Venture capital (VC) is going through a deep crisis. While it is often supported by governments for its ability to create successful entrepreneurial companies, it struggles to attract a steady flow of private money.
A stark picture of the dramatic downsizing of the industry emerges from comparing the number of VC funds raised and maturing over the past dozen years (click to see chart).
The number of new funds raised since 2008 is tiny compared with the number of maturing funds – those reaching their 10th year of life and therefore ripe for being closed.
If the trend of the first half of 2010 is confirmed throughout the year, there will be more than 300 fewer funds active in Europe, and more than 200 fewer in the US.
In terms of amounts of funds raised, this corresponds to nearly $20bn less in Europe, and $60bn less in the US. One reaches the same conclusions by assuming funds mature after five years, the typical period of time after which they stop making new investments and start exiting companies.
From the entrepreneur’s perspective, the number of companies that obtain venture funding has halved since 2000. These numbers suggest VC investing is shrinking and that many VC firms are forced to close down.
There is more than gloom, however. Many new venture management teams are entering the market. In Europe, about a third of the venture firms active in 2004 have ceased to operate, but about a quarter of those currently active started operating in the past three years. VC is therefore a shrinking industry that is also experiencing substantial entry.
What should we expect for the future?
To answer this question we first need to understand the relationship of venture firms with limited partners (LPs) – the institutional investors that ultimately provide the money.
During the past decade, LPs have put large amounts into this asset class, attracted by the promise of a Midas touch. They have often been disappointed. As a result, many of them are retreating to more familiar investments.
Those that remain active in investing have become more demanding of venture firms, more aware of fee structure, more skilled at performance measurement, and ultimately more selective in their investment decisions.
A second key point is that investors from the Middle East and Asia have made fundraising increasingly global. Companies from regions far apart are competing for funding, and entrepreneurship becomes more diffuse and mobile. This dismantles established sources of proprietary dealflow and forces venture firms to compete. This may seem like bad news for venture capitalists, but
I do not think so. Fundraising is going to be more difficult for those that have failed to generate adequate returns, either because they lack the skills or because market conditions prompted them to invest at valuations that were far too high. On balance, the exit of these firms should benefit both entrepreneurs and investors.
Moreover, many venture firms that enter the market are experimenting with new ways of generating returns for investors and of supporting promising entrepreneurial ideas.
I expect the future will belong to these innovators. Their responsiveness to the structural changes in VC markets will rock the model that has worked so well for two decades.
We are going to see different ways of raising money from limited partners, which is likely to lead to new fund structures.
We are also going to see new ways to deploy the money, as venture firms will exploit the changing nature of the world economy, and new ways to create and diffuse entrepreneurial ideas.
Exciting times lie ahead, for those ready to grab the challenge.