Hidden Crash: The Dumping of Venture Funds

In the financial markets, there are two kinds of crises: the ones you can track on CNBC and the Web, and the ones that stay hidden until something nasty happens. Ergo, while it is easy to watch the stock market crumble; it’s not so easy to know exactly what’s happening in the venture capital market.

Sure, we know that the IPO market is shut down, that there isn’t much M&A activity, and that venture partners have been lecturing their portfolio companies on how to survive a downturn. But what wasn’t as clear is that investors in venture funds are doing exactly what stock investors are doing: They are dumping their positions.

Bloomberg’s Tim Mullaney today reports that universities and pension mangers are rushing to the exits, depressing values of venture fund stakes by as much as 50%.

The piece notes that there are venture stakes valued at more than $2 billion up for sale, more than twice the $800 million of venture positions for sales at this time last year, according to Hans Swildens, principal at Industry Ventures, a San Francisco-based firm that buys venture stakes.

Swildens asserted that the glut could lead to a downturn in venture investing comparable to the 2000-2003 period, when investments fell 81%. He warned that “2009 will feel like 2001.”

According to Adams Street Partners CEO Bondurant French, venture capital fund stakes are changing hands for as much as 50% less than their original value. The piece also notes that most pension funds have policies that cap their exposure to alternative investments; as equity markets fall, they are forced to sell VC positions.

Comments

[WhynoT:]

This is not only the hidden crash but also the hidden depression. Just wait for the tax increases and other barrier increases that will push venture firms overseas or out of business. Living in the valley you can feel the pressure, start-ups are closing, craigslist is full of basement cubicles for sale, entrepreneurs are taking extended vacations and/or accepting "safe" corporate jobs if they can find them.

it's easy to track those things that go down, it is much more difficult to account for those things that never were...

2008 Nov 14 01:31 PM

[whidbey:]

Great insight on the trends. My experience as a lawyer is about the same, product extension mergers are still alive compared to portfolio acquisitions which are dying or dead. I suspect that the portfolio investors are right to be slowing down. I have been in practice 40 years and seen downturns and I agree with your concusions. The economic slow down will hit venture investing hard and I think that a good part of that is the earnings shifts that change the PV analysis of the targets revenues and shifts a lot of attention to asset analysis. That means that service oriented ventures are virtually off the market for a time. The shift investors is also interesting. Well done.

2008 Nov 14 03:06 PM

[investor88:]

Confirmation that the economic weakness is spreading into the wider economy. No signs of upturn to be sure.

2008 Nov 14 10:44 PM

[Old Hand:]

There is no real news here. Expectations-based valuation is the most commonly used technique (in many different stripes) for pricing financial assets. In essence, a current price is derived from the outlook for the future, broadly defined, for a particular asset. In the case of venture capital assets, the fundamentals have deteriorated sharply with the problems in capital markets and the expected problems in the economy. These include, for example, much more difficult and uncertain markets and demand for sources of revenue, greater difficulty in obtaining financing, and, highly uncertain exit routes in M&A and IPO transactions. In addition, VC portfolios contain by far a greater percentage of dead ducks, companies that are living dead, and companies whose outlooks while positive are by no means winners. Less than 1 percent of VC portfolio investments include shares in skyrockets like Google.

Consequently, VC as an asset class has taken a thump in valuation, and the muddy future for this class of assets looking out over the next several years justifies the thump in price. Larger holder who are dumping interests on the market, and these area always done in very private transactions among investors who qualify under SEC Rule 144a, are simply saying that they do not believe the returns from VC, even at discounted prices, will justify keeping resources in this asset class.

Finally, one of the fundamental problems in the VC industry is that there is simply too much money in the hands of too many people (some 4,800 funds) chasing too few deals. This has been the case for at least 10 years. There are simply not that many worthy business ideas out there, and the current VC business model, which is primarily an old boy network at the top, does not work in reaching worthy ideas and teams that are not connected. As a result, funds have stretched to back crazier and crazier concepts.

It is not clear to me how much should be returned to investors, but the VC industry as a whole may be as much as 50 percent or more over funded. These excess funds should be returned to investors, as Charles River Ventures did a few years ago.

But, the fact is that a small team of VC managers can become fat cats simply off of the annual management fees from a sizable VC fund. For example, 2 percent on $1 billion is $20 per year to keep the lights on, fund routine operating expenses, and so on. If these add up to even as much as $1.5 million, which would be lavish, it leaves $18 million to be divided up by the partners. Deal costs? These are always crammed down on to the funded companies. Then, the fund managers can stand by to peel off 20 percent of the gains, if they ever come in, while having absolutely no personal liability or skin in the game save small investments that most fund agreements require managers to take.

Back here in the east, institutional investors began a few years back to realize that this is a sucker's game for them. Some shifted over to LBO funds, but that, too, is a short term expedient form of investing.

In short, with the fundamentals now shakey, and with the prospects of yet more asset devaluations in VC and private equity portfolios, a prudent institutional investors would put this kind of asset on the block. They are doing so now. Same goes for other private equity funds. Dumping private equity investments by Harvard Management Company, which manages the Harvard University endowment is another example of institutional managers concluding that the low hanging fruit is gone, and that the asset class has a dramatically poorer outlook.

As for the VC, LBO and private equity funds whose shares are getting hammered, well, it couldn't be happening to a nicer bunch of people. For at least the past two decades, this form of investing has added relatively little economic value, and like Wall Street investment banks, it has enriched a few people in way that would make Gecko envious.

The outlook for VC investing is bleak. No one knows what the next great thing will be. (Great things in the past were the computer, software, telecommunications, health care, the LBO financial engineering model, etc.) Too much capital chasing too few deals. Shaky fundamentals.

Time to dump, protect capital from further principal losses, and move on.

2008 Nov 15 09:51 AM

[goldenhinde:]

of course no one knows what the next great thing will be. However, a contrarian view is that there has NEVER been a better time to invest in American innovation. There are big hairy problems that must be fixed and the United States, right or wrong is one of the only places on the planet where it they can be fixed.

Venture funds will not move overseas because no one who has cash will innovate and let them it. The Arabs don't innovate. The Russians - yeah right. The Chinesse don't need our money so the impact of US centric VC firms will be minimal.

There is no other place. WE are it and therefore we had better get to work or our kids are screwed (more than we've already screwed them).

2008 Nov 15 02:02 PM

[mikefarr:]

Not to be a sap, but I'd have to agree with everyone. Sure discretionary investment income will be tight for a while but this is actually the perfect storm for venture investing: there are real exciting and critical problems to solve while at the same time valuations are cheap and there are smart people in need of jobs. Would you rather have valuations skyhigh, talent expensive, and have to choose between solutions looking for a problem?

Mike

2008 Nov 15 03:43 PM