Why Venture Capital Now?

The time when venture capital was a suspect investment class has long since passed. But when is a good time to dip into the private market?

By Edwin A. Goodman

The short answer to this article title is, "venture capital always," which is to say that all legitimate asset classes which offer a history of competitive returns and sufficient critical mass must be included in the asset allocation mix of an astute money manager.

Except for a shrinking minority, the time when venture capital was (in the eyes of professional money managers) a suspect class has long since passed. This year, investors will invest approximately $60 billion in hundreds of venture capital partnerships and dozens of venture-focused funds-of-funds, indisputable evidence that venture capital has found its rightful place along with timber, real estate and oil & gas within the "alternative assets" portion of many investment portfolios.

The other, more distinctive argument for the inclusion of venture assets is performance. Over many years, private equity has outperformed other asset classes, as illustrated in the table nearby.

However, skeptics may well point out that even on a relative basis, VC performance has been terrible within the last three years. To this, I would reply that venture performance should never be viewed within a window narrower than five years and that the three-year portrait in particular focuses on an aberrant period of historic dimensions: the lead-up to the 2000 bubble and the debacle in its wake. Unlike other investments, venture funds require time to deploy, nurture and harvest assets, and therefore fund performance should be assessed in the fifth year and beyond. Some purists argue convincingly that, particularly with respect to early-stage venture capital, the only meaningful measure is the 10-year end-of-fund cash-on-cash return.

WHEN IS NOW?

The title of this article is mischievous because it implies both that there are propitious times to invest in venture capital and that one can discern these evanescent opportunities. The fact is, there are indisputably optimal times to invest and the wisdom of hindsight reveals them, but no one can predict them.

The ideal generic time to proceed is when the economy is somnolent but gaining strength -- and a robust stock market, an exuberant IPO issues market and lively M&A activity all are in prospect about four to five years down the road. These ideal conditions allow VC fund general partners to invest at reasonable (low) prices, to nurture companies as the economy accelerates and to orchestrate exits when the public markets and corporate acquirers have a keen interest and will therefore pay top dollar.

As an example, venture funds that invested heavily in 1993, 1994 and 1995 and harvested in 1998 and 1999 did extremely well. Conversely, those that invested in '98 and '99 and sought exit opportunities in 2000 and 2001 generally suffered from abominable timing.

The solution adopted by sophisticated investors in venture capital is investment programs that utilize "time averaging." By investing approximately the same amount every year in the best possible managers available on a continuing basis, these programs generate strong returns over the long haul, allowing the best vintage years to offset the worst.

"NOW" MEANS NOW

Despite my views regarding the naiveté of market timing, I believe that one can discern the markings of a favorable climate for venture investing now, particularly for early-stage venture investing. I share the consensus view that the U.S. is in the early stages of an economic recovery and business at all levels is improving. But the advances are slow and steady and not pervasive, and therefore caution is still in the air and entry level prices are reasonable for investors.

In addition, a structural anomaly currently affecting the private equity industry favors early-stage investors. Up until the mid '90s, annual investment in the venture industry in the U.S. from all sources, including ERISA plans, ranged from $3 billion to $5 billion per annum. With the advent of the Internet and the perceived attendant business opportunities, venture investing volume accelerated rapidly each year peaking in 2000 at over $100 billion. By 2004, venture investing was still running at the rate of $60 billion, 12 times the historical norm.

The number of venture firms and professional venture investors did not expand commensurately during this period. As a result, the average venture fund now manages about $300 million and many manage considerably more. These firms cannot efficiently deploy this much money in young enterprises that can only productively absorb $2 to $4 million and, in any event, don't welcome the dilution attendant to raising more money than absolutely required.

Therefore, at a time when there is more venture liquidity than ever before, a dearth of capital is available for the fledgling enterprise with modest capital requirements. From the early-stage venture investor's perspective, opportunity beckons with the prospect of light competition.

GRASPING TECHNOLOGY

Finally, I believe, we have reached a second wave of opportunities spawned by the Internet. The Web is certainly a disruptive technology because it is pervasive and touches virtually every aspect of our business and personal lives. It therefore attracted huge amounts of risk capital as have other major innovations within recent memory such as semiconductors, PCs, biotechnology and PDAs. However, there was insufficient experience to grasp the potential, the limitations and the distinctive properties of the Web during the initial phase of investment from 1995 through 2000. Accordingly, in the midst of triumphs such as Google, there were many disasters, such as Webvan.

Now, in the course of this second wave, both entrepreneurs and investors are wiser in the ways of the Web, and business plans avoid the pitfalls and utilize the Internet's distinctive capabilities. The second-wave applications of a new technology provide an auspicious context for identifying attractive high-growth investments.

U.S. PRIVATE EQUITY PERFORMANCE
(Periods Ended June 30, 2004)

Source: Thomson Venture Economics/
National Venture Capital Association

Now, certain otherwise sophisticated money managers and pundits have declared that venture investing isn't really an attractive investment option because it is only the top quartile of venture funds that truly outperform and drive the favorable venture performance statistics. The argument continues that if one cannot gain access to the top 20 firms, one shouldn't bother to participate. Needless to say, the advocates of this point of view are, frequently, investors in those top funds and are promoting this access.

However, I believe, their position is akin to concluding that one shouldn't invest in public equities because the great majority of the money managers don't beat their benchmarks such as the S&P 500 and the Nasdaq Composite. And the minority (the successful asset managers) are unable or unwilling to accept more mone.

Of course, the difficulty with these arguments is that they presuppose that past performance is an indicator of future performance and that the venture investing community is a static universe with fixed rankings unaffected by retiring general partners and talented emerging ones. In any event, the so-called top 20 or 30 firms are simply not open to new investors and in several cases, having emerged with bloated coffers in the course of the bubble, have reduced the size of current and prospective funds.

Therefore, the challenge for the investor today remains what it has always been: decide on a sensible venture allocation, establish a five-year program of annual investing and aggressively seek out the most compelling venture strategies and the best mangers to implement them. If history is any guide, you will be richly rewarded.

Edwin A. Goodman, General Partner, Co-Founder, Milestone Venture Partners, is a 30-year veteran of venture capital funds, was CEO of Hambro America and General Partner of Hambro International Venture Fund. Among his more than 200 investments were early-stage companies including Corporate Software, Komag, Rasna (Parametric), Solectron, Staples, Telematics, and Veeco.

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