fifteen years. I believe that early stage venture investing, styled as "Early/Seed VC" below, will out-perform the historical numbers by as much as 25% and that the Later Stage VC and All Buyouts categories will under-perform. By forecasting returns generated from 2010 through 2020, I am focused on funds created in the vintage years 2005 through 2010.
Sophisticated observers of the venture scene argue that the real challenge is to make the best fund selections within the asset class because the stars perform dramatically better than the mean. They are correct but there are other important currents in the flow of the venture business, which are important to chart to enhance the opportunity for successful venture investing. The fact is that many ignored some of these trends in the late 90s and lost money investing with a number of prestigious firms. Furthermore, many of the great firms have replaced their extraordinary first generation general partners with smart, talented but unproven newcomers of the next generation. So brand name buying (even if you can get a place at the table) does not constitute an investment strategy. Furthermore, we all have absorbed the mantra that past performance is not an indicator of future performance. I would argue that this is particularly so within the venture community where the velocity of change is high and pervasive.
Of course one must make every effort to select the best firms but first it is essential to establish a private equity investment thesis, informed by current trends, that guides your search. One can think of this initial step as akin to asset allocation within the context of investing in listed securities. For example, as French venture capitalist Jean Schmitt of Sofinova recently observed, some 40% of the largest companies in the US didn't exist 10 years ago while in Europe none of the 100 largest companies was founded with the past decade. Accordingly, if one were interested in technology companies in rapidly developing new markets - generally the purview of early stage venture firms - one would tend to look to the U.S. rather than Europe.
This record of successful new company formation reflects a U.S. entrepreneurial culture, our deep capital markets (including conspicuously NASDAQ), and our lead in technology research and innovation. Our technology leadership is, however, under challenge by the likes of Japan, China and India. As Bill Gates and others have warned, if current negative trends in U.S. education at all levels continue, we will surrender this dominant role within the next twenty years - a key macro trend to watch.
Once we settle on the U.S. as the world's most currently appealing private equity market, we have to contend with the allocation of capital. My argument for the early stage category is based on several factors.
One reason is the law of large numbers, which is a major factor within the asset class. Simply put, it is less challenging to achieve outsize venture returns with a $150 million fund than with a $1 billion dollar pool.
And other factors are at work, which reinforce this truism. Over the past two decades as pension funds have grown dramatically because of generally favorable listed equity markets they, in parallel, have become a bigger part of the private equity investor base. Allocations within pension funds to "alternative investments" have also grown as a percentage of assets under management. The net effect of these changes is that expanding capital flows seek out a finite number of private equity investment opportunities.
To give a generic example, a $4 billion pension fund may have a 10% allocation target ($400 million) for private equity. In order to deploy this capital efficiently and wisely within a reasonable time frame and to avoid creating a very extensive portfolio of funds, which is exceedingly difficult to superintend, such funds invest in chunks of $25 million and up. To manage risk, they also generally avoid a limited partnership position in excess of 10% of the targeted fund. These guidelines inevitably result in investments in larger funds either within the "Later Stage VC" or "Buy Out" categories. These trends are exacerbated by the post bubble restraint of many venture funds that are strictly limiting the size of their prospective funds with reductions of from 25% to 50% in fund size. This results in capital flowing increasingly to the high end of the market, which heats up competition and pricing and axiomatically drives down returns. If good managers are selected, double-digit returns can be achieved but I see the trend in large funds leading toward single digit performance.
In contrast, my optimism for the early-stage end of the market is based, in the first instance, on the same capital flow pressures just discussed. Since large institutional capital sources cannot put enough money to work at the low end, they ignore it. The result is relatively light competition for venture firms managing less than $200 million and, in turn, fewer sources of capital for entrepreneurs who seek to raise $5 million or less. Therefore, the venture funds within this space generally can negotiate more favorable (lower) pricing and other preferable deal terms with the prospect of higher fund performance.
But in my view, the most exciting aspect of the low end of the market, which will drive lucrative returns, is the dynamism of new company development and the prospect of rapid growth within new markets. As noted, the large funds must seek out large enterprises that can fruitfully absorb large amounts of capital. Therefore their target investments tend to be within mature industries where historical data can be reviewed and cash flows are stable. In contrast, with less money, a tolerance for greater risk, and an aspiration for dramatic growth and attendant higher returns, the smaller funds shun mature markets in search of newer high growth sectors. If the venture capitalist is diligent and skillful he will perceive these opportunities well before they are generally visible.
For example, within Information Technology, the Gartner Group has developed its own colorful nomenclature for these markets and their evolution as reflected in the graph below.
Milestone and other firms of our ilk are very much focused on companies laboring forward within the "Trough of Disillusionment" and those climbing the "Slope of Enlightenment." The Internet has created whole new markets and enabled many innovative companies - Google, Yahoo and eBay are the best known of the significant insurgent companies that have emerged over the past decade on the vast enabling platform of the Web. I think this process of Internet-linked invention and innovation will only accelerate.
In 1968, Ecologist, Garret Harden, wrote apocalyptically about the "tragedy of the commons" by which he meant the observable decline in the scope and quality of our shared heritage of clean water, clear air, national parks and also man-made shared amenities such as roads and railroads. He perceived these resources withering under the demands of an expanding population. But the information age has turned this paradigm on its head. Our new, largest and most pervasive public shared resource is the Internet, which is enriched by the millions of participants who interact with it and contribute to it. At this juncture, some 53 million people have contributed, in a variety of forms, to the content on the Internet. And yet the Web remains in its early stages of development. Users are full of hope and high expectations. The Internet has recently been referred to as the cornucopia of the commons in contrast to Hardin's dark vision.
Professor Yochai Benkler of Yale Law School has coined the phrase, "commons-based peer production" in an effort to capture the way in which people use the network, frequently without any central authority or guidance, to perform a wide variety of useful tasks such as to create software, to acquire information, to impart information, to compute (peer-based computing), to store data and to establish connectivity (VoIP).
The list of new markets and opportunities is expanding rapidly. Some of the more visible ones include: vertical market search tools, query tools to search unstructured data such as emails and blogs, compliance tools to cope with Sarbox and other regulatory requirements, compression and streaming technologies to permit the downloading of rich content (e.g. films), pod casting of music, video, and text, and on-line gaming.
One aspect of this robust innovation is an accelerated version of what economist, Joseph Schumpeter, referred to as creative destruction. He argued that only societies that embraced the inevitable changes wrought by technology, despite the attendant dislocation and pain, would be able to grow and prosper. The clear implication is that companies must be willing to change, sometimes swiftly, in order to compete with the insurgents to which early venture capital dollars flow in search of explosive growth. One illustration of this phenomenon is SUGARCRM - an open source CRM (customer relationship management) software company that initially allows its customers to download its software from the Internet for free. It has captured 235,000 customers to date and is stalking the market leaders, Siebel and Salesforce.com, which offer more conventional SAAS (software as a service) business models. In the case of SUGARCRM, after they sign up their customers, they charge them $40 per month for support, and offer a more deluxe product for $239 per user per year.
Although Internet-enabled companies will dominate the contest for early stage venture investment, other markets such as biotechnology and clean energy also offer exciting opportunities. Indeed, many of the innovations within biotechnology will be facilitated by the availability of specialized bioinformatics search tools. As to energy, we have all heard this song before but that should not suggest that energy's venture moment has not finally arrived. Here too, it appears that advanced software and super fast computers may have much to contribute through much more intensive analysis of existing seismic data which opens the possibility of extracting considerably more oil from fields once deemed exhausted. (BusinessWeek, July 11, 2005,"Tapping Gushers Beneath The Gushers")
There are also some arresting data points and anecdotal indicators that energy will emerge as an appealing investment target. Recently, T.J. Rogers, the founder of Cypress Semiconductor and a quintessential Silicon Valley entrepreneur, personally invested $750,000 in his friend's struggling company, Sun Power which manufactures solar panels and photovoltaic cells which capture and harness the sun's energy for a variety of tasks such as home heating, water heating etc. Clearly, Mr. Rogers anticipates a turn in Solar's fortunes as the photovoltaic methodology becomes more efficient and traditional fossil fuels grow scarcer and more expensive. The Financial Times recently gave prime coverage to an OPEC press conference at which the cartel announced that within a decade it would be unable to meet the energy demands of the West, which are forecast, to triple by 2015. Less speculative data concerns BP which having sold $400 million of photovoltaic products during 2004, realized its first profits in this area.
The harbingers are everywhere for attentive observers who seek high private equity returns. Investors should abandon the idea of large volume private equity deployments, seek out those funds of modest size that are embracing strategies tied to innovation, and manage the risks associated with early stage funds by backing a dozen discreet managers across different markets. Adapting such a program will optimize the opportunity for outsized returns over the next decade.
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