Venture Capital Bounces Back

[This post first appeared at on April 12, 2012.]

Venture capital has been getting a lot of support from politicians and the press recently, notably the passage of the JOBS (“Jump-start Our Business Start-ups”) Act. A key provision, much mentioned by President Obama, lets Joe Ordinary become a venture capital investor via legalization of Crowd Funding (more).

Active Venture Funds & Capital Commitments; Source: NVCA yearbook.

It’s ironic that just as the barriers for small investors have been lowered, the large institutional investors have been backing away from venture capital. As the chart shows, the amount of money committed to venture capital funds in the U.S. (most of which comes from institutions) and the number of funds making active investments have shrunk by about half in the last five years.

Institutions invest by the numbers, which leads to a focus on the past. The average return on venture capital investments for the past ten years, a common institutional benchmark, has been pathetic:  2%-3% per year. By comparison, liquid public equities returned 5%-7% and buy-out funds returned 8%-9%. Creating new businesses may be more politically popular, but investing in old businesses has paid investors better (1).

The good news is, venture capital is bouncing back, pushed by several forces:

1.  The U.S. innovation sector is performing well. Smart phones, the cloud, and the good old web are clearly the most powerful innovation platform the world has ever seen. Flash commerce, daily deals, new forms of media, digital advertising technology, social networking, and mobile and casual gaming are just some of the major innovation categories that have become important in the last five years.

Number of Exits of Venture-Backed Companies; Source: NVCA

2.  Exits have come back in both quantity and quality. Pandora, Zynga, GroupOn, and LinkedIn are examples of recent high-profile exits, with Twitter and Facebook (the mother of all venture exits) in the pipeline. Total venture exits are up by close to 2x from the doldrums of 2008 and 2oo9.

3.  New software methods, cloud infrastructure, and marketing via app stores and social networks have shrunk the cost of building a new software company versus ten years ago. As a result, many more are started, with many failures, but an increasing number of successes, too.

Venture capital certainly has its challenges. Current success is very concentrated in a narrow range of market segments (social/local/mobile and deal businesses like GroupOn) and geographies (Silicon Valley, New York, and Boston). In too many cases investors are trying to do the same thing: invest in the same kinds of deals, pile into the same funds, etc. Usually that is a recipe for disappointment. Venture capital has always been a hit-driven business, however, I think the industry will be stronger when it is hitting on more cylinders.

Last Decade VC Returns By 2-Year Intervals; Source: Cambridge Associates

Venture capital returns are coming back, however, and the data shows that this has been developing steadily over the last eight years. The chart at right divides the ten-year venture return into five two-year periods (the ten-year return cited above is the geometric average of these returns (2)).

Venture capital returns took a huge hit in 2001-2003, when the tech bubble collapsed — investors lost 40%  in two years. Since then the industry has been recovering, and the severe 2008-2009 financial crisis produced only a small dip. Absent the financial crisis, returns have been in the 12%-16% range.

Half the supply of venture capital has disappeared since 2006. The cost of starting businesses is way down. Exits have rebounded, and the “IPO On-Ramp” provisions of the JOBS Act promise further upside. Fundamentally, the prospects for Venture Capital investment look very bright. I’m looking forward to the next few years very much.

(1) Data sources: Prequin & Cambridge Associates.

(2) See:

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