The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment and the hindrance of successful exits around the world, but it may have exacerbated the existing problems. Poor returns over the past decade indicate most fund managers do not earn their fees, and investors have been increasingly wary of taking on added risk without getting the reward. Structural changes are inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.
State of the Venture Capital Market Pre- and Post-Financial Crisis
It is widely recognized that the venture capital industry is subject to massive booms and busts, but since the start of the financial crisis in August 2007, venture capital has been in particularly hard times, as documented in the recent Oxford Handbook of Venture Capital.1,2 To follow up-to-date specific market trends in venture capital. There are several capital market assumptions. It is possible to access publicly available aggregated datasets such as Pitchbook3 or to purchase deal-specific data from vendors such as Pitchbook, Thompson SDC4 or Zephyr DBV.5 To illustrate the massive boom and bust in recent times, we present data from Pitchbook that shows the current state of the venture capital industry in the United States. Below, we also present data from Thompson SDC to provide an international perspective.
Definitions of venture capital and private equity have differed over time and across countries. Worldwide, the term private equity generally refers to the asset class of equity securities in companies that are not publicly traded on a stock exchange. Both private equity funds and venture capital funds invest in private equity, the difference being that venture capital funds invest in earlier stage private investments. Venture capital funds often style drift into other types of private equity investments such as late stage and buyout deals,6 some venture capital funds invest in publicly traded companies,7 and even other funds are themselves publicly listed.8 A common characteristic of most stages of venture capital investments is that although investee companies require financing, they do not have cash flows to pay interest on debt or dividends on equity. The more nascent the company, the more unlikely that the venture capital investor will be able to recoup investment amounts. Investments are made by venture capitalists with a view towards capital gain on exit. The most sought after exit routes are an initial public offering (IPO), where a company lists on a stock exchange for the first time to obtain additional financing, and an acquisition exit (trade sale), where the company is sold in entirety to another company. Venture capitalists may also exit by secondary sales, where the entrepreneur retains his or her share but the venture capitalists sell to another company or another investor, by buybacks, where the entrepreneur repurchases the venture capitalists’ interests, and by write-offs or liquidations.9
It can be said therefore that if the industry is indeed in crisis, then essentially it is a crisis for critical growth of new technology companies. Not only is there less capital to be invested in high-growth companies, but whatever capital there is to be invested may not be advanced to the companies that need the capital most. Also, as venture capital investors are increasingly challenged to obtain liquidity through preferred, most profitable exit routes, they are increasingly wary of investing in the asset class, thus further reducing the amount of venture capital available.
Exhibit 1 shows the slowdown in venture capital fundraising and the growth in the overhang of uninvested capital, or capital that is being held by venture capital funds but have yet to be invested in high growth companies. In 2010 there was $81.66 billion in uninvested venture capital. For private equity funds, in 2010 there was $485 uninvested private equity.10 The drop-off in venture capital shown in Exhibit 1 is not as dramatic in recent years for venture capital as it is for private equity.10 The reasons are twofold. First, private equity deals have a greater reliance on the use of debt, and the credit crisis obviously curtailed credit markets. Second, venture capital investments tend to be more counter-cyclical relative to private equity investments insofar as there are relatively more venture capital deals when IPO markets are weak. Venture capital deals take a longer time to bring to fruition, and as such investors invest more heavily in venture deals with the expectation that they will be ready to exit when IPO markets are at a peak.11,12
Exhibits 2a and 2b may explain why venture capital fundraising has slowed down, albeit not as dramatically as private equity fundraising. Exhibits 2a and 2b show venture capital funds have not performed very well in the past decade, and have been outperformed in many years by private equity funds of the same vintage year. For recent years, one would hope that the J-curve kicks in for subsequent years; that is, one would hope that despite low performance figures currently, returns will increase dramatically in upcoming years. Exhibits 2a and 2b show DPI, which refers to distributions to paid-in capital, a measure of the cumulative distributions returns to limited partners as a proportion of the cumulative paid in capital. The DPI measure reflects the funds realized return, or the cash-on-cash return; it does not reflect valuations of unexited portfolio companies, which at times can be inflated relative to actual subsequent investment outcomes.9,13 Exhibits 2a and 2b also show the RVPI, or the residual value to paid-in capital, which measures how much of a fund investor`s capital is tied up as equity in the fund (not yet realized) relative to paid-in capital. That is, while DPI measures the realized return on investment, RVPI measures the unrealized return on investment.
Exhibits 2a and 2b also show the TVPI, or Total value to paid-in capital, which is the sum of DPI and RVPI. DPI, RVPI and TVPI are measured net of fees and carried interest. Typically venture capital funds have a 2% fixed management fee and a 20% carried interest performance fee.9,14,15 There has been a striking increase in the RVPI component of TVPI relative to the DPI component of TVPI in recent years for both venture capital (Exhibit 2a) and private equity (Exhibit 2b), but the comparatively lower DPI for venture capital is particularly noteworthy.
Exhibit 3 shows that for median 1-Year rolling horizon IRRs by fund type, venture capital has not performed as well as private equity or other comparable asset classes in recent years.
Clearly, the state of the venture capital industry in the United States does not appear to be terribly optimistic or attractive, at least on average, to investors at 2010, based on performance over the past decade. Nevertheless, there is massive performance persistence in venture capital and private equity, as top quartile funds have a significant likelihood of remaining in the top quartile over time.16 Issues such as this, therefore, need detailed examination to understand venture capital fundraising, structure and performance, particularly in light of the recent financial crisis. In this regard, the new book The Oxford Handbook of Venture Capital is timely in that it provides more detailed analysis of most of these aspects of venture capital investment to provide a comprehensive picture of effective venture capital structures, fundraising, contracting, valuation, staging and syndication, value-added, and arguably most importantly, exit. More significantly, it comprises contributions from fifty-five authors currently based in twelve different countries: Australia, Belgium, Canada, France, Germany, Italy, Korea, the Netherlands, Singapore, Spain, the United Kingdom, and the United States. These authors collectively represent some of the world’s leading researchers in their areas of expertise, and have international work experience that spans the globe to enable such detailed analysis of venture capital worldwide. As an example, we highlight a chapter by Block et al.2 that illustrates the effects of the crisis on venture capital funding rounds, the industries within which venture capital funds invest and the stages of financing that were affected.
The Effect of the Crisis on a Venture Capital Industry Already in Distress
Indubitably, during the crisis, venture capital activity slowed down. In Block et al.,2 the authors found that the crisis led to a decrease in the number of funding rounds. This decrease occurred within all industries and is larger for first rounds than for later rounds. The authors observed that venture capital funds were more reluctant to provide first-round investments toward “new” start-ups during the crisis than during the pre-crisis period, especially in the Biotechnology, Internet, and Medical/Health Care industries. Within these industries, the percentage decrease in first-round investments was approximately four times larger than the decrease in later-round investments.
The slowdown of venture capital activity due to the crisis has been found to be more severe in the US than elsewhere. Block et al.2 not only show that the decrease in the number of funding rounds per month is more pronounced within than outside the US, but also that the difference is particularly strong for first-round investments in nearly all industries in the US. This difference in US versus non-US investments is confirmed with the Thompson SDC presented in Exhibit 4.
Crisis Leading to Opportunities? In addition to weakening in fundraising and weakening of performance, venture capitalists are finding it increasingly difficult to exit from their investments. Looking at Exhibit 5, it is clear that not only have the number of IPO exits for venture capital funds in the US drastically declined since 2002, and this drop has been more severe in the US than outside the US.
This decline in IPOs may not necessarily be attributed to the crisis, as the numbers have been declining since the bursting of the tech bubble and even more so after the introduction of the Sarbanes Oxley as companies found the more onerous operational and disclosure requirements too costly to implement. It is essentially too expensive for nascent companies to seek listing and as such it is taking longer for these companies to go public. As these companies take longer to initiate an IPO, venture capital fund managers are unable to provide their fund investors with the sought after profits by the time the fund life ends, traditionally ten years from fund establishment. It may be the case that the traditional life of a fund has to be extended to fifteen years, and while this may deter fund investors who do not wish to be locked into an investment for that duration, the extension will enable venture capitalists to dedicate both the financial and value added resources to ensure that their investee companies are more than ready to initiate an IPO.15
In addition to increased difficulties to exit from their investments through IPOs, and particularly since the global financial crisis, there has been a growing market in secondary private fund interests whereby fund investors transfer their limited partner interests to secondaries. The market for secondaries represents an important way for many investors to achieve liquidity, particularly since most funds are closed at the end of their ten-year lifespan and do not offer early redemption rights. Most of these secondaries to date have been buyout fund portfolios, often held by banks, although there is increasing interest in venture capital by secondaries. For the secondaries in the buyout market, it has been reported17 that sellers routinely achieve 90% of a portfolio’s net asset value. With a growing secondaries market, it is possible that more investors may re-evaluate their view of venture capital and even when new fund structures with increased life-spans are introduced, such investments may still be attractive to potential fund investors. And for the sake of nascent companies, it is crucial that venture capital remain an attractive investment class.
Finally, in view of the weak performance of venture capital, it is also possible to question the compensation structures currently in place for industry participants. It has been suggested by Mulcahy et al.,18 among others, that the model of paying a 2% annual management fee and 20% carried interest or performance fee may not be sufficiently incentivising fund managers to seek the most profitable investments, as it may just be easier to rely on the management fees, especially when the funds are large enough.
About the authors
Douglas Cumming is a Professor of Finance and Entrepreneurship and the Ontario Research Chair at the Schulich School of Business, York University. His research spans areas that include entrepreneurship, entrepreneurial finance, venture capital, private equity, IPOs, law and finance, market surveillance and hedge funds. He has published numerous articles in leading journals and is the editor of The Oxford Handbook of Venture Capital (Oxford University Press 2012). Sofia Johan, York University – Schulich School of Business; Tilburg Law and Economics Center (TILEC). Her research is primarily focused on law and finance, market surveillance, hedge funds, venture capital, private equity and IPOs. Prior to her Ph.D., she was the head legal counsel at the largest government owned venture capital fund in Malaysia.
1.Cumming, Douglas J., 2012a. “Introduction to the Oxford Handbook of Private Equity” in Douglas J. Cumming, ed., Oxford Handbook of Private Equity, Oxford University Press, Chapter 1.
2.Block, Joern, Geertjan De Vries, and Philipp Sandner, 2012. “Venture Capital and the Financial Crisis: An Empirical Study across Industries and Countries”, in Douglas J. Cumming, ed., Oxford Handbook of Venture Capital, Chapter 2, Oxford University Press.
6.Cumming, Douglas J., Grant Fleming and Armin Schwienbacher, 2009. “Style Drift in Private Equity” Journal of Business Finance and Accounting 36, 645-678.
7.Chaplinsky, Susan, and David Haushalter, 2012. “VIPE Financing: Venture (Capital) Investments in Public Equity” in Douglas J. Cumming, ed., Oxford Handbook of Venture Capital, Chapter 7, Oxford University Press.
8.Cumming, D.J., G. Fleming and S.A. Johan, 2011 “Institutional Investment in Listed Private Equity” European Financial Management 17, 594-618.
9.Cumming, Douglas J., and Sofia A. Johan, 2009. Venture Capital and Private Equity Contracting: An International Perspective (Elsevier Science Academic Press)
10.Cumming, Douglas J., 2012b. “Introduction to the Oxford Handbook of Venture Capital” in Douglas J. Cumming, ed., Oxford Handbook of Venture Capital, Oxford University Press, Chapter 1.
11.Cumming, Douglas J., Grant Fleming and Armin Schwienbacher, 2005. “Liquidity Risk and Venture Finance” Financial Management, 34, 77-105.
12.This finding has been confirmed in subsequent studies; see, e.g., Gompers et al. (2008). Gompers, Paul A., Anna Kovner, Josh Lerner, and David Scharfstein, 2008. “Venture Capital Investment Cycles: The Impact of Public Markets,” Journal of Financial Economics 87, 1-23.
13.Cumming, Douglas J., and Uwe Walz, 2010. “Private Equity Returns and Disclosure around the World” Journal of International Business Studies 41(4), 727-754.
14.Gompers, Paul, and Josh Lerner, 1999. “An Analysis of Compensation in the U.S. Venture Capital Partnership” Journal of Financial Economics 51, 3-44.
15.Metrick, Andrew, and Ayako Yasuda, 2010. “The Economics of Private Equity Funds” Review of Financial Studies 23, 2303-2341.
16.Kaplan, Steven N., and Antoinette Schoar, 2005. “Private Equity Performance: Returns, Persistence, and Capital Flows,” Journal of Finance, 60, 1791-1823.
18.Mulcahy, Diane, Bill Weeks, and Harold S. Bradley, 2012. “We Have Met the Enemy… and He is US: Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience.” Ewing Marion Kauffman Foundation May 2012.