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The SuperSizing of VC Funds
Bill Burnham has a great post on his blog called Are VC Funds Getting Too Big For Their Own Good? in which he also makes reference to an equally good discussion by Peter Rip of Leapfrog Ventures titled Traditional Venture Capital Sure Seems Broken - It’s About Time.
Bill and Peter contribute to an ongoing discussion in the VC industry that has been building since the bubble burst. Not surprisingly, at Flywheel we’ve been espousing similar views for years.
The gist of the problem in my view is that the total amount of liquidity available for the total universe of venture capital startups being funded by the total industry of venture capital firms is just plain too small for the math to work. Others have made the economic argument so I won’t re-iterate it here. Given this, one would expect a rational free market economy to adjust relatively quickly by decreasing the supply of capital available to VC firms, forcing smaller fund sizes, etc. until the problem is resolved. In fact, this started to happen during 2001-2003, but it quickly leveled off. Why?
I believe that the driver of the supply of capital for VC funds from the LP world has to do with a global savings glut being driven in part by increasing trade surpluses in emerging economies. The central banks of China and a dozen other nations are increasingly managing large excess amounts of dollars, and a lack of domestic capacity for low-risk, long-term investments in their own markets (i.e., the capital markets and accompanying investment vehicles are still largely dominated by Western nations - at least for now).
As a result, the excess worldwide savings continue to flow into U.S. treasuries and similar markets, holding the long-term bond yield curve much flatter than a traditional USA-centric view of economics would predict. I.e. the global demand for U.S. long-term investments exceeds the supply, which keeps yields artificially low relative to other economic activity that traditionally affects interest rates. This, coupled with the relatively tepid performance of public equity markets in the U.S., has forced institutional investors around the world who are searching for better returns to push investments into alternative classes. Hence, the rapid rise in private equity, hedge funds, venture capital, as well as specialty asset classes like timber.
Put another way, if the best returns that investors can expect for relatively low risk are likely to be in the 5-8% range over the next decade (a fairly consistent forecast of various economists I have talked with), then they are likely to accept the prospect of returns from alternative asset classes in the 10-15% range instead of the traditional 20%+. (Disclaimer: I’m not an economist and so these statements merely reflect a summary of what I think I’ve heard from people who are).
All of which suggests, of course, that in some sense the capital markets are indeed working, and the larger VC fund sizes are a natural response to the needs of global institutional investors who need vehicles that promise higher yield. (Emphasis, of course, is on the word “promise”).
Fine and dandy, except for the impact large VC fund size has on seed and early-stage VC investing. Much research has shown that the pace of innovation (and hence the number of new viable innovations suitable for company-building) is relatively inelastic vis-a-vis macroeconomic conditions. In other words, just because there is an excess in size and number of venture capital investors, does not mean that there will be a corresponding rise in the number of viable startup investment opportunities to absorb the excess capital.
Coupled with the length of time it takes to train and grow experienced venture capital personnel (which exceeds the time constant of most economic cycles), the industry now finds itself with a large number of medium-to-large-sized VC firms, growing rapidly in assets under management, all looking to fund essentially the same number of viable startups with essentially the same number of VC investment personnel. No wonder deal sizes and valuations go up.
On the flip side, this is precisely why we think it is an attractive time to be a small, seed- and early-stage VC investor. At exactly the time one would predict that more VC competitors would be arriving at the table to put down seed- and early-stage bets, instead we continue to see relatively little VC interest in deals requiring $500k-$1M in funding. It just doesn’t “move the needle” for our increasingly larger brethen. That’s great for us, because it means that we can focus on what we do best: partnering with entrepreneurs using innovative technologies to build real businesses that solve real problems and generate real cash flow. Compared to many our peers in the VC industry, I believe we spend almost none of the time they do simply jockeying for position on overcrowded deal syndicates.
We founded Flywheel with a core strategy to “fish where everyone else wasn’t.” At the time, in 1999, we thought of that goal primarily with respect to our geographic choice of the Southwest / Rockies. As it turns out, while the number of VC firms has continued to grow, even in our geographic region, we continue to find ourselves largely fishing alone - only now, it is mostly the size and stage of investment that defines our little pond. And, like all good fishermen/women, we’re happy to have visitors occasionally, but at the end of the day, we won’t argue with having our favorite fishing spots largely to ourselves.